After an extended period where inflation expectations in Australian financial markets have been declining, the evidence is mounting that this trend may have run its course. The most recent example of this is last week’s new ten year inflation linked bond issue from the Australian Government, where around A$5 billion of interest was expressed for a A$3 billion transaction.
Inflation expectations in Australia have been falling steadily for at least a decade.
In the financial markets context, this can be shown by looking at the Break Even Inflation (BEI) rate, which looks at the difference between nominal bond yields and their inflation linked counterparts (which pay a ‘real’ yield plus the observed inflation rate). The chart below illustrates that the expected inflation rate has declined with the observed trend in inflation, with the low being seen mid-2016 when market pessimism was at its peak after the ‘Brexit’ vote. This was not something specific to Australia, and similar movements were seen in inflation markets across the globe.
Figure 1: Historically low BEIs have improved since Brexit
Inflation expectations then bounced late in 2016 after the US election, on hopes that stimulatory fiscal policy would boost growth and inflation. As it has become clear that it will be difficult to enact any meaningful economic reform, and observed inflation in both Australia and the US have underwhelmed, inflation expectations have since come back a touch but importantly remain above the lows set last year. This supports the idea that a base may be forming in this market implied measure of inflation expectations.
New Inflation-Linked Bond Was Snapped Up
The environment outlined above, where the cost of protecting yourself against inflation is low, set the foundation for a very strong level of interest shown when the Australian Office of Financial Management (AOFM) came to market last week. Around A$5 billion of interest was expressed in the new inflation linked bond with a November 2027 maturity, considerably greater than the A$3 billion transaction which was then issued.
The composition of investors that participated in the transaction (illustrated below) showed that domestic fund managers were the largest investor group to support the transaction. This demonstrates an increased willingness on the part of local investors in seeking to build inflation protection positions at current levels, particularly relative to the recent years when investors have been reluctant to build such positions against a declining trend.
Figure 2: New AOFM issuance dominated by Australian Fund Managers
Source: Australian Office of Financial Management
While around A$2.7 billion of inflation linked bonds maturing in 2018 were also bought back by AOFM on the same day, these bonds offered much less inflation protection than the new 10 year bonds. The resulting shortfall in the issuance of the 2027 maturity inflation linked bonds, relative to what was demanded, saw a significant bounce back in the market implied BEI rates immediately after the transaction, quickly reversing the prior recent declines in the lead up to the transaction.
How and what we think about Australian Inflation
Looking forward, there are a number of factors that our Australian Inflation signal owner, Kris Bernie, considers when allocating an underweight, neutral or overweight position in Australian inflation.
Subdued inflation expectations a long term impact
After a long period of CPI prints being lower than forecast, expected inflation is forecast to be at or slightly above levels that are already priced into the market. Core inflation is largely expected to be subdued at around 2% in coming years, reflecting continued mild growth in wages and some disinflationary impacts from the stronger Australian dollar. Whilst 2% is only at the lower end of the RBA’s target range for inflation of 2-3%, this is still above the current 10 year break even inflation rate of 1.80%. The risks to this inflation outlook are balanced.
The rise in electricity prices and the impact of the increase in award wages in the September quarter point to some near term upside risks. On the downside, the main risk comes from technological advances and new entrants into the Australian market place keeping inflation lower than traditional macroeconomic variables/models would suggest.
Technical downtrend no longer a concern
As outlined in the background section above, inflation expectations may have found something of a base over the last year, around the time of Brexit just over one year ago. Technical analysis suggests this break of the downtrend of the past decade is an important psychological signal, which supports the idea that the lows in the cost of protecting yourself against inflation protection may have already been seen.
Investment flows are likely to be more positive
The signal from the amount of demand from the Australian investor base in the recent new issue has been discussed above, with offshore investors also likely to be attracted to this space given the relativities to offshore real yields. The large increase in Australian linked bonds on issue could also see passive inflation funds look to rebalance at the end of this month or in November (for maturity constrained benchmarks). It is this investor base that has been particularly absent over the past few years, and any return in focus to the Australian space would be a significant departure from this recent experience.
Summarising the key drivers above, market-based inflation expectations have fallen to a level that is below our expected inflation rate and also below the RBA’s 2-3% target range for inflation. Technically, expected inflation appears to have found something of a base over the past year, and the strong participation of domestic investors in the recent ten year inflation linked bond points to a potential change in mindset for this asset class. Offshore demand would only bolster this trend further. This leads us to believe that it’s time to consider an increase to the amount of inflation protection that investors hold in their broader portfolios.
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