Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 278

The impact of negative Australian versus US rate spreads

Australian sovereign bond yields have typically traded above many global counterparts, particularly those in the US. This has reflected a number of fundamental factors, including Australia’s higher long-term average economic growth and inflation. Australia's inflation target of between 2.0% and 3.0% per annum is slightly higher than the Federal Reserve's 2.0%. Higher Commonwealth Government Securities (CGS) yields have also arguably reflected Australia’s higher term premium, given the economy is relatively small and largely influenced by commodity exports.

A reversal of historical norms

Accordingly, the Australian economy can be susceptible to fluctuating fortunes. The current desynchronised global growth environment, in which the Australian economy is lagging the US, has seen a reversal in this historical relativity. The spread between Australian and US 10-year sovereign bond yields has moved materially into negative territory for the first time in over 30 years, although CGS spreads relative to German bunds, UK gilts and Japanese government bonds are little changed this year. This raises questions over the sustainability of this negative spread and, in turn, whether it might affect offshore demand for Australian bonds in the future.

An additional issue is the impact of front end interest rate differentials on hedged returns. Historically, hedged exposures have been the norm, but in a world of negative returns from hedging, this default setting needs revisiting.

The sustainability of negative Australian versus US spreads

From a fundamental economic perspective, most would argue that equilibrium interest rates in Australia should be somewhat higher than those in the major G3 countries. A medium-term view of the key drivers of 10-year yields – potential growth, long run inflation outcomes, and term premia – are all consistent with higher yields locally. Consider:

  • Australia’s population growth rate (through both natural increases and immigration) remains higher than in the US.
  • Productivity has been higher in Australia than the US historically, and while this is less certain going forward, the balance of risks remains skewed towards higher Australian outcomes.
  • The inflation target is higher than in the US, Europe and Japan.
  • As a small open economy, Australia is subject to volatility in domestic and external demand so term premia should be structurally higher for Australia than other markets.

Notwithstanding, Australia’s sustained economic prosperity and credit rating stability has historically supported demand for Australian paper, particularly against a background of sub-par economic outcomes, deteriorating fiscal positions and declining credit quality globally. Indeed, Australian CGS have become a core diversifying holding for many central banks, sovereign wealth funds and other large institutional investors worldwide. The case for diversifying into Australia in such an environment is a logical one from a default risk perspective, and makes even more sense when there’s also a clear return benefit in making the allocation.

Although the return advantage of Australian bonds has been removed, the diversification benefits remain, particularly when considered against Japanese and European alternatives. We believe demand for Australian paper will persist, potentially allowing local yields to trade below comparable US Treasuries for sustained periods of time, albeit with an average ‘over the cycle’ profile that continues to show a positive spread relative to the US.

Short end differentials and implications for hedging

Front end (cash and money market) rates have also recently fallen below their US equivalents. With the Federal Reserve committed to a path of monetary policy tightening while the Reserve Bank of Australia (RBA) is expected to keep local rates unchanged for an extended period, this differential could widen further and persist for an extended period of time.

This environment represents a different dynamic from a hedging perspective for AUD-based global fixed income investors. Historically, hedging global fixed income exposures back to AUD provided a higher yield and lower volatility in total returns. However, there is now a distinct trade-off between return and volatility, on at least part of the portfolio.

Hedging policy considerations must factor in expected total returns of a hedged exposure, as well as the hedging costs themselves. We believe Australian investors will continue to favour hedged offshore exposures due to:

  • The diversity benefit that global fixed income provides, and
  • The continued positive hedge benefits from the non-US elements of these exposures.

Where specific US-only exposures are included, hedging appears likely to remain the default option to help mitigate the potential portfolio impact of currency volatility. Overarching currency views, as well as a focus on the forces that may influence them beyond interest rate differentials, will undoubtedly continue to drive hedging decisions.

Could persistent negative spreads have long-term implications for Australia?

