Rates strategists look ahead

In January 2020, KangaNews convened its annual roundtable of Australian major-bank rates strategists to discuss the outlook for the local government-sector bond market. There is a degree of confidence in the outlook for bond performance. Immediate ends to Australia’s sluggish growth profile and dovish rates outlook are less likely.

PARTICIPANTS

Damien McColough Head of Australian Dollar Rates Strategy WESTPAC INSTITUTIONAL BANK
David Plank Head of Australian Economics ANZ

Alex Stanley Senior Interest Rate Strategist NATIONAL AUSTRALIA BANK
Martin Whetton Executive Director and Head of Bond and Interest Rate Strategy COMMONWEALTH BANK OF AUSTRALIA

MODERATOR

Laurence Davison Head of Content and Editor KANGANEWS

AUSTRALIAN MACRO CONDITIONS

Davison The prevailing theme in the Australian market over the last 18 months or so has been the evaporation of rate-hike expectations. Indeed, the prospect of QE is now firmly on the agenda as the Reserve Bank of Australia (RBA) approaches its lower bound for the cash rate. What outlooks for monetary policy in 2020 do strategists have at the start of the new year?

MCCOLOUGH We are anticipating two further rate cuts, in April and August, to reach the effective lower bound of 0.25 per cent. We are pretty comfortable with our view that the RBA will have to do more.

This is based in part on the fact that we have a completely opposite view to the reserve bank on unemployment, which we think will rise to 5.6 per cent during 2020. We also have a significantly weaker view on business investment, dwelling construction and consumer spending than the RBA is forecasting.

STANLEY We look for the RBA to take the cash rate to its effective lower bound of 0.25 per cent this year. QE is not our base case, but it is a risk further down the track if the economy deteriorates more than we now expect.

Our conviction in further easing reflects our view the economy is moving further away from the targets that the RBA has set. Growth will remain below trend, while we think the RBA is too optimistic in its unemployment and inflation forecasts.

We do not expect much in the way of fiscal-policy support, although this is something that could have a significant bearing on outcomes for rates.

PLANK I can add to the consensus in the room that the RBA will go to the effective lower bound. The uncertainty is around when this will happen. But we think by the end of the third quarter, if not sooner, the cash rate will be at 0.25 per cent.

We also take the view that the RBA is being optimistic in its forecasting. We don’t think growth will be strong enough to reduce unemployment in the absence of further rate cuts. But we do take the view that trend growth is quite a bit lower than the RBA, federal Treasury and market believe. This means it will take less growth than many expect to get unemployment onto a downward path.

We don’t anticipate QE. We believe the hurdle for QE is very, very high for the RBA. The governor has already made clear that QE is something the RBA would deploy only in a crisis – that it is not a natural progression of monetary policy. Even if QE did eventuate, our feeling is that it would be at least a year after the last rate cut, unless there was a negative shock.

WHETTON We also think two cuts are coming, in April and August – and we agree that the timing of the next cut will depend on what happens in the labour market. The most recent print being firmer suggests the RBA can wait a little.

The fiscal side is probably more important, though. The government has been committed to surplus this year, but we will be interested to see whether the impact of bushfires and now coronavirus provides sufficient cover for that commitment to be wound back. It’s a political consideration, but there might be scope for the government to say consumption has weakened as a result of the disaster and it is for the greater good to spend a bit more money.

The states have already started spending more and we have to ask what capacity they have to increase this. They already have quite large borrowing programmes and there is some limit coming from how we think the rating agencies might view further growth in borrowing. This applies mainly to New South Wales (NSW).

A federal response is what’s needed, and this may mean a delay to delivery of fiscal surplus. On the other hand, we don’t see a massive fiscal disbursement as likely, because the government won’t want to damage its prospects of surplus for a year hence.

MCCOLOUGH We actually do have QE in our base case – starting some time after the last rate cut. The main reason for our different outlook is that we think global growth will be weak. For instance, we have three US Federal Reserve (Fed) rate cuts in our forecast.

Our view is that the RBA needs to get bang for its buck in the transmission mechanism through the currency. It will be up against competing influences globally and will not want to lose the impact of rate cuts.

