After a sharp adjustment in 2022, bond yields have been in a range trading environment since last October.
US and Australian long-bond yields are moving closely together, with little current difference in local and US 10-year yields. This is in contrast to the short (policy) end of the curve where US rates sit at a large premium to Australian rates.
As is often the case, the US bond market is proving the dominant influence on movements in long-term interest rates. Despite growing evidence of falling inflation in the United States, the US 10-year bond yield has lifted to the top of the range in recent months, which has also dragged Australian yields higher. Indeed, US yields pushed through their October 2022 highs last week to sit at 4.28% (as at August 18). Australian 10-year yields are currently identical to this figure.
Part of the move up in long-term yields in recent months is merely a readjustment from the sharp drop in yields experienced around March this year, when concerns emerged around the US banking system. This drove a flight-to-safety shift into US government bonds, with Australian yields also dropping.
While a rebound in yields from the March/April lows was not surprising, the concerted push through the 4% level in recent weeks is interesting when assessed against the recent backdrop of easing inflation and a relatively stable market expectation of an imminent peak in the Fed Funds rate. The market has priced only a 40% probability of one last rate rise this year, with multiple cuts expected next year.
The recent lift in US yields to a cycle high has several drivers in our view. We discuss these drivers and our outlook for fixed interest below.
Better-than-expected US Data Reduces Need for Bond “Recession Protection”
US economic data has been more resilient than expected both in the US and Australia. Indeed, the consensus call for a US recession to begin in Q3 2023 looks embarrassingly at odds with the Atlanta Fed’s Q3 nowcast of US GDP at 5.8%.
While this figure likely overstates the strength of the US economy, the US certainly seems a fair way from recession. As a result, while expectations of the Fed’s terminal policy rate have not moved significantly of late, there seems to be some long-term bond “recession protection” being unwound in recent weeks.
Heavy Bond Supply Has also Been an Issue for Bond Yields.
The US treasury announced large issuance intentions recently, which appeared to put upward pressure on US long-term bond yields. The US Treasury boosted the size of its quarterly bond sales for the first time in 2.5 years to help finance a surge in the budget deficit. Related to the heavy issuance pipeline was the Fitch downgrade of US debt from AAA to AA+, which also appeared to push US yields higher.
Japanese Bond Butterfly Flaps Its Wings
The tweak in Japanese monetary policy, or “yield curve control,” to allow a wider trading range for Japanese 10-year yields also appears to have caused upward pressure in most foreign bond markets, including the US and Australia. Japanese investors are typically big buyers of foreign bonds.
Bond Backup Starting to Challenge the Equity Advance
The combination of better-than-feared growth outcomes and shifting supply demand dynamics has lifted bond yields to fresh cyclical highs. The US equity market has for the most part taken the rise in bond yields in its stride, delivering strong performance over recent months. However, the recent push higher in yields in August seems to be finally weighing on the US stock-market.
We expect the US yield ascent will retrace over coming months, as evidence of easing inflation and cooling growth accumulates. This should put a floor under the current US equity correction, although next month’s inflation print may show the impact of the recent jump in oil prices.
From Australia’s perspective, the supply-demand equation for bonds appears more supportive with a Federal budget surplus. However, US correlations continue to be tight, even with Australia’s better supply-demand fundamentals.
One potential bear point for Australian bonds is that the disinflation downtrend playing out in the US does not appear to be quite as clear in Australia’s case. However, both the Reserve Bank of Australia (RBA) and the market now both appear to be coming around to the view that the RBA has done enough. This is in line with our existing view. The Q3 consumer price index (CPI) print will be important to the current view that the RBA has tightened enough, which remains our central case.
Where to for Bond Yields from here?
On balance, we see the recent US-led backup in Australian bond yields as an opportunity for domestic investors. While Australia is likely a few months behind the US in terms of the inflation cycle, we expect the disinflation trend playing out in the US to be broadly repeated here. Inflation should continue to ease. Australian growth, while avoiding a hard landing, should also slow.
At a yield of 4.28% (10 year), we see government bonds as well and truly regaining their role as a portfolio diversifier. While a 4.28% 10-year yield does not look that compelling in isolation, we expect bond yields to track the deceleration in inflation and growth over the coming year. A 50-basis point (bps) decline in yields equates to a ~3% capital gain on a domestic government bond portfolio (5 to 6 year duration), providing a total return of over 7%. If growth slows more than we expect, it would be reasonable to assume a 100 bps fall in the current 10-year. This would equate to a total return of over 10%.
Our central case is somewhere between these 2 scenarios, but the risk-return tradeoff for bonds at current levels appears attractive in our view. A touch further out the risk return curve, high quality investment grade corporate bonds are yielding around 5.5%. Arguably even more attractive is high quality floating rate credit, with an attractive spread over the 4.1% cash rate seeing yields above 6% on short-term floating rate debt. Further out the risk curve again, good quality private credit funds are offering 8-8.5%. So, putting together a core and satellite fixed income and credit portfolio, offering both attractive returns and portfolio insurance, is a much easier task than it was 12-18 months ago. We are moderately overweight fixed interest in our fund allocations.
What about Global Credit Markets?
A common question from investors is whether significant stresses could emerge in global credit markets, particularly in respect of the high yield and private credit space. With growth surprising to the upside, high yield spreads have been fairly well behaved overall. Default rates are an important influence on high yield spreads and, for now, they remain relatively low.
With spreads at or slightly below long-term averages, we do not see global high yield as offering compelling value. We expect defaults rates to rise over the coming year and pockets of stress are likely to emerge. However, in aggregate, we do not believe high yield credit will prove a major threat to the global economy such as we saw in 2008. We prefer domestic private credit over global high yield and global private credit, given our expectation of less economic risk and stronger underlying lending covenants. We continue to hold an allocation to private credit in our Alternatives allocation, supplementing our fixed interest allocations.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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