Trouble is brewing in the bond market

A dramatic fall in bond rates and equity values and decline in commodity prices are signs of more tumultuous things to come for the Australian economy.

This week we have seen a ‘shorters’ picnic’. Those selling the market down have made big profits.

But the bad news is that what the share and bond markets are predicting will become apparent to the general population over the next six to 12 months.

Last week we rejoiced in the fact that the shorters were routed because an unexpected fall in Chinese interest rates caused commodity shares to rise and forced the institutions that had sold stocks they didn’t own (the shorters) to cover by buying back the stocks at prices that were above what they had sold.

The shorters suffered big losses as resource shares jumped (China’s short lesson is sending a powerful message, November 25).

But more bad news on the oil and long-term iron ore front has again sent the market into reverse and the shorters have again sold it down to multiply the falls.

As I explained last week, the shorters borrow stock from big Australian superannuation fund managers, who effectively depress the market by lending their clients’ stock, albeit not in the clients’ interest.

At some point there will be a short covering rally.

But there is a second development in our markets that actually has greater importance than the shorters’ picnic we are currently seeing.

The Australian ten-year bond market is rising dramatically as yields fall. Richard Morrow of Baillieu Holst sent me a graph that shows the declining Australian ten-year bond rate has broken through the 3 per cent mark ahead of today’s Reserve Bank meeting. It is two years since our bond rates have been so low.

That tells us that the bond market expects the Australian economy to slow and indeed Bank of America Merrill Lynch economist Saul Eslake has warned of an income recession, with the national accounts tipped to show a second quarter of weakness this week (Eslake warns of income recession, December 2).

There is no chance of a rise of interest rates, which a clutch of analysts were forecasting earlier this year. 

Today’s rate will be steady and, if there is future movement, it will be down and not up.  

The Reserve Bank is unlikely to lower rates until it is satisfied that housing prices are not about to boom. The only place where a boom is likely is the Sydney market. Both Sydney and Melbourne are over building one and two-bedroom apartment blocks as a result of an influx of Chinese and Asian capital. When the inevitable oversupply hits the market, it will remove any likelihood of a boom but that is a couple of years away. 

Behind that fall in the bond yields and equity values (leaving aside the shorters) is the fact that in this slowing Australian economy wage rises are going to be hard to come by. Therefore people will have less discretionary spending, which will reduce the ability to pay high rents.

In the front line of lower discretionary spending are department store retailers but there will also be a wider array of other activities, including attendance at sporting events, where high prices are charged for entrance and/or food and drink. 

Australia’s lower growth environment puts us at odds with US and Europe, and even China. Unfortunately China’s growth will not be in the areas of the economy that require our commodities. Low Australian growth is going to make politics an extremely difficult arena and, at some point, the politicians are going to have to tell the truth to the electorate. Tony Abbott has had a stab at it but, as he didn’t warn anyone in the election campaign as to what was ahead, he did not have the credibility.