Fixed Income

Why aren't wages responding to low unemployment?

A faster pace of accommodation withdrawal by central banks would surely pose risks to bonds and other assets. Perhaps at risk of fighting the last war, central banks remain focused on inflation, currently missing-in-action despite the growth uplift.


Stuart Dear

Stuart Dear

Deputy Head of Fixed Income

The best stretch of synchronised global growth in more than 10 years has continued to buoy risk assets in spite of already stretched valuations. Meanwhile bond yields are little moved despite the cyclical improvement, arguably supporting the risk asset rally. Central banks remain key to both parts of this bifurcation – a loose stance both supports risk assets and contains bonds, while the macro variables, though lifting, remain relatively stable.

A faster pace of accommodation withdrawal by central banks would surely pose risks to bonds and other assets. Perhaps at risk of fighting the last war, central banks remain focused on inflation, currently missing-in-action despite the growth uplift. Serial undershooting of inflation objectives, and uncertainty about this cycle (why aren’t wages responding to low unemployment?) provide justification for a slow pace of policy adjustment to date. We believe that both domestic and global closure of output gaps – now or soon - will force cyclical inflation moderately higher despite the dampening structural influences of globalisation and technology.

The accelerated flattening of the US yield curve recently has attracted plenty of attention. Much of this move has been driven by stronger conviction about the number of Fed rate hikes likely in 2018 (with market consensus shifting towards 4), which has pushed up short end yields. This shift in Fed expectations is interesting as it has not been driven by higher inflation expectations (though these have lifted very marginally), nor has it resulted in expectations for the ‘terminal’ Funds Rate moving higher. Ongoing structural headwinds – including a problem of central banks’ own making, massive debt load – are no doubt key to pinning down long term yields, along with ongoing central bank bond buying in Europe and Japan. Risk assets have not been materially disrupted by the flattening (though some profit taking out of equities back into longer dated bonds is perhaps part of the flattening story) suggesting markets are not yet interpreting it as a recession warning signal. We continue to see higher inflation and/or a faster pace of policy tightening (on a combination of greater central bank confidence in future inflation, and financial stability concerns) as the likely triggers for a rise in market volatility.  

Australian bonds have enjoyed a scenic round-trip over recent months, firstly weaker as sentiment shifted towards earlier tightening by the RBA, then back again as softer data confirmed the on-hold status quo. With the Fed about to lift the US Funds Rate to parity with the RBA cash rate, Australian bond yields are threatening to trade below those of the US for the first time since early this century. However, while Australia is clearly lagging the US cycle, if the global cyclical uplift continues to broaden as we expect, Australia will likely be pulled along with it. The RBA won’t hurry to tighten, but they have made it pretty clear that the next move, barring disaster, is up.

Meanwhile credit markets continue to enjoy a sweet spot of improving cyclical growth prospects with little apparent fear of profitability or liquidity effects of central bank withdrawal. With spreads at post-GFC tights however, further outperformance of credit is likely to only come through higher coupons, with prospects for further price appreciation limited.

Given the backdrop, portfolio positioning remains cautious along both interest rate and credit dimensions. In rates, we’re holding about 0.90 years less duration than the benchmark. We’ve recently pared some Australian bond exposure following outperformance, leaving the aggregate relative to benchmark position distributed equally between short duration positions in the US (where the cycle is most advanced), Europe (where valuations are most extreme) and Australia. We responded to the aggressive flattening of the US yield curve by moving to position for a re-steepening. In general, the bulk of our interest rate positioning is premised on poor valuations for longer term bonds and a cyclical uplift flowing through to inflation. However, with prospects for policy tightening underpriced in Australia, in addition to selling the duration mentioned above, we have also been gradually shifting our preference on the Australian yield curve from shorter to longer maturities. Together these aspects of positioning along with an exposure to inflation linked bonds, should help protect the portfolio against an upwards turn in the domestic cycle.

In credit we hold a very modest absolute exposure, a little above the benchmark weight, maintaining a strategy of accessing a small amount of ‘safe’ carry until better value is restored. During October we added back a little to domestic investment grade credit, at present our preferred fixed income asset for its high quality and short duration. Our exposure to lower quality domestic and global credit remains limited. We’ve also recently marginally topped up exposures to longer-dated semis and to AAA RMBS, which have lagged the spread tightening of other sectors.

Altogether this positioning is defensive as we patiently await the triggers for market volatility that should provide the opportunity to position more constructively. 

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