We doubt rally in Australian government bonds will unwind soon - Capital Economics
Capital Daily

We doubt rally in Australian government bonds will unwind soon

Capital Daily
Written by Thomas Mathews

We are not surprised by the big rally in Australian government bonds today and expect the 10-year yield to settle around its current level as the RBA ups its purchases.

  • Outlook for UK and euro-zone economies worsens as new restrictions are put in place
  • Euro-zone inflation data to shed some light on core rate fall in September (10.00 BST)
  • US retail sales & industrial production likely to confirm that the pace of activity growth slowed

Key Market Themes

We are not surprised by the big rally in Australian government bonds today and expect the 10-year yield to settle around its current level as the RBA ups its purchases.

A speech by RBA Governor Lowe was the trigger for falls in Australian government bond yields and the Australian dollar on Thursday, after he signalled that the RBA was open to additional monetary easing. We have been arguing for some time that the RBA was overestimating how quickly inflation would recover and would have to consider further easing before long. Indeed, this has been a key factor underpinning our forecast for lower yields on Australian government bonds this year. The market has moved towards this view recently, and seems to have interpreted Lowe’s speech as something of a confirmation of it.

That said, Lowe’s speech didn’t move the needle much on expectations for the RBA’s targets for the overnight rate and three-year yield; reductions in these have been increasingly priced in over the past few weeks. (See Chart 1 for the rate.) Instead, the action has been further along the curve, amid speculation the RBA may be considering more asset purchases.

Chart 1: Australia’s Overnight Interest Rates (%)

Sources: Bloomberg, RBA, Capital Economics

The RBA’s original 3-year yield target was developed in part for consistency with its forward guidance that overnight rates would be on hold for at least that long. It could well therefore choose to ease policy further by adding something like the five-year rate to the target set, if it wanted to signal that overnight rates are likely to stay lower for even longer.

On the other hand, as Lowe noted, the 10-year yield in Australia has been quite high relative to that in other developed countries (many of whose central banks are already purchasing bonds at this tenor). And the Australian yield curve remains relatively steep. A program targeting the 10-year yield might provide the RBA with more bang for its buck.

The reaction of the market to Lowe’s speech suggests a focus on this longer tenor is seen as increasingly likely, consistent with our view that the 10-year yield will stay around its new lower level. (See Chart 2.)

Chart 2: Australian Government Bond Yields (%)

Sources: Refinitiv, Capital Economics

All that said, we don’t expect any upcoming easing will halt the advance of the Australian dollar for long. We think it will probably continue to appreciate against the US dollar in coming years, supported by an ongoing improvement in the global economy, particularly in China, and a related increase in risk appetite (see here).(Thomas Mathews)

Selected Data & Events

BST

Previous*

Median*

CE Forecast*

Fri 16th

EZ

CPI (Sep, EU Harm., Final)

10.00

+0.3%(-0.3%)p

+0.1%(-0.3%)

+0.3%(-0.3%)

US

Retail Sales (Sep)

13.30

+0.6%

+0.7%

+0.8%

US

Uni. of Mich. Consumer Confidence (Oct, Prov.)

15.00

80.4

80.0

80.5

*m/m(y/y) unless otherwise stated; p = provisional

Key Data & Events

US

We wouldn’t read too much into the reported rise in initial jobless claims last week given that the series is currently being distorted by data-processing problems in California, owning to the huge backlog of claims there. Most other data, including the latest regional manufacturing surveys for October suggest that the economic recovery has continued.

The retail sales and industrial production data due on Friday are likely to confirm that the pace of activity growth slowed further in September, although GDP still appears to have rebounded by close to 30% annualised over the third quarter as a whole. Meanwhile, the University of Michigan consumer confidence index should reveal whether the renewed upturn in virus cases in the Midwest, or the looming Presidential election, are having much impact on sentiment. (Andrew Hunter)

Europe

With the virus spreading rapidly, euro-zone governments are ramping up their containment measures. For example, France’s President Macron announced a new 9pm-6am curfew for nine major cities on Wednesday evening. The new restrictions have been, and we suspect will continue to be, more targeted, regional and time-specific than those imposed during the first wave of the pandemic this spring. But they are still likely to cause a new contraction in the services sectors of many euro-zone economies in the coming months.

