Time to fear the bond steepener?

Via the excellent Damien Boey at Credit Suisse:

US Treasuries sold off aggressively overnight on upside surprises in manufacturing PMI readings for the US and China.

We are not surprised by weakness in US Treasuries, nor reflation coming out of China. After all, we are long resources stocks in our model portfolio, and have flagged the expensiveness of US bonds in recent articles, even after accounting for European sovereign risk. For further discussion, please see our recent note “The RBA’s double entendre” dated 19 March 2019.

Yet from an Australian perspective, we remain positive on bonds, and related exposures within the equity market, despite Chinese reflation. We note that:

  1. The term risk premium is negative for US Treasuries – but it is not negative for bunds, JGBs or ACGS, when we account for European sovereign risk.

2. From a cyclical perspective, strength in China is a reason for Australian bonds to sell off – but weakness in the domestic economic is a reason for them to rally. We believe that the cyclical impulses are largely offsetting, leaving impairment to the monetary transmission mechanism and its influence on the neutral rate, to be the key driver of valuation. And the commercial banks are admitting that pass through of RBA rate cuts will be quite limited from here, if only because rate cuts increase the relative cost of fixed rate deposits offering no, or low interest.

3. Our duration risk appetite measure has just fallen out of euphoric territory. The 10-year yield range between 1.8-1.9% seems to be technically important from this perspective – but whether it is resistance or support is another question entirely.

4. US retail sales growth has slowed, and surprisingly sharply. The reported slowdown in US consumption might be suspect, because the BEA has had less time to compile the data, owing to government shutdown. But if it is correct, there is a sustainability question to consider. After all, the US consumer has historically been the buyer of last resort of goods and services produced globally. For this reason, US retail sales growth leads world industrial production growth by roughly 6 months. If US retail sales growth remains sluggish, we should not expect to see much of an inventory cycle-driven recovery in world growth, or trade growth. USD strength will not help matters either, because it could add to capital outflow pressure for the emerging markets, and cause global supply chains to shorten on tighter trade financing conditions.

So while we can see a tactical case for bonds to sell, we do not see a lasting case for weakness. Today’s RBA announcement could support bonds, if there are any dovish leanings in the commentary. On the other hand, fiscal stimulus in tonight’s budget could compel the ALP to better or match the LNP’s plans, alleviating some of the pressure on the RBA to cut, if the stimulus is material enough. The short-term outlook for bonds is admittedly fluid, given the prevailing event risks. But the longer-term down-trend in yields still appears to be intact, given the deadly combination of sharply slowing domestic growth and impaired transmission.

As an interesting aside, one of the most powerful leading indicators of the slope of the Australian real yield curve in recent years has been the CBA composite PMI. The history of the PMI is quite short, and so we need to be wary of overfitting. If historical relationships are any guide, the curve could steepen a little, to levels consistent with the PMI from a few months ago. But given that the PMI has stalled more recently, we should expect to see more curve inversion longer term.

As for commodities, our positive view has been driven less by cyclical dynamics, and more by financial demand:

  1. Real commodity prices are not far off long-run average levels, making commodities as an asset class surprisingly attractive relative to other alternatives, like equities, bonds, credit or property, which are priced far more expensively.
  2. We also note that US pipeline inflation pressure remains elevated, supporting the demand for commodities as an inflation hedge. The New York Fed’s leading indicator of underlying inflation points to stubbornly high inflation pressure to come, notwithstanding short term slowing in activity growth.
  3. For a few quarters now, we have witnessed re-balancing of growth expectations towards emerging markets, and away from developed markets. The improvement in relative growth expectations has supported the financial demand for commodities, and resources outperformance within the Australian equity market.


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