More on the bond bloodbath

Via the excellent Damien Boey at Credit Suisse:

With bond yields rising sharply, the Australian yield curve (10-year bond yield minus cash rate) is no longer inverted. Investors have started to price out further RBA rate cuts for this year, although the expectation remains for one more cut on the balance of probabilities.

Connected with the question of how long the recent value rotation will go on for, is the question of how long central bankers will remain in easing mode. Value does well when the yield curve steepens, because curve steepening usually foreshadows a bottoming out in the growth cycle, giving investors confidence to pick up cheap cyclical exposures. At present, the expectation is for curve steepening on two fronts – higher long-term bond yields, and possibly, lower cash rates. But should the central bank decide to respond to the signal in higher bond yields, and start contemplating tightening, we could see curve flattening return more quickly, challenging value factor performance. How confident therefore, are we that the RBA will allow itself to get behind the (tightening) curve? And if they do deliberately slip behind the curve, for how long are officials happy to do this?

The fate of the housing market is clearly a factor in this choice. Recently, RBA Deputy Governor Debelle suggested that house prices were stabilizing more so than rising. This turn of phrase suggests that the alarm bells have not yet rung for Bank officials to dial up their weights on macro-prudential factors, and dial down their weights on conventional growth and inflation factors.

Some in the property industry are concerned about the lack of diversification in the construction cycle, with both residential and infrastructure work drying up at the same time. Related to this, some commentators are concerned that unemployment will rise materially as the construction downturn really manifests itself, and higher unemployment could be a weight on housing demand (especially for first home buyers).

Interestingly, our core domestic demand tracker points to the sharpest contraction in activity since 1990.  This reflects the synchronized downturn in residential and infrastructure cycles, as well as subdued consumer confidence and sluggish credit growth. Our tracker is more of a “now-casting” tool than it is a forecasting tool. That said, it has historically lead actual activity growth by a quarter or so, and on this basis, there may be more bad data to come before we close out 2019. Importantly, the RBA will have to deal with the negative data flow, even if it has more hawkish convictions. In our view, weak data is likely to keep the RBA on the sidelines for quite some time. Indeed, the challenge will be for Bank officials to avoid the temptation to cut rates if indeed they are serious about macro-prudential factors. It will be quite some time before RBA officials start talking hawkishly.

The good news worth noting is that our activity tracker only monitors non-mining expenditure, and excludes consideration of the external sector. In other words, to gain a holistic picture of GDP, we also need to account for exports and mining capex. Timely and leading indicators of these variables are looking up. Iron ore and coal export volumes are rising, while mining profits and sentiment towards emerging markets have lifted sufficiently to support the outlook for mining capex. To be sure, mining capex is feeling the hangover of overinvestment during the China boom years and may therefore experience a subdued recovery relative to past cycles. But the good news Is that the fundamentals are in place for recovery. Indeed, mining capex has now registered two consecutive quarters of growth.

All of this will not be enough to hold up GDP growth at or above a trend pace. But when we throw into the mix very strong, and accelerating population growth, as well as the possibility of fiscal stimulus, the likelihood is that the economy continues to experience moderate growth, rather than outright recession. This outlook is good enough to support a rise in bond yields for now from such overbought levels, even if it does not stop the RBA from easing further in the short term.

That will very much depend on the external environment. Here the RBA still has several cuts ahead and yields will fall, all else equal.

David Llewellyn-Smith
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