Overseas Markets will have an Increasing Influence on the Domestic Yield Curve

International events are having a greater influence on the Australian economy now than has been the case over the last few years when things have been more stable internationally, both politically and economically.

A comparison of the number of developed countries with negative interest rates between November 2018 and August 2019 is shown below.  Bloomberg reports a quarter of all bonds issued by governments and corporates worldwide now trade at negative yields. 

During August, the German government issued €784 million of 30-year debt with a 0% coupon and at a premium to par, meaning the debt was issued with an effective negative interest rate with investors being promised total cash flows less than their initial investment.  An obvious question is “what fool” would buy a bond with a negative interest rate?  Apparently, there are many of them currently.  The only possible way a buy and hold investor can gain from such an investment is if inflation is negative over the period meaning the investor received a positive “real return” (or a positive return in inflation adjusted terms).

It is not a coincidence the countries with negative interest rates are Japan and the more credit-worthy European countries whose economies are in stagnation.  Germany recorded negative GDP growth in the last quarter and economic growth across the European Union is just above 1% per annum with a downward trend.

In the USA, which accounts for around a quarter of global GDP and is still the largest economy in the world, President Trump is unusually transparent as to his economic policy in that he is vigorously pursuing a trade war with China (which will have a negative impact on global growth; affecting other countries and not just the USA and China). To compensate for the impact on the US economy, Trump is vociferously calling on the US Federal Reserve to reduce interest rates. 

The Federal Reserve cut interest rates in mid-September by 0.25% to a target of 1.75% to 2.00% to which President Trump tweeted “Jay Powell and the Federal Reserve Fail Again. No “guts,” no sense, no vision!  A terrible communicator!” in what was one of his milder communications having previously called Federal Reserve Chairman Jerome Powell a “bonehead” for not reducing interest rates to zero to match those of Germany.

For Australia, if global interest rates are heading lower they will drive down the Australian yield curve.  This has already been demonstrated with the Australian 10 year swap yield being whipsawed from 1.41% at the end of July to 1.06% at the end of August and then back up again, largely in response to movements in US Treasuries over the period. 

The same is true for the domestic cash rate, but this is linked more closely to fundamental economics because if interest rates are being reduced globally this is because individual economies are deemed to be requiring additional stimulus. If collectively the global economy is struggling this means that as a very open economy, Australia will be adversely affected by a global slowdown and therefore will most likely follow other central banks in lowering interest rates, particularly if all the major international economies are moving in the same direction which now seems to be the case.

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