The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Tuesday, June 7, 2011

What on earth is happening to Aussie bond prices?

I might coin this question the Aussie yield curve puzzle. As the chart below shows, government bond prices (yields) are a couple of hundred basis points above (below) their pre-GFC, mining boom mark I levels. The short-end of the curve is barely pricing in one hike over the next 12 months, whereas the consensus economist expectation is that we will get 3-4. Even the RBA itself has come out and declared market pricing way off beam, showing that if it assumes two further rate hikes inflation is forecast to remain unacceptably high this year, next year, and the year after that.

What is going on? It is my belief that the Aussie yield curve is being distorted by two related influences:

(1) Excessively loose US monetary policy, which is radically reducing the yields (interest rates) available in what was once the world's reserve asset. There is a double-whammy here for foreign investors given that they are also suffering from a declining US dollar, which many believe will be a secular trend notwithstanding the likelihood of a bounce-back when US yields recover as US inflation pressures grow; and

(2) The understandable knock-on response of many large private fixed-income investors (eg, PIMCO) and foreign governments (central banks in particular) to seek to diversify away their US currency and related government bond risks. And with the US Federal Reserve prepared to step into the demand breach, this shift away from US treasuries has yet to have any price effects. Among the favoured destinations for private and public sector diversification are the Australian and Canadian commodity currencies, which give investors a liquid and tradeable exposure to Asia. This in turn means buying the government bonds of these two nations.

And since governments can hold these AAA-rated assets to maturity, they are not necessarily as concerned about capital/duration (ie, price) risks associated with a further increase in Aussie/Canadian yields. Indeed, since Aussie yields are comparatively high, and the RBA relatively close to the peak in its monetary policy cycle, investors have arguably much lower downside risk by investing in Aussie government bonds than almost any other developed country. Put differently, there are potentially big duration (or capital growth) opportunities available in Aussie government bonds over the medium-term.

While the short-end of the yield curve should be mostly influenced by probabilities around the RBA's target cash rate changes, investors typically do not price in more than two further interest rate hikes once the cash rate passes its 'neutral' level (currently believed to be around 4.5%). This is because interest rate risk is highly asymmetric: investors know that in a future crisis (eg, GFC mark II) the RBA could in theory cut the cash rate, say, 300 basis points. In contrast, it is most unlikely that the RBA would raise rates by the same margin (to be clear, that would be another 12 rate hikes!).

Combined with additional distortions in the short-end yield curve driven by (a) Australian banks placing excess capital in high-yielding 'cash' securities in the presence of extremely low credit growth, which only serves to further drive up prices, (b) the fact that speculators who have tried to short bond prices and thus benefit from rising rates have had their positions consistently blow-up in their faces care of an unusually persistent series of domestic and international crises, and (c) the close correlation between short-end interest rate futures and the benchmark 3 year government bond rate (which, as noted above, is being pushed down as a by-product of US monetary policy), I would venture that Aussie interest rate expectations are providing a bum-steer on actual RBA outcomes.

Having said that, the rolling natural and political catastrophes that we have had to contend with in the recent past have, admittedly, made market pricing look prescient.