In the UK the announcement that London and some other regions will be designated as COVID-19 Tier 2 areas, which prohibits people who don’t live together from meeting indoors, marks yet another tightening in restrictions. We don’t think that GDP will rise at all in October, November or December given the resurgence of the virus and the restrictions now in place. And the risk is that the government has to go further, which would cause GDP to fall back.

Meanwhile, EU leaders discussed progress on the UK-EU Free Trade Agreement negotiations at the European Council summit. A deal isn’t expected to be announced, but both the UK and the EU seem likely to judge that they are close enough to continue with talks in the hope that a deal can be reached in the next fortnight.

On the data front, we expect final euro-zone inflation data for September to shed some light into what caused the further drop in the core rate. (Melanie Debono & Andrew Wishart)

Other Developed Markets

In Canada, we think that manufacturing sales declined by 2.0% m/m in August. But the large rise in freight volumes carried in September, as well as the positive message from the business surveys, bodes well for a quick rebound.

Meanwhile, the drop in Australia’s employment in September was largely due to weakness in Victoria. As restrictions ease there, we expect the unemployment rate to fall again in the coming months. Meanwhile, RBA governor Phillip Lowe gave a speech today which gave hints supporting our long-held view that the RBA will step up its asset purchases before long. (See Key Market Themes.) (Stephen Brown & Ben Udy)

China

Headline consumer price inflation continued its decline in September. But core consumer prices rose again for the second straight month and factory gate prices continued to edge up on the back of the ongoing improvement in economic activity. Looking ahead, with infrastructure-led stimulus still being ramped up and consumption rebounding, demand-side pressures on prices will probably strengthen in the coming months, pushing up underlying inflation. But the rebound in core consumer price inflation will still leave it relatively subdued and food price inflation looks likely to drop back further in the near term. All this suggests that inflation is unlikely to be a major driver of policy decisions in the coming quarters. (Sheana Yue)

Other Emerging Markets

In Emerging Asia, the renewed risk of domestic political unrest in Thailand following the declaration of a “severe” state of emergency could act as a further drag on the already beleaguered economy. Student-led protests have re-erupted since July and are calling for the resignation of the prime minister and curbs on the power of the monarchy. Following a contraction of 7.5% this year, we think GDP will grow by 6.0% in 2021, but the uncertain political outlook means the risks to our forecast are firmly to the downside.

In Latin America, Chile’s central bank is likely to keep its policy rate at 0.50% at its meeting later today, and we expect it to keep an accommodative monetary stance through 2022.

In the Middle East and North Africa, Saudi Arabia’s headline inflation slowed from a nine-year high of 6.2% y/y in August to 5.7% y/y in September on the back of easing food price pressures and a sharp decline in education inflation as primary and secondary schools reduced tuition fees. The effect from the tripling of the VAT rate, from 5% to 15% in July will continue to dominate and keep inflation elevated until the middle of next year. But as austerity weighs on demand, underlying price pressures are likely to weaken. (See here.)

In Sub-Saharan Africa, the rise in inflation in Nigeria, from 13.2% y/y in August to 13.7% y/y in September, will probably be followed by similarly high inflation readings in the coming months. We think that the central bank will keep its policy rate on hold at the upcoming November MPC meeting, but deliver further rate cuts in early 2021 to prop up the economy. (Alex Holmes, Nikhil Sanghani, James Swanston & Virág Fórizs)

Published at 16.33 BST 15th October 2020.

Editor: John Higgins

john.higgins@capitaleconomics.com

Enquiries: Oliver Byrne

oliver.byrne@capitaleconomics.com