Have Australian bond and currency markets got it wrong

Matthew Peter, Chief Economist

Hawkish sentiment among the major central banks of the US, euro area and UK over June has resulted in sharp retracement of global yields, with the US 10-year sovereign bond yield rising by 22 basis points (bps). Australian yields have followed the rise in global yields, but consistent with their status as a so-called ‘high beta’ market the Australian 10-year bond yield has risen by 37 bps compared to the US rise of 22 bps.

The reason for the high beta associated with Australian bonds is the observation that the Australian economy, through its high weight to commodity exports, is more leveraged to swings in investor sentiment towards the global economy than, say, the US economy. The transmission mechanism from the outlook for the economy to bond markets is central bank monetary policy. When the global growth outlook is improving, investors begin to expect the Australian economy to outperform and, hence, for the Reserve Bank of Australia (RBA) to raise cash rates more aggressively than central banks in economies less open to international trade, such as the US, the euro area and Japan. The opposite is the case when the global economic outlook deteriorates, when investors anticipate that the RBA will ease rates more aggressively than the Fed, ECB and BOJ.

Another feature of Australia’s status as a high beta bond market is the tendency for the Australian dollar to rally against the US dollar when global interest rates are rising and a tendency to devalue when global interest rates are falling. This reflects capital movements by investors, who will tend to seek out higher yielding Australian bonds during periods of optimism and shed Australian bonds during more uncertain times. While the high beta relationship tends to hold in bond and currency markets during typical business cycles, there are periods when the relationship breaks down. These are typically periods when the Australian economy is out of synchronisation with the global economy. A recent example of such a period was during the European debt crisis from 2010 to 2012.

During the crisis, global growth fell from 5.4% in 2010 to 3.5% in 2012 and our close trading partners in the Asia region including China and Japan also experienced sharp slowdowns in real GDP growth. As the growth in the global economy deteriorated, bond yields fell sharply, with the US 10-year yield falling by around 3 percentage points. Australian bond yield also fell during this period, but by far less than predicted by its historical beta to the US market. In addition, the Australian dollar rallied by over 15% during this period, rather than falling as predicted by the beta assumption. Of course, we know the cause of the rally in the currency and the lack of beta in bond markets was due to the impact of the mining investment boom, which caused the Australian economy to desynchronise with the global economy.

In stark contrast to the global trend, Australian real GDP growth picked up from 2.3% in 2010 to 3.7% in 2012. As we argued in last week’s brief, the Australian economy is once again entering a period of desynchronisation with the global economy. While capex spending by the mining sector created a boom in domestic demand and real GDP growth during 2010-12, balance sheet deleveraging by the household and government sectors and an end to the housing boom will constrain domestic demand over the coming two years and cause the Australian economy to underperform its global peers, even as global growth rises.

In our view, bond and currency markets are placing too much emphasis on the influence of stronger global growth and a likely spike in inflation later this year as higher energy costs feed into consumer prices. Our view is that the RBA will look though the one-off lift in inflation due to the higher cost of electricity and will keep rates on hold to assist an orderly deleveraging of debt by Australian households and governments.

In contrast, the Fed will continue to lift rates throughout 2017 and 2018. We expect the fed funds rate to rise above the RBA cash rate of 1.5% sometime in the first half of 2018 and will be the first time the fed funds rate has exceeded the cash rate in 17 years. Although Australian bond yields may rise as global rates rise, they will rise by less than US yields, not by more as the beta assumption would suggest. Consequently, the Australian dollar will fall and we expect the Aussie to retrace to around US$0.70.

Table 1: Financial market movements, 06 - 13 July 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,447.8

1.6%

US

2.34%

-2.2 bps

US Dollar Index (DXY)

95.73

-0.1%

Nikkei 225

20,099.8

0.5%

Japan

0.08%

-2.0 bps

USD-JPY

113.28

0.1%

FTSE 100

7,413.4

1.0%

UK

1.30%

-1.4 bps

GBP-USD

1.294

-0.2%

DAX

12,641.3

2.1%

Germany

0.60%

4.1 bps

EUR-USD

1.140

-0.2%

S&P/ASX 200

5,736.8

-0.4%

Australia

2.69%

4.7 bps

AUD-USD

0.773

1.9%

Source: Bloomberg


Economic Update

United States

US jobs market continues to boom, but where is the wage growth?
  • Employment growth rebounded by more than expected in June, as non-farm payrolls grew by 222,000 jobs from an upwardly revised 152,000 in May, signalling ongoing strength in the labour market. The unemployment rate edged up to 4.4% in June (from 4.3% in May), driven by an increase in the labour force participation rate, which ticked up to 62.8%. This follows a slight fall in the participation rate in May which had contributed to last month’s fall in the jobless rate.
  • Despite the strong employment data, wage growth disappointed again in June, with year-ended growth in average hourly earnings edging up only slightly from 2.4% in May to 2.5% in June. 



Euro area / United Kingdom

Euro area and UK economies continue to diverge

  • Euro area data continues to surprise on the upside, with industrial production in the region growing 1.3% in May, a stronger result than expected and the highest rate of growth in six months. Growth in industrial production was better than expected in Germany, France, Italy and Spain, the region’s four largest economies, which bodes well for Q2 GDP given that industrial production comprises almost a quarter of the euro area’s total GDP.
  • By contrast, industrial production in the UK fell below market forecasts for the fourth straight month, declining by 0.1% over the month and 0.2% from a year earlier despite expectations of slightly positive monthly and year-ended growth. The data suggest that industrial production is yet to see any material boost that might have been expected through stronger exports from a weak pound. 
  • On a more positive note, the UK’s unemployment rate fell to 4.5% in the three months to May from 4.6% in the equivalent April period, a fresh 43-year low. Weekly wages excluding bonuses were 2% higher in the three month to May over a year earlier, up from 1.7% annual growth in the three months to April. Although real wage growth has turned negative in the UK, the strong labour market is likely to put upward pressure on wages, and the BoE expects real earnings to turn positive “over the next few years”. 

China / Japan

China trade data point to robust external and domestic demand
  • China’s trade recovery continued in June, as year-ended growth in imports and exports both jumped and China’s trade surplus widened. Exports were 11.3% higher than a year earlier in US dollar terms on the back of firmer global demand, up from 8.7% growth in May. Year-ended growth in imports rose to 17.2% in June from 14.8% growth in May, suggesting robust domestic demand. Over the first half of the year, China imported 9.3% more iron ore than over the same period in 2016. China’s year-ended CPI and PPI inflation both steadied in June at 1.5% and 5.5% respectively, unchanged from May and in line with expectations.
  • In Japan, core machinery orders (an indicator of planned capital spending), surprised on the downside in May, falling by 3.6% after a decline of 3.1% in April.

Sources: Thomson Reuters, Bloomberg, FactSet, ABS.


Australia / New Zealand

Housing investor lending continues to moderate following APRA measures
  • Housing finance approvals for owner occupiers grew by 1% in May after three straight months of decline, though they were 3.5% lower than a year earlier. Housing finance for investors declined by 1.4% by value in May after a 2.5% fall in April. This is the second month of data since APRA’s macro prudential tightening announced in late March. 



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