Historically, Australian sovereign bond yields have typically traded above their global counterparts, particularly those in the US. This has reflected a number of fundamental factors, including Australia’s higher long-term average economic growth and inflation. It’s worth remembering that Australia has a slightly higher inflation target than the Federal Reserve; between 2.0% and 3.0% per annum, compared to 2.0% in the US. Higher Commonwealth Government Securities (CGS) yields have also arguably reflected Australia’s higher term premium, given the economy is relatively small and largely influenced by commodity exports.

Accordingly, the Australian economy can be susceptible to fluctuating fortunes. The current desynchronised global growth environment, in which the Australian economy is lagging the US, has seen a reversal in this historical relativity. The elimination of the CGS yield premium relative to Treasuries appears more attributable to developments in the US rather than Australia; CGS spreads relative to German bunds, UK gilts and Japanese government bonds, for example, have been little changed this year. Either way, the spread between Australian and US 10-year sovereign bond yields has moved materially into negative territory for the first time in over 30 years. This raises questions over the sustainability of this negative spread and, in turn, whether it might affect offshore demand for Australian bonds in the future.

An additional and somewhat related issue is the impact of front end interest rate differentials on hedged returns. This is particularly relevant for Australian investors with exposure to global fixed income markets.  Historically, hedged exposures have been the norm, but in a world of negative returns from hedging this default setting is likely to be revisited.

The sustainability of negative Australian / US spreads

From a fundamental economic perspective, most would argue that equilibrium interest rates in Australia should be somewhat higher than those in G3 countries. A medium-term view of the key drivers of 10-yea yields – potential growth, long run inflation outcomes, and term premia – are all consistent with higher yields locally.

• Australia’s population growth rate (through both natural increases and immigration) remains higher than in the US. Productivity has also been higher historically, and while this is less certain going forward, the balance of risks remains skewed towards higher Australian outcomes.
• With an inflation target higher than that of the US, Europe and Japan, the bias on this estimate would also favour higher outcomes in Australia than elsewhere.
• Finally, as a small open economy that’s subject to volatility in domestic and external demand, term premia could also be expected to be structurally higher for Australia than other markets.

All of that said, Australia’s sustained economic prosperity and credit rating stability has historically supported demand for Australian paper (particularly against a background of sub-par economic outcomes, deteriorating fiscal positions and declining credit quality globally). Indeed, Australian CGS have become a core diversifying holding for many central banks, sovereign wealth funds and other large institutional investors worldwide. The case for diversifying into Australia in such an environment is a logical one from a default risk perspective, and makes even more sense when there’s also a clear return benefit in making the allocation.

With local yields now below those of their US counterparts, the return advantage of Australian bonds has been removed. But the diversification benefits remain, particularly when considered against Japanese and European alternatives. As a result, we believe demand for Australian paper will persist, potentially allowing local yields to trade below comparable US Treasuries for sustained periods of time, albeit with an average ‘over the cycle’ profile that continues to show a positive spread relative to the US.

Short end differentials and implications for hedging

It isn’t only longer duration Australian yield differentials that have turned negative relative to US Treasuries. Front end (cash and money market) rates have also recently fallen below their US equivalents. With the Federal Reserve committed to a path of monetary policy tightening while the Reserve Bank of Australia (RBA) is expected to keep local rates unchanged for an extended period, this differential could widen further and, again, be sustained for an extended period of time.

This environment represents a very different dynamic from a hedging perspective for AUD-based global fixed income investors. Historically, the positive interest rate differential meant that hedging global fixed income exposures back to AUD was a sensible default policy. Hedging provided a higher yield and, importantly, lower volatility in total returns. With short end interest rate differentials moving into negative territory, however, there is now a distinct trade-off between return and volatility, on at least part of the portfolio.

Hedging policy considerations must factor in expected total returns of a hedged exposure, as well as the hedging costs themselves. Taking these into account, we believe Australian investors will continue to favour hedged offshore exposures due to:

• The diversity benefit that global fixed income provides; and
• The continued positive hedge benefits from the non-US elements of these exposures.

Where specific US-only exposures are included, the analysis becomes more interesting. But even in these instances, hedging appears likely to remain the default option to help mitigate the potential portfolio impact of currency volatility. Overarching currency views, as well as a focus on the forces that may influence them beyond interest rate differentials, will undoubtedly continue to drive hedging decisions and will affect any potential change in behaviour.

Could persistent negative AU / US spreads have long-term implications for Australia?

We do not believe negative spreads alone will have any significant adverse impacts on Australia, or on the domestic bond market in general. Supported by AAA ratings, lower rates are favourable for the

Commonwealth Government – and State issuers, too – from a funding perspective. They also reflect confidence among the international investment community in Australia’s long-term economic prospects. Lower rates might also be expected to be supportive of domestic economic activity and, if anything, should make it more comfortable to fund current account deficits.

Perhaps a more interesting question is whether the RBA could miss out on participating in a global rate hiking cycle altogether and, in turn, what risks this might present over time.

The RBA continues to suggest the next move in domestic rates will be upward. But with inflationary forces under control and with lenders increasing variable mortgage rates independently of moves in official policy, we are unlikely to see a rate hike in Australia in the foreseeable future – potentially not until 2020. If that’s the case, there’s some risk that the global interest rate cycle will have turned before domestic conditions justify an increase in Australia. The RBA could therefore miss an entire hiking cycle globally. If that were the case, with local rates staying lower for longer, current policy settings would increasingly be perceived as the norm by both fixed income investors and Australian households. In turn, this would potentially increase the vulnerability of the local economy to future rate increases, as businesses and households had structured their activity and spending based on current settings. One more thing for the RBA to think about in the pursuit of balanced growth over the short and long term.

A balanced risk approach

Yield differentials between CGS and Treasuries have been among the most notable developments in the Australian bond market this year. But yield movements and duration positioning are by no means the only drivers of performance in our fixed income strategies. To varying extents depending on individual investment parameters, our Australian and global fixed income portfolios maintain exposure to a wide range of alpha sources globally. Australian and US signals including rates, curve, country spreads and FX are just a subset of the alpha sources that are utilised globally; there are other levers we can pull. The ‘Balanced Risk’ approach employed in the management of all portfolios ensures they are constructed in a balanced and diversified manner. No individual risk position or view has the ability to dominate the return profile, increasing the likelihood of us accomplishing portfolio objectives and providing investors with better risk adjusted returns over time.