We do not believe negative spreads alone will have any significant adverse impacts on Australia, or on the domestic bond market in general. Supported by AAA ratings, lower rates are favourable for the Commonwealth Government and state issuers from a cost perspective. They also reflect confidence among the international investment community in Australia’s long-term economic prospects. Lower rates might also be expected to be supportive of domestic economic activity and should make it more comfortable to fund current account deficits.

Perhaps a more interesting question is whether the RBA could miss out on participating in a global rate hiking cycle altogether and, in turn, what risks this might present over time.

The RBA continues to suggest the next move in domestic rates will be upward. But with inflationary forces under control and with lenders increasing variable mortgage rates independently of moves in official policy, we are unlikely to see a rate hike in Australia in the foreseeable future, potentially not until 2020. There’s some risk that the global interest rate cycle will have turned before domestic conditions justify an increase in Australia and the RBA could therefore miss an entire hiking cycle globally. If that were the case, with local rates staying lower for longer, current policy settings would increasingly be perceived as the norm by both fixed income investors and Australian households. In turn, this would potentially increase the vulnerability of the local economy to future rate increases, as businesses and households had structured their activity and spending based on current settings.

A balanced risk approach

Relative yield differentials and duration positioning are by no means the only drivers of performance in our fixed income strategies. To varying extents, our Australian and global fixed income portfolios maintain exposure to a wide range of alpha sources globally. Australian and US signals including rates, curve, country spreads and FX are just a subset of the return sources that are utilised globally. The ‘balanced risk’ approach employed in the management of all portfolios ensures they are constructed in a diversified manner. No individual risk position or view has the ability to dominate the return profile, increasing the likelihood of accomplishing portfolio objectives and providing investors with better risk-adjusted returns over time.

 

Stephen Cooper is the Head of Australian Fixed Income at Colonial First State Global Asset Management, a sponsor of Cuffelinks. This article is for general information only and does not consider the circumstances of any individual.

For more articles and papers from CFSGAM, please click here.

 

1 Comments
Terence Z
November 01, 2018

Great thought leadership Stephen.

 

Leave a Comment:

RELATED ARTICLES

Should equity investors fear higher bond yields?

Are debt and its servicing cost serious worries?

Why are Aussie bond yields at lowest ever?

banner

Most viewed in recent weeks

How much do you need to retire comfortably?

Two commonly asked questions are: 'How much do I need to retire' and 'How much can I afford to spend in retirement'? This is a guide to help you come up with your own numbers to suit your goals and needs.

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Latest Updates

Investment strategies

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Economy

A pullback in Australian consumer spending could last years

Australian consumers have held up remarkably well amid rising interest rates and inflation. Yet, there are increasing signs that this is turning, and the weakness in consumer spending may last years, not months.

Investment strategies

The 9 most important things I've learned about investing over 40 years

The nine lessons include there is always a cycle, the crowd gets it wrong at extremes, what you pay for an investment matters a lot, markets don’t learn, and you need to know yourself to be a good investor.

Shares

Tax-loss selling creates opportunities in these 3 ASX stocks

It's that time of year when investors sell underperforming stocks at a loss to offset capital gains from profitable investments. This tax-loss selling is creating opportunities in three quality ASX stocks.

Economy

The global baby bust

Across the globe, leaders are concerned about the fallout from declining birth rates and shrinking populations. Australia, though attractive to migrants, mirrors global birth rate declines, and faces its own challenges.

Economy

Hidden card fees and why cash should make a comeback

Australians are paying almost two billion dollars in credit and debit card fees each year and the RBA wil now probe the whole payment system. What changes are needed to ensure the system is fair and transparent?

Investment strategies

Investment bonds should be considered for retirement planning

Many Australians neglect key retirement planning tools. Investment bonds are increasingly valuable as they facilitate intergenerational wealth transfer and offer strategic tax advantages, thereby enhancing financial security.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.