And perhaps more importantly, short-term traders expect the RBA’s cash rate to peak well above 4%, compared to around 3.3% for the US Federal Reserve.
While Australian bonds have historically tended to trade above US rates, this has not always been the case as the spread has gradually narrowed over the past decade.
And right now, the gap is hard to explain by fundamentals. The inflation rate in the United States is much higher, at 8.6%, compared to 5.1% in Australia.
And our economy is, according to Richard Quin of Bentham Asset Management, 10 times more interest rate indebted in the United States (based on the average interest rate term of a mortgage).
The Great Disconnect
This backdrop suggests that interest rates here should not be higher than in the United States and therefore all of our bonds should pay a lower rate.
The Reserve Bank Governor seems to think so, although he acknowledges that the market has proven to be a better predictor than it has lately.
But he pointed out that the market implied it would have to raise the cash rate at a faster rate than at almost any time in history – in a tone that did not suggest that was at all likely.
And so the gap between what the RBA thinks will happen and what it communicates is likely to happen, is still totally at odds with the market.
Christian Baylis of the Fortlake bond fund says it’s “simply a statement of fact” that the RBA ranks at the bottom of the developed world in terms of communications.
“There is/was no greater disconnect between communication and market prices than in Australia,” says Baylis, who is a former RBA staffer.
The Federal Reserve has done a good job, Baylis says, of closing the credibility gap with decisive action, and it is now more in tune with the markets.
This 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 tougher starting point, the market thinks it can get the problem under control – and that’s reflected in lower long-term rates.
(He notes that the US inflation curve is aligned with Australia’s despite the much higher US spot inflation rate.)
“The bigger the credibility gap, the more you have to do on monetary policy tools – that’s why the market tells us that the RBA has a lot to do to restore its inflation targeting credibility” , Bayliss said.
“People, rightly, have started to question the RBA’s reaction function, which is supposed to be the 2-3% inflation target, while across Tasmania and in the US , we have seen central bankers insist on the issue of reaction functions.”
Another bond fund, which preferred not to be named, says there is a “clear lack of trust in what they say and do” and that explains the higher returns.
“Unfortunately, it is the taxpayers who bear the cost of their constant mistakes in the form of ever-increasing financing costs, as investors are unwilling/cannot trust them to keep their word.”
What are foreign investors saying? Many hedge funds were gutted when the RBA dropped its bond peg, so they are either not there or remain well out of the bond market.
Martin Whetton, head of bond strategy at Commonwealth Bank, visited US clients in April and is currently in Europe.
He reported that at least some participants cited the yield curve control episode as a “justification to avoid the market” as traders looking for higher yields opted to hold New Zealand bonds. .
But credibility is relative. Ardea’s Tamar Hamlyn, another former RBA staffer, said the central bank was not the only one caught off guard.
“The Fed’s unfortunate view that inflation would prove to be transitory is arguably at least as bad as the RBA’s commitment not to raise rates,” he says.
Hamlyn says Australia’s yield gap is more likely explained by the return of a 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 those closely tied to Asia have generally exhibited higher cyclicality and greater exposure to fluctuations (up and down) in global growth,” he said. .
ANZ’s David Plank tends to agree. He noted that the widening of the 10-year yield spread between the United States and Australia was “largely in response to market volatility and an increase in the risk premium embedded in the difference”.
“There may also have been activity related to positioning, amplifying movements.”
Another more technical reason cited by a few bond funds is the common use of interest rate swaps to hedge interest rate risk, as the bulk of Australian lending is fixed at a short term floating rate. This has created structural pressure in our interest rate market.
But there is no doubt that central banks, including the Reserve Bank, have work to do to regain the credibility not only of the market, but of the population at large.
Quin de Bentham said there was more confidence in central banks because they had an inflation target and were seen as politically independent.
But there has been a huge increase in government spending, which tends to be inflationary, and central banks, including the Reserve Bank, have not changed their minds. This leaves them with work to do to restore the faith they once commanded.