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

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

The greatest investor you’ve never heard of

Jim Simons has achieved breathtaking returns of 62% p.a. over 33 years, a track record like no other, yet he remains little known to the public. Here’s how he’s done it, and the lessons that can be applied to our own investing.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

Latest Updates

Shares

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Property

Baby Boomer housing needs

Baby boomers will account for a third of population growth between 2024 and 2029, making this generation the biggest age-related growth sector over this period. They will shape the housing market with their unique preferences.

SMSF strategies

Meg on SMSFs: When the first member of a couple dies

The surviving spouse has a lot to think about when a member of an SMSF dies. While it pays to understand the options quickly, often they’re best served by moving a little more slowly before making final decisions.

Shares

Small caps are compelling but not for the reasons you might think...

Your author prematurely advocated investing in small caps almost 12 months ago. Since then, the investment landscape has changed, and there are even more reasons to believe small caps are likely to outperform going forward.

Taxation

The mixed fortunes of tax reform in Australia, part 2

Since Federation, reforms to our tax system have proven difficult. Yet they're too important to leave in the too-hard basket, and here's a look at the key ingredients that make a tax reform exercise work, or not.

Investment strategies

8 ways that AI will impact how we invest

AI is affecting ever expanding fields of human activity, and the way we invest is no exception. Here's how investors, advisors and investment managers can better prepare to manage the opportunities and risks that come with AI.

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.