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Growth disappoints, bonds may outperform

Nicki Bourlioufas  |  11 Dec 2018Text size  Decrease  Increase  |  
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Australian government bonds could outperform US treasurys in 2019 and 2020, as domestic monetary policy diverges from the US Federal Reserve.

A soft third-quarter reading for economic growth could push the central bank to downgrade its growth forecasts for 2018 and hold interest rates next year and beyond.

The Australian economy grew 0.3 per cent in the September quarter 2018, up just 2.8 per cent from a year ago, the Australian Bureau of Statistics (ABS) said. The economy has lost momentum in the second half of 2018 given weak consumer spending, with households hampered by high levels of mortgage debt and low income growth. Business investment too has wound down.

Bill Evans, chief economists at Westpac, expects the Reserve Bank of Australia (RBA) to lower its gross domestic product (GDP) growth forecast for 2018 to 3.0 per cent from 3.5 per cent. He predicts the lower growth momentum may keep interest rates on hold in 2019 and 2020.

“Westpac has consistently forecast that the cash rate would remain on hold through 2019 and 2020. If we are right that the Bank will revise down its growth forecasts on the basis of this [GDP] result, then lower-expected-growth momentum going into 2020 may also temper the bank’s attitude to rates in 2020 as well,” Evans said.

Stephen Miller, an adviser with Grant Samuel Funds Management, also believes the RBA’s growth forecast is too high. He too expects interest rates could remain on hold.

“I regard the RBA forecasts as optimistic. That too is the message from the GDP numbers. In large measure, that prognosis reflects an uncomfortable confluence of the imbalances wrought by excessive household debt and a deteriorating Chinese growth outlook, which itself is a combination of domestic imbalances and fall-out from the trade dispute with the US,” said Miller.

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“Falling house prices and high household debt combine to restrain household consumption growth which accounts for about 60 per cent of GDP growth.”

Reserve Bank of Australia

Slower growth may prompt the RBA to keep interest rates on hold in 2019 and 2020

This subdued growth scenario could push Australian government bonds to outperform US government bonds in the near to medium term, says Miller.

“Australian 10-year bonds traded under the US in 2018 by as much as 50 basis points or more. That is the first time the Australian 10-year bond yield has traded under US yields since 1998 when it did so ever so briefly.

“With the US Fed likely to raise short term rates again in December 2018 and maybe another couple of times in 2019, and with the RBA on hold, I expect that differential to grow and go above 50 basis points from its current level at circa 40 basis points,” says Miller.

Indeed, Miller sees the gap widening to as much as 75 basis points. “If I am correct and say US 10-year bond yields increase to around say 3.50 per cent from their current level near 2.90 per cent, then Australian bond yields probably also increase but by a lesser amount, say from their current level of around 2.50 per cent to say 2.75 per cent. In other words, the yield differential could go from around 40 basis points currently to around 75 basis points next year,” he says.

“To put that in context at the start of the year Australian 10-year bond yields were above the US by about 20 basis points,” says Miller.

Scott Haslem, chief investment officer with Crestone Wealth Management, also expects interest rates to remain on hold in 2019 in Australia.

“We believe the 10-year is rallying because both US growth has slowed from its frenetic pace mid-2018 and core inflation has slowed over the past couple of months.

"In all likelihood, this will lead to the US Fed Reserve tempering the pace of planned rate hikes, providing some support for growth and markets,” says Haslem.

He expects solid Australian growth in 2019, led by infrastructure investment, consumer and business capex. However, some slowing in growth to a near-trend pace of 2.75 per cent to 3 per cent in 2019 – from well above 3 per cent through 2018 – seems likely.

More good news for the Australian economy could come from tax cuts next year, according to chief economist at AMP Capital, Shane Oliver.

The Mid Year Economic and Fiscal Outlook report due December 17 is likely to show the Federal budget is running around $9 billion per annum better than expected – thanks to higher than expected commodity prices and tax revenue, according to Oliver.

“This is likely to enable the Government to announce $9 billion in income tax cuts and other pre-election goodies starting in July 2019 and still maintain a surplus projection for 2019-20,” he says.

“The upside of bigger and earlier income tax cuts is that it will inject a bit of spending power into household budgets providing a partial offset to what looks like being an intensifying negative wealth effect from falling house prices on consumer spending next year.”


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