Is the bond market penalizing the Reserve Bank of Australia?

Perhaps most importantly, short-term traders are pricing in a peak RBA cash rate north of 4 per cent compared to around 3.3 per cent 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 decreased over the past decade.

At present, the gap is difficult to explain with the basics. The US inflation rate is much higher at 8.6 per cent, compared to 5.1 per cent in Australia.

According to Richard Quinn of Bentham Asset Management, our economy has 10 times greater leverage than US interest rates (based on the average interest rate term of a mortgage).

The big breakup

This background suggests that interest rates here should not be higher than they are in the US, and therefore all our bonds should pay a lower rate.

The Reserve Bank governor seems to think so, although he admits that the market has proven to be a better indicator than it has been lately.

But he noted that the market is hinting that he will have to raise cash at a faster rate than at almost any time in history – in a tone that doesn’t suggest that was ever likely.

Thus, the gap between what the RBA thinks will happen and what is likely to happen, is still very much at odds with the market.

Christian Baylis of bond fund Fortlake says it is “just a statement of fact” that the RBA is in the back of the developed world package in terms of communications.

“There has been/no greater separation between telecom rates and the market than there is in Australia,” says Bayliss, a former employee of the Reserve Bank of Australia.

Bayliss says the Fed has done a good job of closing the credibility gap with decisive action, and they are now more in line with the markets.

This leaves the Fed in a stronger position to use communications to do the tough jobs rather than using other policy tools.

granulation time

So, despite the Federal Reserve’s more challenging starting point, the market believes they can get around the problem – and that’s reflected in lower long-term interest rates.

(Note that the US inflation curve is in line with the Australian curve despite the high rate of spot inflation in the US.)

“The wider the credibility gap, the more you have to do about monetary policy tools – which is why the market is telling us the RBA has a lot to do to restore its inflation targeting credibility,” Bayliss says.

“People, rightly, started to question the RBA’s reaction function which is supposed to be the 2 to 3 per cent inflation target when we saw central bank governors in Tasman and the United States press the issue around reaction functions.”

Another bond fund, who preferred not to be named, says there is a “clear lack of confidence in what they say and do” and that explains the higher returns.

“Unfortunately, it is taxpayers who pay for their ongoing mistakes in the form of higher and higher financing costs as investors will not/cannot trust them to deliver on their promise.”

What do foreign investors say? Many hedge funds were gutted when the Reserve Bank of Australia dropped the bond peg, so they either don’t exist or are staying out of the bond market.

Martin Whitton, Commonwealth Bank’s head of bond strategy, visited US clients in April and is currently in Europe.

He again stated that at least some participants cited the yield curve control loop as a “rationale reason to move away from the market”, as traders seeking higher yields chose to own New Zealand bonds.

But credibility is really relative. The central bank wasn’t the only one making a mistake, says Ardea’s Tamar Hamlin, another former employee of the Reserve Bank of Australia.

“The Fed’s ominous view that inflation will prove transient is at least as bad as the RBA’s commitment not to raise interest rates,” he says.

Hamlin says the Australian yield gap can likely be explained by the return of more of the normal “term risk premium” as bond investors demand higher rates to compensate for general uncertainty – which is greater for our economy.

“Typically higher-growth markets and markets closely related to Asia have shown higher cyclical volatility and greater exposure to volatility (up and down) in global growth,” he says.

ANZ’s David Blank tends to agree. He noted that the 10-year extension of US returns to Australia was “largely in response to volatility in the markets and the increased risk premium embedded in the spread”.

“There may also have been some activity associated with positioning, which leads to amplification of movements.”

Another more technical reason mentioned by a few bond funds is the prevalent use of interest rate swaps to hedge interest rate risk as the bulk of Australian loans are set at a short-term floating rate. This has created structural pressures on our interest rate market.

But there is no doubt that central banks, including the Reserve Bank, have work to do to restore credibility not only in the market, but also in the general public.

Bentham’s Quinn said there was more confidence in central banks because they had an inflation target and were considered politically independent.

But there has been a significant rise in government spending, which tends to be inflationary, and central banks, including the Reserve Bank, have not changed their approach. This leaves them with the work they need to do to restore the faith they once recommended.

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