- Australian government 10-year bond yields have been higher than their US equivalents since 1999, but the gap is shrinking.
- Some observers worry this will mean offshore interest rates will start to drive borrowing costs in the Australian economy.
- Credit Suisse analyst Damien Boey believes it will be counteracted by moves in the Australian dollar.
We’re staring down a little bit of history for the Australian bond market.
For the first time since 1999, the yield on benchmark Australian 10-year government bonds is close to matching those of 10-year US Treasurys.
This week, they’ve come within 2 basis points on a cash basis and a single basis point on the futures market.
The trend is clear: the difference between the two will close some time soon, and there are a range of views on what this means for the economy.
This chart from Damien Boey, Research Analyst at Credit Suisse, shows the gradual narrowing between both nominal and real 10-year yields between Australia and the US since 2011.
Boey puts the narrowing in the spread down to a combination of where Australia sits in the economic cycle compared to US, creating a divergence in monetary policy settings between the RBA and the Fed.
“History suggests that Australian-US 10-year bond yield differentials are very closely linked to policy rate differentials,” he says.
“Movements at the short end of the curve eventually reverberate throughout the curve. Whereas the Fed seems to be on ‘auto-pilot’ with rate hikes, the Reserve Bank of Australia (RBA) seems to be far more cautious in its approach to policy settings and normalisation.”
Contributing to that policy divergence, Boey says “inflation seems to be a far greater risk in the US than it is in Australia”.
“For the US, potential growth is slowing materially on deteriorating demographics, meaning that the threshold for closing the output gap is much lower. Put differently, the US economy does not need to grow especially rapidly to create inflation risk. Yet fiscal stimulus is being applied to reflate the economy,” he says.
“On the other hand, potential growth in Australia is actually quite high and arguably is rising, as immigration temporarily slows the pace of population ageing. At the same time, despite the benefit of strong population growth and a ramp-up in infrastructure spending, the economy has barely been able to keep pace with its potential growth rate, because consumer and housing sectors are showing signs of fragility.”
Under such circumstances, Boey suggests “bond and money markets are rightly pricing in that the RBA would be a very late participant in the global tightening cycle, if at all”.
While the Australian enjoys a AAA credit rating, Australia also runs a current account deficit, meaning that it borrows from the rest of the world. And with yield differentials between Australia and the US already negative in shorter-dated bonds, some may be concerned that lower yields at the long end in Australia may make it harder for Australia’s banks to obtain funding from abroad, potentially raising borrowing costs.
“Traditionalists focus on Australia’s large net foreign liability position,” Boey says.
“Seemingly, banks have borrowed heavily abroad to fund Australian mortgages. Traditionalists believe that the inversion of Australian-US yield differentials make it harder for banks to obtain ‘cheap’ funding abroad. This could complicate the transmission of monetary policy, as Fed rate hikes ‘take over’ RBA policy.”
Boey, however, thinks these concerns are overblown.
“We disagree with the traditionalist position. Their logic applies to fixed exchange rate regimes — but Australia has a floating currency. Loans create deposits. Borrowers buy houses in Australian dollars — not US dollars. Banks have no need for offshore funding.
“In the event that foreigners cease providing this funding, banks need to sell Australian dollars to buy US dollars to pay off their term debt.
“In other words, [a lower Australian dollar] is likely to do the bulk of adjustment, rather than funding costs.”
As such, Boey says he does not “subscribe to the view that inversion of the Australian-US rate differential must be read as a worrisome signal for the economy”.