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Aussie Yield Curve Offers Most Shelter

31 July 2017 by Mark Holman

One of the most frequent debates we’re currently having on the desk is where in the world of core government bonds can we position ourselves with the least fear of mark-to-market losses. Naturally, when the market is in risk-off mode this question is easily answered, as tactically holding longer dated government bonds makes complete sense, but strategically positioning for the medium term in many of these core markets is almost certainly going to produce a negative return after inflation.

As a consequence low duration is favoured by many managers, but here too there is little room for error in today’s government bond markets as curves remain relatively flat, despite the more positive economic backdrop and the general move towards policy normalisation.

The front end of yield curves are essentially a compounded view on short term rate expectations and this is a view that all bond managers try to predict in order to assess which yield curves offer the most shelter.

 

Country Base Rate 1 year 3 year 5 year
US 1.25% 1.22% 1.51% 1.84%
Germany -0.4% -0.70% -0.52% -0.18%
UK 0.25% 0.28% 0.29% 0.56%
Australia 1.5% 1.62% 1.88% 2.19%

Source: Bloomberg

Starting with the US and looking at the Fed ‘dot plots’ together with the frequency of recent hikes, it feels that investors could very quickly be offside by straying anywhere along the front end of the US yield curve, as today’s positive carry is likely to be eaten up by higher Fed Funds rates in the near future. In Germany, along with the rest of core Europe, there are technical reasons why the curve is flat and yields are so low, but investors with choice are unlikely to consider investing in this type of exposure. In the UK, one can easily argue that rates should be left on hold for the foreseeable future, but even here there is only room for one rate hike to the five year level, and the MPC could well surprise us if we import too much inflation from our ailing pound as we try and negotiate through Brexit. This leaves us with Australia where we do have a reasonable yield curve, and where we believe rates will remain on hold for the medium term as slack in labour markets still exists and core inflation feels reasonably well anchored.

Consequently, when it comes to rates markets, which we still believe hold less value than credit markets,  the front end of the Aussie curve is our shorter duration rate curve pick of choice for the moment, currency hedged of course.

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