Global divergence: What will it take for bond yields to move higher?
The European Central Bank (ECB) and Bank of Japan (BoJ) are lowering cash rates or easing monetary policy at a time when the US Federal Reserve is gradually edging towards raising rates.
Global divergence: US / Europe and Japan
The story of 2014 was a divergence in growth opening up amongst the key developed economies. The weakness in Europe and Japan brought renewed economic stimulus in the form of monetary easing. The outlook for 2015 will be determined by the extent to which easing monetary conditions bring about a coordinated period of stronger global growth.
US: Towards the end of 2014, as the labour market gained strength, The Federal Open Market Committee (FOMC) ended its program of steadily purchasing government bonds to support mortgage markets and promote a stronger economic recovery. Despite benign wage growth and early signs that the lower oil price is exerting downward pressure on core inflation, the FOMC is expected to raise interest rates, possibly towards the second half of the year.
Europe: Core inflation became uncomfortably low and inflation expectations were falling in the Eurozone before the dramatic slump in the price of oil. As a result, the ECB stepped up its easing efforts in 2014 with interest rate cuts, including the introduction of a negative deposit rate. More recently, the ECB announced plans to make purchases of 60 billion euros per month until at least September 2016. It will be expecting the expansion of the monetary base, lower yields and greater liquidity support for asset prices to all contribute to stronger credit and GDP growth.
Japan: From a policy perspective, the BoJ has committed to purchasing more short-term and long-term government bonds. It has also been supplying loan funds to stimulate commercial banks’ lending to the private sector. Recently, the BoJ voted to continue implementing money market operations so that the monetary base (supply of money) will increase at an annual pace of ¥80 trillion. The decision, which was in line with market expectations, is aimed at meeting the BoJ’s inflation target of 2.0%.
What does this mean for Australia?
Worries about deflation and negative yields in many parts of the world have seen an increasing demand for safe income yielding assets, particularly as populations in developed countries age. As a result, yields in ‘safe’ high yielding countries like Australia are being pushed towards convergence with low yielding countries by global investors chasing yield. While valuations are becoming increasingly expensive, the overall repricing of inflationary expectations globally has provided persistent support for the bond market.
The key unknown for Australia is China. China is suffering from ongoing excess capacity and this means global bond prices will stay very low. It also means an ongoing weak outlook for Australian exports and the terms of trade. Easy policy from the Reserve Bank of Australia will be needed to facilitate the rebalancing of the Australian economy away from a reliance on mining investment.
A pick-up in growth will likely see bond yields rise
Collapsing oil prices and sluggish growth are helping keep inflation low and stoking deflation fears. This has led to a period of extremely low interest rates globally. In the short-term, we expect government bond markets (and hence base yields) to remain somewhat supported due to central bank activity and the absence of a pick-up in inflation. This will see spreads for corporate bonds compress in this continued ‘search for yield’ environment. In the medium to longer-term, we continue to believe that a growth rebound in major developed economies will lead to a gradual move higher in bond yields, which means that prices are expected to fall.
1A country’s central bank is responsible for monetary policy. Monetary policy involves setting the interest rate on overnight loans in the money market (the cash rate). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term.