Is the bond market punishing the RBA?

And perhaps most significantly, short-term traders are pricing in a spike in the RBA cash rate well above 4 percent compared to around 3.3 percent for the US Federal Reserve.

Although Australian bonds have historically tended to trade above US rates, this has not always been the case as the spread has gradually narrowed over the last decade.

And at present, the gap is hard to explain by fundamentals. the The US inflation rate is much higher at 8.6 percentcompared to 5.1 per cent in Australia.

And our economy is, according to Richard Quin of Bentham Asset Management, 10 times more leveraged than interest rates in the US (based on the average term of a mortgage interest rate).

the great disconnect

This backdrop suggests that interest rates here shouldn’t have to go any higher than in the US, and therefore all of our bonds should pay a lower rate.

The Reserve Bank governor seems to think so, although he acknowledges that the market has proven to be a better predictor than him of late.

But he pointed out that the market implies he would have to raise the cash rate at a faster rate than at almost any other time in history, in a tone that did not suggest that was likely.

And so the gap between what the RBA believes will happen and what it is communicating is likely to happen, remains totally at odds with the market.

Christian Baylis of the Fortlake bond fund says it is “simply a statement of fact” that the RBA lags behind the developed world pack in terms of communication.

“There is and has been no greater disconnect between communication and market prices than in Australia,” says Baylis, who was a former RBA staffer.

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

That leaves the Fed in a stronger position to use communication to do the heavy lifting rather than use other policy tools.

expression of affection

So, despite the Fed’s more challenging starting point, the market thinks it can solve the problem, and that’s reflected in lower long-term rates.

(He points out that the US inflation curve is in line with the Australian one even though the US spot inflation rate is much higher.)

“The bigger the credibility gap, the more you have to do with monetary policy tools; that is why the market is telling us that the RBA has a long way to go to restore its inflation targeting credibility,” says Bayliss.

“People rightly started to question the RBA’s reaction function, which is supposed to be the two to three percent inflation target, when all over Tasmania and in the US we saw central bankers pushing the topic around reaction functions”.

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

“Unfortunately, it is the taxpayers who bear the costs of their ongoing mistakes in the form of ever-increasing financing costs as investors are unwilling/unable to trust them to keep their word.”

What do foreign investors say? Many hedge funds were gutted when the RBA removed their bond peg, so they are either not present or staying away from the bond market.

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

He reported that at least some participants cited the yield curve control episode as a “fundamental reason to stay away from the market” as traders seeking higher yields chose to own New Zealand bonds.

But credibility is really relative. Tamar Hamlyn of Ardea, another former RBA staffer, says the central bank wasn’t the only one who got it wrong.

“The Fed’s unfortunate view that inflation would be transitory is possibly as bad as the RBA’s commitment not to raise rates,” he says.

Hamlyn says Australia’s yield gap is most likely explained by the return of a more normal “term risk premium” where bond investors demand higher rates to offset overall uncertainty, which is higher for our economy. .

“Higher-growth markets and those closely tied to Asia have generally shown greater cyclicality and greater exposure to swings (up and down) in global growth,” he says.

ANZ’s David Plank tends to agree. He noted that the widening of the 10-year yield spread from the US to Australia was “largely in response to volatility in the markets and an increase in the risk premium built into the spread.”

“There may also have been some activity related to positioning, magnifying the movements.”

Another more technical reason cited by some bond funds is the frequent use of interest rate swaps to hedge rate risk, as most Australian loans are fixed at a short-term floating rate. That has created structural pressure in 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 to the market, but to the general population.

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

But there has been a big increase in government spending, which tends to be inflationary, and central banks, including the Reserve Bank, have not changed their tune. That leaves them with work to do to restore the faith they once held.

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