PLANK I agree that the global backdrop will be important, though we don’t have Fed rate cuts in our outlook so we don’t think the RBA will have to overachieve with the currency. I suspect that, if we did see cuts in the US, the likelihood of QE in Australia would be different. Even so, I wouldn’t downplay the mental gymnastics the RBA would have to complete to get from cutting rates to QE.

MCCOLOUGH I agree that the RBA isn’t keen on QE. It’s just a case of whether conditions will force its hand.

"We are starting to see early signs of the wealth effect from housing coming through in motor vehicles, though we are not seeing it in other sectors. Wages have not grown anything like we might have expected by this point in the employment cycle."

Davison The efficacy of rate cuts seems to have been limited so far. Australia is undergoing an apparent property revival and the equity market is strong, but there is still very little wages growth or private-sector investment, and household confidence remains low. Do these circumstances depict a cyclical slowdown or a more structural change?

WHETTON We are starting to see very early signs of the wealth effect from housing coming through in motor vehicles, though we are not seeing it in other sectors. It comes down to wages, which have not grown anywhere near as much as we might have expected by this point in the employment cycle. The debt-to-income ratio is still really high in Australia, too – households are tapped out.

STANLEY The big underlying issue here is slow wages growth. Households have come to expect slow wages growth to persist and they have constrained their spending plans. The result of weaker income growth and high debt levels can clearly be seen in the distribution of spending growth, which has been concentrated in essential, rather than discretionary, items.

PLANK We can’t prove the counterfactual. It’s easy to say monetary policy isn’t working but we have no way of knowing where we would be if the RBA hadn’t cut.

At the same time, although we have seen house prices recovering they are still below peak levels. There is still a negative wealth effect from housing, in other words – though this probably won’t be around for much longer.

Consumer-confidence surveys consistently indicate a disconnect between how people feel about their own finances – which essentially are at a record high – and the economic environment. This divergence is of a record scale and it reduces the efficacy of monetary policy. I think this comes down to a whole range of factors, including digital disruption, trade tension and domestic policy uncertainty.

Historically, economic negativity tends to fade provided employment holds up. Households have built up quite a buffer in their borrowing so confidence could improve if we get a continued wealth effect from housing and shares, and employment holds up – which is the biggest question mark. It’s more a hope than a central possibility for us, though.

STANLEY I agree that we could also see confidence come through from the housing market.

Davison The information from the states suggests that housing turnover has stayed relatively low even as prices have rebounded.

PLANK NSW is starting to pick up, or at least turnover has been revised upwards relative to forecasts.

Davison There seemed to be early positive signs in the household sector after tax cuts in 2019, but these faded fast. Why wasn’t there a longer boost to confidence and spending?

WHETTON You’re right, signs of confidence faded inside two months. Our modelling suggests 60 per cent of a lump-sum rebate gets spent almost immediately. This was offset by negative rate movement on deposits and a rapid increase in unemployment fears.

These circumstances pretty much continued through the second half of 2019. All the numbers suggested a pick up in consumer activity around Black Friday, but it seems largely to have been spending brought forward: the data so far suggest 2019 had a really poor December for retail sales.

STANLEY It’s not that unusual for consumer sentiment to remain quite weak during rate cuts. It takes a bit of time for this – and any other stimulus – to have the desired impact.

MCCOLOUGH The really interesting thing we found in the consumer data is how many survey respondents didn’t know about the tax offset. They couldn’t say how much it was going to be or whether or not they had already received it. It came through as a net figure in refundable tax – which is much less visible than we might assume.

Davison Going back to the issue of cyclical versus structural influences, the RBA has revised the nonaccelerating inflation rate of unemployment (NAIRU) down to 4.5 per cent from 5.25 per cent a few years ago. Given the challenges of underemployment, does the NAIRU need to be even lower?

PLANK Our research suggests the relationship between total underutilisation – meaning slack in the labour market, which includes unemployment and underemployment – and wages has not changed. I have plenty of charts showing that wages are pretty much exactly where we expect them to be at any combined level of under- and unemployment.

