A rates pressure gauge

PORTFOLIO POINT: Economic challenges around the globe, and strong demand for Australian bonds, should exert downward pressure on yields and limit the likelihood of losses on bonds.

The Reserve Bank’s decision to cut interest rates by 25 basis points on October 2 could be the first of several cuts – one of the consequences of a slowing Asia.

Certainly I expect Australian cash rates to continue falling in 2013 as the previous Asian engines of growth – most notably China – cool down, with Australia being caught in the rip. If this prognosis is correct, it will be positive for investors in the domestic bond market.

According to the latest PIMCO Cyclical Outlook for Asia, China’s growth will fall to 6.5-7% over the next six to 12 months. In this economic environment, a slowing China will continue to act as a drag on the rest of the region in a number of ways. One of these is falling commodity prices – critical for Australia.

In particular, as China’s fiscal focus shifts from public investment to tax cuts and consumption subsidies, demand for steel will fall. Iron ore is our largest export and recent price weakness will have a significant impact on Australia’s terms of trade and nominal income. This will make the federal government’s goal of delivering a budget surplus in 2012-13 much more challenging, and require a more aggressive monetary policy from the Reserve Bank as the mining sector learns to adapt to lower demand and falling prices.

But as the recent Reserve Bank meeting minutes demonstrate, China’s economy is not the only factor in play likely to influence the central bank to push rates lower. The fact is, the world is facing a number of very significant challenges for which there are no easy solutions.

The Eurozone faces high debt levels, a lack of structural growth and pressure to get the policy mix right to avoid contagion. The US is suffering slow growth, high debt, a looming fiscal cliff and political polarisation. And globally, a lack of policy coordination, increased income inequality and the growing use of social networks as communication tools also present long-term challenges.

Uncertainty is one common theme, and another is the potential for more extreme outcomes, good or bad. The Eurozone, for instance, has to either find a path towards fiscal union or create a mechanism for orderly exits, with very little room to manoeuvre in between. Likewise, the US needs to find a way to resolve its fiscal issues or face the consequences of a further downgrade and eventual loss of reserve currency status.

The implications of this economic outlook are important for Australian investors, particularly those that keep a close eye on Australian interest rates. In short, the story bodes well for fixed income, but not so for term deposits.

The fall in GDP growth as the sting comes out of the commodity boom will require a policy response. In a recent study of foreign ownership of Australian government bonds, PIMCO identified that with the federal government to embark on a sharp 3% fiscal consolidation over the coming financial year the burden of this response is likely to fall on the Reserve Bank. I would expect it to be in the form of a lower cash rate in the first instance rather than direct intervention in the foreign exchange market.

If this occurs, it will have the combined effect of further depressing term deposit rates, forcing holders to roll over at lower levels, and also provide support for Australian bond prices over the next six to 12 months as rates stay lower for longer.

Furthermore, demand for Australian Commonwealth Government Bonds (ACGBs) remains strong, with overseas investors seeking our government debt as a safe haven investment. This is due to Australia’s AAA rating, stronger overall economic fundamentals and still healthy balance sheet, especially when compared with many other sovereign balance sheets around the world.

In the 12 months to June 30, 2012, foreign investors bought A$48 billion of ACGBs, making government paper our second biggest export after iron ore and ahead of coal for the same period.

As a consequence, the coalescing of these overseas trends out of China and the rest of the globe, along with the keen demand for ACGBs, should continue to exert downward pressure on yields and limit the likelihood of any capital loss for bonds.

Peter Dorrian is head of Global Wealth Management at PIMCO Australia.