Bonds: tyranny of distance a bonus
The thing to remember when you read reports that the US Federal Reserve's quantitative easing rollback timetable and tighter inter-bank money supply in Chinese economy is causing mayhem in our own government bond market is that Australian government bonds trade in majestic isolation. Other key debt markets, including the home lending market, are not tied to them.
Bond markets adjust yields in an environment where rates are expected to rise, and do so by lowering the price of bonds on issue. This moves the yield on issued bonds up in the same way that paying less for a share that pays dividends boosts that dividend yield in the hands of the share's new owner.
In the US, however, rising bond yields feed directly into economic activity because they are the pricing benchmark for other debt products, including most of America's housing debt. Mortgage rates are rising in America in tandem with rising US bond yields, raising concerns that retreating quantitative easing will undermine the housing market, and America's economic recovery.
Although 10-year US government yields have risen by 40 basis points in a week on the back of the Fed's announcement, they are still objectively low, about 2.54 per cent. The Fed believes the US economy is strong enough now to handle less QE, and if it is correct, America will digest higher bond yields and the higher business and household borrowing costs that flow from them. Remember too that Fed chairman Ben Bernanke says that if the economy does stumble under the weight, the pace of QE's retreat will slow. QE could even expand if the American economy tanks again.
The Fed's $US85 billion QE cash splash boosted liquidity around the world, and bond yields have jumped everywhere on the prospect of a tightening. Rising yields on government debt in Europe are renewing concerns about the debt servicing capacity of Europe's cot cases, Italy and Spain in particular: they are definitely debt markets to watch closely.
The rise in Australian government bond yields since the Fed announced its QE retraction timetable last week is less worrying.
The 10-year Commonwealth bond yield snuck above 4 per cent on Monday to be up half a percentage point since the announcement, and was still elevated at 3.825 per cent on Tuesday, but Australian Commonwealth bonds aren't price-setters in this economy.
Mortgage and business rate loans are influenced by bank deposit costs that are stable, and wholesale borrowing costs that have edged up since last week, but are still as low as they were at the beginning of this year.
Key short-term rates in this market also do not signal a liquidity squeeze. The Reserve Bank's bellwether cash rate fell from 3 per cent to 2.75 per cent in May, and the overnight indexed swap (OIS) rate has only risen from around 2.6 per cent to about 2.67 per cent since the Fed announcements. The OIS was above 3.2 per cent a year ago and is still tentatively pointing to another cash rate cut, although the Reserve is likely to sit on its hands when it meets next Tuesday, and wait to see what boost the recent slide in the value of the Australian dollar delivers.
Higher long-term bond yields here make new money more expensive for the Australian government to borrow, but the result in this financial year may be a wash. The government will issue about $50 billion of Treasury bonds, but within that program it will issue $27 billion of new debt and spend $23 billion to replace debt that is maturing. The $27 billion of new debt will cost an extra $135 million to service if yields remain half a percentage point higher, but the $23 billion of rollover debt that is issued will still replace existing debt that costs more, remembering that 10-year Commonwealth bonds were at yields of almost 7 per cent ahead of the global financial crisis and the world's discovery of Australia as a Triple-A rated safe-haven.
The debt service impact of higher yields is not very large for our government anyway because government debt here is not large by world standards, even after the spending that occurred to bolster the economy during the financial crisis. In a post-crisis world where a debt to gross domestic product ratio of 100 per cent is the panic-stations plimsoll line, Australian Commonwealth and state debt is about 21 per cent of GDP.
Higher fixed interest rates and yields do bear down generally on sharemarkets, and a northern hemisphere bond market price slump that drove yields up aggressively would be imported by Australia if it reignited Europe's sovereign debt crisis and undermined the US economy, dragging global demand, commodity prices and export income down.
The fact that Australia's sovereign debt market runs its own race is a windfall, however, because household debt here is about 93 per cent of GDP, 90 per cent of it in home loans. If home loan and business rates were following government yields up in the wake of the Fed's move, we would have a much more pressing problem.
Reserve Bank assistant governor Guy Debelle is perfectly placed to monitor developments as the Fed changes tack, by the way. He has just been appointed chairman of the Markets Committee of the Bank for International Settlements.