The liquidity glut created by central banks is forcing investors across the spectrum – from reserve managers to life insurance companies – to stretch valuations even further from economic fundamentals.
Australian bonds have also been caught up in this yield-grabbing frenzy and, on some valuations, look expensive. Asian buying has been particularly prevalent, as Japanese insurers look to diversify their large JGB holdings.
That said there is no shortage of ‘bond bears’ waiting to challenge the bond market’s recent strength on stronger signals from central banks.
However, we advise caution. Given external vulnerabilities, notably a weaker Chinese economy, and Australia’s own uncertain domestic demand profile, the Reserve Bank of Australia (RBA) is likely to hold rates steady for longer than US and other major central banks.
In the central banking world of shifting doves and hawks, a firmly neutral RBA gives welcome refuge for safe-haven flows, and so we continue to prefer Australian bonds on a cross-market basis.
Turning to look at the prospects for economic growth; previous investment in production capacity should continue to support Australia’s external sector.
However, while net exports added substantially to growth in the first half of the year, we expect some moderation going forward.
Safe as houses?
The picture on the housing side is more complex. The contribution of residential construction to the economy remains elevated, as a contraction in mortgage-spreads has given investors and homebuyers access to record-low borrowing rates.
Yet the Bank appears to be increasingly monitoring the risks that the buoyant housing market may pose to wider financial stability.
Expectations that a bubble in the housing market will lead to higher interest rates in the near term appear wide of the mark however.
Instead, the RBA looks likely to focus on macro-prudential tools, including efforts to curb excessive investor finance and reinforce sound lending practices.
There are other factors at play. Specifically, the high exchange rate raises concerns around domestic demand.
An elevated Australian dollar will exert downward force on unit labour costs as the lack of external competitiveness forces greater internal competition.
For Australia, the real exchange rate remains significantly overvalued, creating difficulties for trade-sensitive sectors.
During 2014, the currency has remained stubbornly high in the face of lower interest rate differentials and declining terms of trade.
Nevertheless, like many other central banks, the RBA seems happy to wait for a shift in US Federal Reserve policy to do most of the heavy lifting.
Recent RBA minutes highlight concern around accuracy in economic forecasting, given the unusual global financial and economic environment.
Ironically, this can have the effect of bolstering belief in the RBA’s forward guidance, as improving forecasts and official data can be met with a tinge of scepticism, keeping front-end rates firmly anchored.
‘Animal spirits’ lacking
From a monetary policy perspective, the most likely scenario at present is for the RBA to examine how the mining investment cycle recedes and the non-mining investment cycle recovers.
Business investment intentions lend cause for optimism, although the RBA remains wary that ‘animal spirits’ may be lacking.
From a cautiously optimistic stance, we feel it would take a marked deterioration in either economic outlook or inflation to alter the current stable trajectory of monetary policy.
If anything, the RBA’s apparent preference for macro-prudential tools in tackling any imbalances in the housing market reinforces our view that policy rates are unlikely to move any time soon.
In a world where central bank liquidity is king, this should be enough for investors in front-end ‘carry’ trades, as the path of least resistance, to continue benefiting.
Ten-year Australian yields should pay some lip-service to global bond market developments and the much anticipated sell-off, although for the reasons outlined above we expect further yield compression versus the US.
Liam O’Donnell is the investment director at Standard Life Investments.
