Over the last couple of weeks, global bond markets experienced levels of volatility not seen since March last year when the pandemic hit.
The moves in yields were severe, rocking bond investors as prices fell precipitously, and bond funds globally recorded negative returns for the month of February.
While Australia tends to follow global markets, this time around the Australian bond market took center stage, exhibiting volatility levels far in excess of the US and other developed markets says Anthony Francis, investment dealer at Western Asset Management – part of the Franklin Templeton Group.
“The Australian government 10 year yield moved sharply from a close of 1.435% on Friday the 19th of February to a 22 month high of 1.91% at the close on Friday the 26th of February,” Francis said.
“To put this into context, the yield in the 10 year bond is back to levels not seen since April 2019, and the steepness of the curve (the difference between the 3 year and 10 year bond) was at a 29 year high.
Also read: Your Questions Answered: Inflation
“In portfolio terms, this resulted in the AusBond Composite Index recording its worst monthly return in history, declining by 3.6%.
“We remain watchful for further volatility, though similar to the view of our global colleagues, we think the sell-off is overdone.
“With market pricing beyond where we see fundamentals, consistent with our value philosophy we are cautiously looking to add duration at points on the curve into the Legg Mason Western Asset Australian Bond Fund.
“In the wake of the sell off, investors have been left licking their wounds, but also assessing what were the drivers of the shift in sentiment, and wondering whether last week represents a shift in the “new normal”.
“In answering the first question, we believe that a number of factors led the increase in volatility.”
Australian bond market and factors at play
- Positive headlines around global vaccine rollouts
- Increased likelihood of a US stimulus plan being passed by Congress
- Australian data continuing to strengthen the belief the RBA may remove some monetary accommodation sooner than expected
- A perceived level of comfort with higher rates from the US Fed
- Many investors taking profit on long positions which in turn led to others being stopped out as rates moves higher
- Central bankers in New Zealand bringing house prices into their remit which added pressure on rates to move higher there
- An increased focus on inflation and what a global recovery ahead of schedule will mean for it
“While an understanding of how we got here is important, the question remains; “Where to now?” Francis said.
“Recent communication from central bankers has expressed a renewed focus on maintaining stimulatory monetary policy settings for as long as necessary to ensure the recovery remains on track, as well as an increased focus on the sharpness of the move in global yields.
“Locally, the RBA has responded by increasing bond purchases under both its Yield Curve Control (YCC) program as well as its broader Quantitative Easing (QE) program, and while initially the market was underwhelmed at the size of the buying, we have seen yields retreat from the highs seen on Friday.
“Also helping sentiment was the statement by the RBA at their Board meeting on Tuesday where they maintained they would remain flexible in regards to QE purchases and could step them up if required to maintain orderly markets.
“In order to justify the rapid change in yields to the current elevated levels we would need to see the global recovery play out with minimal setbacks, and at the same time would need to see some broad-based inflation start to come through. This inflation is only likely to present itself if we start to see real movement in wage prices and at this stage we are yet to see that materialise.
“When it does it will likely happen slowly and give policy makers plenty of time to adjust settings. It is expected that we will see pockets of inflation emerge as the global economy gets back on its feet, but central banks have stated they will be prepared to look through such events.
“There may be some belief that the RBA may have to follow the lead of the RBNZ and focus more sharply on house prices when looking at the cash rate but we believe they would prefer to leave such responsibility to other Regulatory bodies such as APRA who could re-introduce macro-prudential measures should they feel the need. This would assist the RBA in keeping the cash rate very low which in turn helps to relieve some pressure on an appreciating AUD.
“All told we see the recent price action as overdone, and while short term volatility is likely to remain while the market adjusts to all the factors mentioned above, the current levels of yields presents an opportunity to tactically add value to portfolios.
“The Australian government 10 year is now 25bps above the US 10 year and not where the RBA wants it to be. Such a gap is a lot in global terms and we expect to see some foreign buyers, particularly as currency hedging is cheap with the cash rate so low.”
About Western Asset
At a glance:
- Founded in 1971. Specialist Investment Manager of Franklin Resources, Inc. since July 31, 2020.
- Fixed-income value investors
- $484.5 billion (USD) AUM
- $428.9 billion (USD) long-term assets
- $55.6 billion (USD) cash and cash equivalent assets
- 804 employees
- More http://www.westernasset.com/us/en/