Risk Off for the final month of the year as Aussie bonds experience a bull flattening
The Federal Reserve delivered their 4th rate hike for the year despite President Trump trying to influence the Fed decision making. There was however a dovish tone to the Fed comments and a repricing of future rate hikes in 2019. President Trump’s tweets and leaked comments about his displeasure with the Fed Chairman’s performance unsettled markets. At the same time the US government could not resolve budget negotiations and the US Government went into a partial shutdown at the year.
These events caused volatility and contributed to a repricing for all asset classes especially equities (lower prices) and bonds (higher prices).
Review of the US Market
The US 10-year bond ended the month at 2.68% down from the November month end high of 2.99% with resulting higher prices. We had previously discussed US 10 year bonds trading in a range, which has now been broken to the downside in yield. The current level in Yield to maturity has not been seen since late January 2018.
There was a similar movement in 2 year US government bonds which also feel in yield by 30 bps to 2.49% (The fall in yield creates higher prices and positive returns for investors).
Review of the Australian Market
For the first time in a while, Australia had independent data that changed many participants pricing of Australian interest rates. The National Accounts (GDP) published in early December showed annual growth had slowed to 2.8% (previously 3.4%). This meant that markets actually started pricing the possibility of a rate cut by the RBA.
The RBA Cash rate for December 2019 was indicating 1.41% down 0.19% from the end of November. This is significant because previously the market was expecting the next rate movement to be higher.
We remain of the view that the RBA will remain on hold for 2019.
The 10-year Australian bond finished 27bps lower in yield at 2.32% with higher prices. Therefore, Australian bonds were able to enjoy similar price rises as their US equivalents.
The 3-year government bond yield also fell (prices higher) by 16bps to 1.85%. Given 10 year bond yields fell more than 3 year, the market talks about Australian bonds experiencing a bull flattening.
What about corporate bonds and BBSW?
Although corporate bonds also benefited from falling government bond yields the credit spreads or the premium required to hold a corporate bond instead of a government bond was higher. The Corporate Bond Index implies that credit spreads moved on average 5 bps higher. The change in premium was small enough that corporate bonds only slightly underperformed government bonds. The movement wider in credit spreads should not be a surprise as riskier assets did not perform as well as their risk-free government equivalents.
3-month BBSW was higher moving from 1.95% to 2.09%. Therefore, despite lower government bond yields borrowers from banks may have higher borrowing costs.
Source Bloomberg and Australian Corporate Bond Company
The Bloomberg AusBond Composite Index for all maturities (the common benchmark) produced a positive return of 1.50% for the month reflecting lower yields (higher prices).
The Treasury Index (government bonds) for all maturities which is the single largest contributor to the composite index produced a positive return of 1.92%. This outperformed the Composite Index due to the contribution of longer dated government bonds with their higher modified duration and the fact that credit premiums widened.
The Credit Index (Corporate Bonds) for all maturities produced a smaller positive return of 0.90% reflecting the fact that the premium required for holding corporate bonds increased. When comparing corporate bonds to government bonds of the same maturity, corporate bonds such as described by the index capturing 3-5 maturities we see the government Bond index returned 1.11% while the corporate Bond Index (Credit Index) returned 0.93%.
The best performing sub index was Government 10+ maturity Index which returned 3.77%. This sub-index has the largest exposure to interest rate risk due to the long dated securities included in the Index.