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Anthony Kirkham, Head of Investments at Western Asset Australia and Portfolio Manager of the Legg Mason Western Asset Australian Bond Fund
With the US Federal Reserve tightening monetary policy and US bond yields rising, the outlook for Australian interest rates has become very topical. Will the Australian market be dominated by tightening financial conditions in the US or are there domestic forces that may enable cash and bond rates to hold their ground in the months ahead?
Australia is different
Whilst Australian bond yields often move in tandem with the US, particularly during periods of market weakness, it is not unprecedented for the domestic market to outperform US moves or even “do its own thing” for periods of time. Market correlation is a strong force, but sometimes domestic fundamentals are even stronger.
In the current environment, we believe there are significant differences between the US and Australia – including the extent of previous policy easing, the structure of the housing market and the level of fiscal stimulus – that suggest Australia may continue to trade somewhat independently. These themes are discussed in more detail below, along with the implications for domestic credit spreads.
The extent of the easing cycle
The first major difference between Australia and the US is the extent to which their respective central banks eased monetary policy following the financial crisis in 2008. US rates went to zero, Australian rates did not. The US used extensive quantitative easing to stimulate the economy, Australia did not. This is significant as it suggests the early stage of the US tightening cycle – the part we are in right now – is actually policy rate normalisation, not really policy tightening. It’s all about getting the Federal Funds rate back up to a more “normal” level relative to history, now that the US economy has recovered.
In Australia, the mining boom initially supported the economy and when that ended in 2012, growth broadened out to other sectors, preventing a recession. Monetary policy was eased but the cash rate settled at 1.5% and no quantitative easing was necessary. So, there is less need to “normalise” interest rates in Australia and this is taking some pressure off the Reserve Bank of Australia (RBA) which has now kept interest rates on hold for 18 consecutive months.
The structure of the housing market
The process of setting Australian mortgage interest rates is also very different to the US and this dictates that monetary policy tightening will have differing impacts on the respective housing markets. Australian mortgage rates are priced off the official cash rate, so a tightening of monetary policy, of say 25 basis points, usually leads to a corresponding 25 basis point lift in mortgage rates. The more monetary policy is tightened, the higher mortgage rates go, and this can slow the housing sector quite significantly, impacting consumption.