Could Australian interest rates continue to fall and, if so, what might this mean for the local bond market? Head of Australian Fixed Income, Stephen Cooper answers some of 2020’s biggest questions for investors.
In 2019, Australian bonds delivered their best performance in five years. Could we see a repeat in 2020?
Valuations tailed off in the final quarter of 2019 as yields edged higher, but the Bloomberg AusBond Composite 0+Yr Index – a good gauge of the performance of all Australian bonds – returned 7.3% over the year; the highest annual return for five years. As ever, forecasting the performance of investment markets is challenging, but it seems unlikely that the local bond market will perform quite as well in 2020.
Over the past 12 months, returns from Australian fixed income securities were buoyed by three interest rate cuts. The Reserve Bank of Australia lowered borrowing costs in June, July and October – by a quarter of a percentage point on each occasion – taking the Official Cash Rate to an all-time low of 0.75%. Moreover, investors have already priced in at least one further rate cut this year. This means that unless we see negative interest rates in Australia, like we have done recently in Europe and Japan, overall returns from the Australian bond market are likely to be more modest in the year ahead.
Are we likely to see Quantitative Easing in Australia this year?
Discussion about the possibility of unconventional policy settings being introduced in Australia refuses to go away. Some commentators are suggesting that a Quantitative Easing program could be introduced to help support the ailing economy, perhaps similar to those seen in the US, Europe and Japan in recent years. For now, the Reserve Bank of Australia seems hesitant to openly discuss the possibility, but there could be increasing calls for a broader policy response if the local economy remains soft. In turn, this could continue to exert downward pressure on Australian bonds, potentially resulting in further positive returns from the asset class.
At this stage, we believe policy makers are more likely to support the Australian economy by increasing spending rather than by introducing a Quantitative Easing program. Similar schemes have had mixed success offshore; Japan has tried to stimulate its economy in this manner for nearly 20 years, for example, without a meaningful improvement in activity levels or inflation. The Reserve Bank of Australia’s reluctance to adopt ‘last resort’ policy settings is understandable and, some might argue, laudable.
If economic conditions deteriorate further, the government could relax its commitment to targeting a fiscal surplus. For now, forecasts suggest the budget will be back in surplus this year following a modest shortfall, but officials may be willing to accept a deficit for a longer period of time if monetary policy adjustments and tax cuts do not have their desired effect. So far, these measures have had a limited impact on spending, particularly as mortgage lenders have not passed on the full benefit of rate cuts to borrowers. Looser fiscal policy – perhaps including substantially higher spending on infrastructure projects – could be on the agenda for 2020 and beyond.
Are rising interest rates a possibility?
It appears unlikely that official interest rates will be increased this year. The unemployment rate remains above the Reserve Bank of Australia’s desired levels and inflation continues to undershoot the official target. The Reserve Bank of Australia is sticking to its inflation forecast of between 2% and 3% per annum, but it has now been more than five years since we saw CPI within this range for two consecutive quarters. With households increasing their savings rate and holding back on discretionary expenditure, it’s hard to envisage a significant pickup in inflation in the year ahead.
Should bond investors expect more volatility?
With limited scope for further yield compression and with rates unlikely to rise significantly, it’s plausible that Australian bonds could tread water in 2020, with yields trading in a sideways range. What does seem clear, however, is that there will be some volatility within that range as investors digest the latest news flow.
In December 2019, for example, domestic bond yields fluctuated first as the tone of US economic data improved and later as potential geopolitical flashpoints returned to the fore. We’ve seen encouraging developments on the Brexit and US/China trade front, but these issues are still not resolved and certainly have the potential to result in periods of risk aversion globally. Events like these can increase the appeal of defensive assets, including Australian government bonds.
How can we aim to achieve above market returns in 2020?
Thankfully, even if the market lacks clear directional momentum, there are levers we can pull in actively managed Australian bond funds to enhance expected returns. Our flagship Australian bond strategy can be positioned to benefit from anticipated fluctuations in country spreads, as well as potential movements in the Australian curve and inflation market. These potential alpha sources complement the use of more traditional active duration positioning in the portfolio.
And in some of our more conservative vehicles, we aim to generate above-benchmark performance through a range of passive enhanced strategies. Passive enhancement allows us to take advantage of the inherent inefficiencies in issuance-based indices to build ‘better’ portfolios. By taking small, quantitatively identified tilts against the benchmark allocations, returns may be enhanced (in both an absolute and risk-adjusted sense) without materially changing the overall beta characteristics of the portfolio.
 Alpha measures the relative return, adjusted for risk, of a portfolio against a specific benchmark.
 Beta measures the historic volatility of a portfolio against a benchmark.
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