Up up but not away

Given the collapse in most assets’ price volatility this year, it has been a relatively volatile few weeks in the Australian Bond market. The market has oscillated from pricing an easing as the next move by the Reserve Bank of Australia (RBA) to almost two hikes over the next two years. In that context and given the importance of the RBA policy rate on the bond market, we thought it would be beneficial to discuss our current view on the outlook for Australian monetary policy.

The shift in market expectations from easing to tightening, started on the 18th July, when the minutes from the RBA’s July Monetary Policy Meeting were released. In the minutes, in the section Considerations for Monetary Policy, two paragraphs, which discussed the neutral real interest rate for Australia, stood out. In summary the discussion centred on the fact that since the Global Financial Crisis the neutral interest rate had fallen by around 1.5% and that equated to a neutral policy rate of 3.5%. Given that the current policy rate is 1.5% and the placement of the discussion in the minutes, the market took this message to be rather hawkish and that the RBA was trying to signal how easy the current policy stance was. The market reacted and bonds sold off approximately 20 bps across the curve, whilst the AUD jumped to a yearly high of over 80 cents to the USD.

The RBA deputy governor and governor in subsequent speeches following the minutes used their opportunities to talk rate hike expectations down and hopefully the AUD as well. They firmly said that the focus on the neutral policy in the minutes was an educational discussion for the board and had no meaning on the direction of the policy rate in the short term.

Then, on Friday 4th August the RBA published their quarterly forecast update in the Statement of Monetary Policy (SOMP). The SOMP confirmed, that the RBA is more comfortable on the balance of risks in the economy’s outlook, due to improved confidence in the international backdrop, strengthening domestic sentiment and a pick-up in labour market outcomes. This has allowed the RBA to forecast a more rapid pace of growth for 2019, at the above trend pace of 3 - 4%. The Bank also seems more comfortable on the path of inflation, modestly lifting inflation profiles as it incorporates new information on the labour market and utility prices. Both of these changes were notable considering the 5% appreciation for the currency since the last forecast round in May.

RBA Forecasts

Year ended (%)
Jun 2017
Dec 2017
Jun 2018
Dec 2018
Jun 2019
Dec 2019
GDP growth
2-3
2½-3½
2¾-3¾
3-4
3-4
Unemployment rate
5.6
5-6
5-6
5-6
5-6
5-6
CPI inflation
1.9
1½- 2½
1¾-2¾
1¾-2¾
2-3
2-3
Underlying inflation
¾
1½- 2½
1½-2½
1½-2½
2-3
2-3
Year average (%)
2016/17
2017
2017/18
2018
2018/19
2019
GDP growth
2
1¾-2¾
2¼-3¼
2½-3½
2¾-3¾
2¾-3¾

Sources: Australian Bureau of statistics; RBA

From a policy perspective, the RBA’s forecast of growth lifting to well above trend in 2018 and 2019, and inflation returning to the middle of the target band in 2019 would imply that it is expecting to be raising rates probably in the second half of 2018.

Investment implications

Our view is that the hurdle to lower the policy rate further is very high, due to the financial stability concerns within the RBA given elevated house prices. Recently, the RBA has explicitly said that they would like growth a little faster and inflation a little higher but there is no point cutting rates now if it increases the risks of a housing bubble. While another cut is always a possibility, we now believe it would require a material shock and given such shocks are not part of our forecast, the next move in the policy rate is up at some stage. The timing of this move we are little less confident on, however if the economy unfolds as per the RBA’s forecasts then the middle of next year seems reasonable. What we do know with more certainty is, given the increased leverage in the Australian housing sector and the floating rate nature of the mortgage market, the next rate hiking cycle will be very slow and short. We would also probably put the neutral rate at 2.50% to 3.00% as global structural issues in the form of an aging population and high levels of debt, continue to weigh on yields and growth.

Our job as a fixed income manager is to protect our client’s capital, whilst generating an income and actively managing a fund which will provide diversification benefits to investors against other risks in their holdings. Given our view that we have probably seen the low in policy rates, we are slightly short of benchmark duration in our bond funds and still maintain an overweight to high quality corporate bonds.

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