What has changed is that there is now a far higher level of underemployment for any given level of unemployment. There has been a step-shift upwards in underemployment as part-time employment has grown.

MCCOLOUGH This is potentially a secular, rather than a cyclical, development.

STANLEY The global experience tells us NAIRU still works as a concept – these days it just requires a much lower level of unemployment. The US has experienced some wages growth but it needed unemployment of 4 per cent or less.

I think most market participants were sceptical of the idea that NAIRU was more than 5 per cent a few years ago. We see some downside risk to the RBA’s current 4.5 per cent NAIRU target, too.

PLANK Over the past decade, participation in the labour market has increased in raw terms but hours worked didn’t change at all – there was no increase in GDP from extra hours worked per person.

“We can't prove the counterfactual. It's easy to say monetary policy isn't working but we have no way of knowing where we would be if the RBA hadn't cut. At the same time, while we have seen house prices recovering, they are still below peak levels."

Davison Most of the Australian states are embarking on large infrastructure spending programmes over the next few years. To what extent will these provide a de facto fiscal stimulus for the local economy?

PLANK The key point here is that we are actually past the peak in infrastructure spending. The contribution to growth from this investment continues for a long time – from things like improved transport – but we have already had the peak lift from investment.

What this means is that the government-sector contribution to GDP growth, on some projections, may actually lessen over the coming years. This is after being extremely strong for the last couple of years, however. The suggestion that governments should do more has perhaps been a bit unfair in recent times, because they were providing most of the growth. Looking forward, arguing the case for additional government support has more merit.

STANLEY Infrastructure investment is making an important contribution, but the direct impact on growth is less than the residential-construction and mining-investment booms that preceded it. On the other hand, infrastructure will deliver a longer-term productivity benefit to the economy.

Performance and relative value

Strategists say Australian bond outperformance may not be able to continue throughout 2020. But they also do not expect a dramatic spread reversal to emerge.

DAVISON We have talked for years about whether bond yields can keep tightening, yet the Australian sovereign and semi-government market continued to perform in 2019. What is the outlook for 2020?

STANLEY We are bullish on semi-government and government bonds. The starting point for yields is a lot lower in 2020 than it was a year ago so the level of returns probably won’t be what it was. We see global growth stabilising at a slower pace, rather than rebounding significantly. Global yields will, therefore, mostly be range-bound. In contrast, we see the Reserve Bank of Australia (RBA) cutting rates more than is currently priced so we expect the drivers of performance to be more domestic than global, relative to last year.

We think semi-governments spreads will grind tighter. Low rates are supportive, the market is familiar with the infrastructure-driven nature of increased bond supply and we don’t foresee ratings issues.

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GLOBAL OUTLOOK

Davison Global markets have started 2020 in dynamic fashion, with the feeling seeming to be that a lot of the previous year’s uncertainty is in the past, even if economic growth remains sluggish. What should we expect for the year ahead?

MCCOLOUGH As I have said, we are somewhat cautious on the US economy because we anticipate a slowdown in the consumer sector due to political uncertainty.

The US election is vital here – in particular the type of alternative government that may be on the table. Candidates such as Elizabeth Warren and Bernie Sanders would ensure discussion of a very different range of options in an election campaign.

We also don’t think trade tensions are resolved. It’s true that the US and China have signed a trade agreement, but we are not convinced of China’s ability to achieve everything it has promised even in phase one of the deal. We certainly think it is possible that the US will be unhappy with China’s conduct again before 2020 is over, and if this happens we could easily envisage the return of tariffs.

PLANK A lot of China’s promises are conditional.

MCCOLOUGH Absolutely. In effect, our view is that trade will be as dominant a theme in 2020 as it was in 2019 with the addition of the US election as a source of uncertainty. If further policy easing is necessary in the US, it probably will not feel the benefit until 2021.

Overall, I would characterise our global theme for 2020 as more of the same, as opposed to achieving a more benign outcome. This is why we see more downside risk than some others. But it’s marginal; for instance, we project Chinese growth at 5.8 per cent relative to a consensus of 6 per cent. This is before the impact of the coronavirus is taken into account. The impacts on Chinese and global growth intensify exponentially the longer the duration of the outbreak.

