And perhaps most significantly, short-term traders are pricing in a peak in the RBA cash rate well north of 4 per cent compared with about 3.3 per cent for the US Federal Reserve.
While Australian bonds have historically tended to trade above US rates that’s not always been the case as the spread has gradually reduced over the last decade.
And at present, the gap is hard to explain by fundamentals. The US inflation rate is way higher at 8.6 per cent, compared with 5.1 per cent in Australia.
And our economy is, according to Bentham Asset Management’s Richard Quin – 10 times more leveraged to interest rates in the US (based on the average interest rate term of a mortgage).
The great disconnect
This backdrop suggests, interest rates here should not have to go higher than in the US, and therefore all our bonds should pay a lower rate.
The Reserve Bank governor seems to think so, although he acknowledges the market has proved a better predictor than he has of late.
But he pointed out that market is implying he would have to jack up the cash rate at a faster rate than almost any time in history – in a tone that didn’t suggest that was at all likely.
And so the gap between what the RBA thinks will happen and what it is communicating is likely to happen, is still totally at odds with the market.
Christian Baylis of bond fund Fortlake says its “merely a statement of fact” that the RBA is coming at the back of the developed world pack in terms of communication.
“There is/was no bigger disconnect between the communication and market pricing than in Australia,” says Baylis, who is a former RBA staffer.
The Federal Reserve has done a good job, Baylis says, in closing the credibility gap with decisive action, and they are now more in sync with the markets.
That leaves the Fed in a stronger position to use communication to do the heavy lifting rather than using the other policy tools.
Term of endearment
So, despite the Fed’s more challenging starting point, the market believes they can get on top of the issue – and that is reflected by lower long-term rates.
(He notes that US inflation curve is line with the Australian one despite the much higher US spot inflation rate.)
“The larger the credibility gap the more you have to do on the monetary policy tools – this is why the market is informing us that the RBA has much to do to restore its inflation-targeting credibility,” Bayliss says.
“People, rightly, began to question the RBA’s reaction function which is meant to be the two to three per cent inflation target when across the Tasman and in the US we saw central bankers pressing the issue around reaction functions.”
Another bond fund, which preferred not to be named says there’s a “distinct lack of trust in what they say and what they do” and that explains the higher yields.
“Sadly, it’s taxpayers who wear the costs of their constant mistakes in the form of higher and higher funding costs given investors won’t/can’t trust them to keep to their word.”
What do foreign investors say? Many hedge funds were eviscerated when the RBA dropped its bond peg, so they’re either not around or staying well away from the bond market.
Martin Whetton, Commonwealth Bank’s head of bond strategy, visited American clients in April and is currently in Europe.
He reported back that at least some participants did cite the yield curve control episode as a “rationale to steer clear of the market,” as traders seeking higher yields opted to own New Zealand bonds.
But credibility is indeed relative. Tamar Hamlyn of Ardea another former RBA staffer, says the central bank was not alone in being wrong-footed.
“The Fed’s ill-fated view that inflation would prove transitory is arguably at least as bad as the RBA’s commitment to not raise rates,” he says.
Hamlyn says the Australian yield gap is more likely explained by the return of more normal ‘term risk premium’ in which bond investors demand higher rates to compensate for general uncertainty – which is greater for our economy.
“Higher growth markets and ones closely linked to Asia have typically displayed a higher cyclicality and greater exposure to swings (up and down) in global growth,” he says.
ANZ’s David Plank tends to agree. He noted the widening of the US to Australian 10-year yield spread was “largely been in response the volatility in markets and an increase in the risk premium embedded in the spread.”
“There may have also been some positioning-related activity, magnifying the moves.”
Another more technical reason cited by a few bond funds is the prevalent use of interest rates swaps to hedge rate risk as the bulk of Australian loans are set on a short term floating rate. That has created structural pressure on our interest rate market.
But there is no doubt that central banks, including the Reserve Bank, have work to do win back the credibility of not only of the market, but the broader populace.
Bentham’s Quin said there was more trust in central banks because they had an inflation target and were regarded as politically independent.
But there’s been a huge ramp up in government spending, which tends to be inflationary, and the central banks, including the Reserve Bank didn’t change their tune. That leaves them with work to do to restore the faith they once commanded.