Besa Deda

Chief Economist, BankSA, 14 July 2017

2017

Slide Pack on the Outlook for Bond Yields

Australian Cash Rate

• The cash rate is at a record low of

1.50%.

• Reserve Bank faces a juggling act.

• In recent months, more

economists have moved away

from calling more rate cuts.

0

5

10

15

0.75 1.00 1.25 1.50 1.75 2.00

Where Will the Cash Rate Be at the End of Q2, 2018?

Bloomberg survey of 24 economists as at 30 June 2017

Inflation Outlook in Australia

• We expect the RBA to leave the

cash rate steady this year and

next year.

• Household indebtedness and soft

inflation supports our view.

1

2

3

4

5

6

Mar-02 Mar-06 Mar-10 Mar-14 Mar-18

Underlying Consumer Prices(annual % change)

RBA 2-3% per annum Inflation Target Band

Australian Bond Yield Curve

• We expect further modest steepening

by end of 2018.

• Consensus is expecting more

substantial steeping than our

forecasts. Consensus expects the

10-year bond yield will rise more

sharply next year (from 2.88%

expected at end of 2017 to 3.50% at

end of 2018). 1

2

3

Cash 1-Yr 2-Yr 3-Yr 5-Yr 7-Yr 10-Yr

31 Aug 2016

Australian Government Bond Yield Curve

31 Mar 2017

%

13 Jul 2017

30 Dec 2016

Source: Bloomberg

Australian Swap Rates Outlook

• Australian swap rates

bottomed in August 2016.

• Australian 3-year swap yields

are up 49 basis points and

Australian 10-year swap yields

are up 84 basis points from

their lows.

1

2

3

4

Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17

Australian Swap Yields(weekly data)

Aust 10-Year Swap Yield

Aust 3-Year Swap Yield

%

Source: Bloomberg

Australian Swap Rates Outlook

• Australian yields are being heavily influenced by US yields, more

so since mid 2015.

• This correlation should continue over the year ahead.

1.0

1.5

2.0

2.5

3.0

1.0

1.5

2.0

2.5

3.0

Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17

Bond & Swap Yields(weekly data)

US 10-Year Government Bond Yield (left axis)

Aust 3-Year Swap Yield (right axis)

%%

Source: Bloomberg

1.0

1.6

2.2

2.8

3.4

4.0

1

2

3

4

5

6

Jan-09 Jan-12 Jan-15

US and Australian 10-Year Yields(weekly data)

Australian 10-year Govt BondYield (lhs)

US 10-year Govt Bond Yield (rhs)

%%

US 10-Year Bond Yields Outlook

• A synchronised global economic recovery is in play. Economic data is

improving in key advanced economies, including Europe and Japan.

• The recent gyrations in US Treasuries is in part a function of what the

market expects US President Trump will do with fiscal policy (and

how successful he will be). US economic data has not substantially

altered in recent months.

• The US Federal Reserve has assured the market that the impending

balance sheet shrinkage will be gradual, minimising the risks of

another tantrum.

• The Fed intends to increase the balance sheet run off cap every three

months until a fully phased-in level is hit.

Risk of Sharp Sell off in US Treasuries

• Net long positions in 10-year US

Treasuries have built up.

• The market is now net long

302,000 in 10-year US Treasury

futures contracts; these are

levels last witnessed in late 2007.

• It leaves US 10-year bond yields

vulnerable to a sharp spike if

inflation and/or economic growth

surprises to the high side. -600

-400

-200

0

200

400

13 14 15 16 17

US 10-Year Treasury Net Non-Commercial Futures PositionsContracts,

000s

Source: Bloomberg

US Inflation Expectations

• Markets are not convinced that

US inflation will push sharply

higher over the next few quarters.

• It is reflected in the 5-year, 5-year

forward inflation expectation rate,

which is a measure of expected

inflation (on average) over the

next five years.

0

1

2

3

4

13 14 15 16 17

US 5-Year, 5-Year Forward Inflation Expectation Rate, %

Source: Federal Reserve Bank of St.Louis

Fed Looking Through Soft Inflation

• Fed appears willing to look

through weaker inflation

outcomes, for now.

• US Federal Reserve Chair still

believes in the Phillips Curve –

the notion that lower

unemployment will generate

stronger wages growth in time.

0.0

1.0

2.0

3.0

4.0

07 09 11 13 15 17

US Inflation & Wages Growth(% annual change)

PCE Core Inflation

Average hourly Earnings

Source: Bloomberg

More Rate Hikes to Come in the US

• Financial markets expect one more rate hike this year and one

more next year. We think markets are not pricing in enough

tightening.

0.00

2.00

4.00

6.00

8.00

92 96 00 04 08 12 16

US Fed Funds Rate(percent)

Source: Bloomberg0

4

8

12

95 98 01 04 07 10 13 16 19

US Unemployment Rate%

Source: Bloomberg1.0

1.5

2.0

2.5

3.0

3.5

Current End Dec-17 End Dec-18 End Dec-2019

Expectations for the Fed Funds Rate (Effective rate, %)

Market pricingImplied by 30-day Fed fund futures

MId-point of Projections from Federal Reserve

Europe

• Europe is at a turning point with

European Central Bank (ECB)

President Draghi recently stating that

the “threat of deflation is gone and

reflationary forces are at play”.

German long-end yields are,

therefore, likely to nudge higher over

the coming year.

• With higher inflation expectations

lacking domestically, data and event

developments in Europe and Japan

will be important. -0.5

0.0

0.5

1.0

1.5

1.0

1.5

2.0

2.5

3.0

Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17

US & German Govt Bond Yields(weekly data)

US 10-Year Govt Bond Yield (left axis)

GE 10-Year Govt Bond Yield (right axis)

%%

Source: Bloomberg

More on Europe

• The European Central Bank’s (ECB) asset purchase program runs

out by the end of the year. Financial markets are speculating that

the ECB may taper the current program for 2018.

• The market is likely to look for greater clarity in the next few ECB

policy meetings.

• Any change in outlook or hint of a reduction in asset purchases

would likely push German 10-year yields higher and thereby prod

US 10-year bond yields higher.

• In other developments, Bank of Canada recently raised their

benchmark rate, making it the first major central bank to follow in

the footsteps of the US Federal Reserve.

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