STANLEY There is stability in some of the headwinds we have been experiencing, at least compared with 3-6 months ago, though I don’t think anyone believes phase one of the US-China deal will provide a sustainable, long-run easing of tensions. Tariffs are still higher than they were historically and there remains an awful lot to deliver on.

On the other hand, one of our key assumptions is that Donald Trump will prioritise being re-elected above everything else this year. History suggests the best way not to be re-elected is to have a weak economy at the time of the election, so there is a clear political incentive to ease the rhetoric around trade.

We agree that if the Fed is going to do anything this year it will be cutting rates. The market will find it hard to price any significant risk of a hike, which makes us think that if the US Treasury 10-year yield reaches about 2 per cent it is a pretty strong buying signal.

We don’t expect central banks globally to be doing much this year. Absent any unforeseen shocks, ongoing easy policy and the flow through to financial conditions will help support stability. But we don’t expect much re-acceleration in global growth.

PLANK We also expect Chinese growth to slow to less than 6 per cent, though we have the US holding up well and don’t expect to see the Fed easing. The risks remain greater on the downside than the upside, but our base case is that the global backdrop won’t be a significant source of concern for Australia in 2020. Of course the dreadful coronavirus could change this significantly.

WHETTON The signing of a phase-one trade deal and an ebullient equity market are not the same as a recovery in business activity – it remains in the doldrums. Purchasing managers indices are all generally still pretty weak, for instance. We expect the Fed to cut twice this year as the business and consumer sectors continue to struggle. Continual tariff changes are not pro-investment. I completely agree with the point that Trump will do whatever he can to get re-elected. To us, this means the Fed put gets exercised and rates are cut.

We have a little concern that financial conditions have been tighter of late, through the repo market and flow-on effects to the cost of money. Longer-end lending is up a little bit, and if a sustainable rise in yield affects the housing market it will really weigh on the US economy. How the Fed plays its hand is going to be very important.

I’d also suggest that no-one who has ever played a game of whack-a-mole would expect nothing to pop up. Any of the concerns we have could surface at any moment, though perhaps the biggest risk is the range of candidates in the US election. The range of economic reactions is very wide.

But there are plenty of things to be aware of: the coronavirus could be a huge issue, if it significantly slows down the only area of the world that is growing at a significant pace, for instance.

Davison Are markets pricing in too much confidence in stability? Equity prices, for instance, simply don’t seem to reflect economic reality.

WHETTON This is a function of low yield. There is simply a lack of alternative yielding investments. Investors have to put their money somewhere.

STANLEY I think investors should have a healthy allocation to bonds purely as a hedge against a downturn in risk assets from current lofty levels.

MCCOLOUGH It’s interesting to me that a group of interest-rate strategists are having this discussion without once mentioning inflation. It just doesn’t seem to hold any fear anymore. It worries me a little that half the distribution profile for monetary policy appears to be off the table completely.

STANLEY There is a whole list of things that could go wrong, but an outbreak of inflation doesn’t seem a likely candidate. In this context, the distribution of risks is likely to remain skewed towards policy easing.

"Absent any unforeseen shocks, ongoing easy policy and the flow through to financial conditions will help support stability. But we don't expect much re-acceleration in global growth."

AUSTRALIAN ISSUANCE

Davison Is the market comfortable with the consequences of state borrowing profiles and debt positions?

MCCOLOUGH I think market participants are quite sanguine about this investment, because they understand that a lot of the borrowing is productive ‘good debt’.

There is a good degree of comfort with the most recent set of state debt projections, and we’re certainly not at a tipping point when it comes to marginal investor concern about funding – or at least I haven’t heard of any push back.

In effect, what the states are asking for is the continuation of a change in investor behaviour that has already happened. This is especially the case for domestic real-money investors but it applies to other investor cohorts, too.

PLANK There has never really been any notable indigestion when it comes to state treasury corporation debt and it’s hard to imagine these issuers collectively ever having a serious problem issuing what they need, except in extreme circumstances of complete market dislocation.

The issue is the price – whether the states will need to pay up for their debt. I suspect they won’t need to, in part because the currency will adjust for them if it is needed to encourage additional demand.

STANLEY There is a lot of interest in the semi-government market in how expanded debt programmes translate to spreads. I think investors and rating agencies draw comfort from the fact that the biggest growth in borrowing programmes is coming from the two states – NSW and Victoria – with the best ratings, best-performing economies and good track records for delivering operating surpluses.

More importantly, the borrowing largely reflects infrastructure investment. If the borrowing had instead reflected increases in recurrent expenditure, it would make it harder for the states to adjust to any shock to revenue or the economy. It’s the right type of debt, and the borrowing is happening in a low-rate environment. I think this provides a backstop to spreads.

PLANK The other thing is that at least some of the assets being invested in have value that could, in theory, be realised. It helps that the last round of asset recycling the states conducted seems to have played out as advertised.

WHETTON The states are also in a good position on the demand side. In part this comes from the regulated sector, where bank demand remains strong. But the Australian sovereign and semi-governments are also in a good position as positive-yielding issuers in a negative-rate world.

New buyers, domestic and offshore, continue to come into the Australian market. One thing that has helped is lower hedge costs, which is actually a positive product of Australia moving closer to the homogenous zero-rate position.

We aren’t worried about volume of supply or by the fact that the semi-governments are becoming a larger component of the market. The federal government has been reducing its borrowing over recent years and 61 per cent of new supply in 2020 is expected to come from the states – in some ways it is an offset.

PLANK Further to the point about hedge costs, I think a lot of market participants underestimated just how many global investors had never bought Australian bonds purely because of that cost relative to US dollars. A lot more are now active in our market.

WHETTON This is one area where a triple-A rating can matter. A lot of buyers that were excluded from our market but can now be active – from sectors like the global insurance space – have triple-A mandates.

"There is a good degree of comfort with the most recent set of state debt projections, and we're certainly not at a tipping point when it comes to marginal investor concern about funding - or at least i haven't heard of any push back."

Davison Are you suggesting that Australian government-sector issuers are now more appealing to global investors than they were when Australia was offering a 5 per cent yield pickup over the US?

WHETTON That was helpful, of course. But it was a long time ago and it stopped being helpful quite a while ago. It’s also worth remembering that when the yield pickup was as great as that the Australian dollar was above parity with the US dollar. That was fine if you thought it was going to go to US$1.20, but most believed US$0.60 was more likely.

PLANK The currency tends to be the biggest driver for investors that buy unhedged. The best period for unhedged buying was the early 2000s, when Australian yields were lower than the US but the currency was at US$0.50. The same investors buying then had no interest in Australian bonds with 200 basis points of additional yield to the US curve but a currency at US$1.10.

Davison The Australian states have observed a pickup in support from domestic real money over the past year or two. What has driven this?

MCCOLOUGH The trend continued throughout 2019. It has been the same demand picture from Australian banks, and the two are interrelated.

Even in the absence of balance-sheet growth, about 25 per cent of the forward issuance growth profile for the states is covered by the banks’ need to replace maturing liquid assets. This baseline demand gives a lot of comfort to real-money buyers.

I don’t expect the high-level mix of investors in the sector to shift too much, because the offshore bid seems at least to be willing to replace maturities.

STANLEY Spread volatility is quite low in the semi-government sector, which improves the attractiveness of the carry in semis relative to ACGBs [Australian Commonwealth government bonds].

PLANK I agree this is supportive, but it means investors need to be careful of events that might cause something to change. This could be a credit rating-related event or something like what we saw in 2008 with the introduction of the federal government’s credit guarantee for banks.

MCCOLOUGH This is true, but I also think the states’ financial-management credentials have increased enormously since 2008. I think they are much better set up nowadays to respond to global credit events.

WHETTON There has certainly been a lot of behavioural change. An illustration of this is maturity profiles. In the past decade, the AOFM [Australian Office of Financial Management] and the semis have all termed out their maturity profiles.

The bulk of these profiles have moved out to 7-8 year tenor, which has substantially diminished rollover risk. I’m not saying they were bad financial managers a decade ago, but they have certainly got better.