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[FIXED INCOME] Heed the Doves, but beware the Hawks…

By Jonathan Baird

Most developed bonds rallied strongly in the formative months of 2016. With soft economic data, structurally low inflation and Brexit fears supported bond prices in Europe, while 'global developments' weighed on the markets view of the Fed's Fund path.

In Australia, Chinese contagion fears pushed yields lower from December through to February, before PBoC stimulus and commodity price stability provided a catalyst to arrest the risk off momentum and enter a more range bound environment.

That was until the global dis-inflation trend raised its ugly head in the Australian CPI print released in April. The structural decline was broad based and highlighted that the RBA is on track to miss its inflation target over the medium-term. The RBA's response was swift—they cut the cash rate by 25bps and lowered their forecasts for inflation in their SoMP.

Both sent bond yields falling, with some well-known economic commentators shifting their outlook from a tightening bias to forecasting a 1% cash rate over the next 12 months.

Our portfolios were positioned well, with a long in the front end of the curve—reflecting our long held view that the RBA would eventually need to ease despite their reluctance. The market continues to price in a further 25–50bps of rate cuts over the coming 12 months—we view the RBA to be data dependent and believe the recent rate cut does little to change the Board's reluctant easing stance. Calls for rapid-fire RBA rate cuts are a little stretched, in our view.

This week's labour data has continued to highlight the fragility of the domestic economy, but has lacked the 'sticker-shock' of last month's CPI release. While the lowest ever wage growth print (series inception 1998) continues to point to the structural decline in inflation, headline employment data remained broadly resilient. That said, the devil is in the detail and in this case the trend away from full time employment and a moderating participation rate indicates employment markets may be softer than the 5.7% unemployment number suggests.

Our base case for Australia remains consistent—anticipating one more rate cut in 2016 with the view that the RBA's August meeting is likely to be the earliest timing as they await the economic data due for release in the coming months (GDP, CPI, etc).

Elsewhere in the world:
Japanese Q1 GDP growth rebounded to 1.7% saar avoiding another technical recession, although Q4 2015 was revised down from -1.1% to -1.7% saar.

In the US, minutes from the Federal Reserve's April meeting showed that many board members believed an increase to interest rates would be 'appropriate' at the June meeting if economic data and labour conditions continue to strengthen. The Hawkish tone surprised the market, which had become overly pessimistic regarding the profile of the Fed Funds path, with bonds selling off across the US curve. Again, our portfolios were well positioned ahead of the event and took advantage of the price action to take profits on our Australia vs US compression trade.

Looking forward, despite the recent polls suggesting a shift towards staying in, the Brexit referendum remains a considerable headwind in the UK and Europe and will be a source of further volatility, globally. Looking further afield, Greece has a significant amount of debt maturing in August and while we do not believe this represents a clear and present danger, we will continue to monitor negotiations closely.

Our Diversified Fixed Income Fund is positioned with these themes in mind—overweight markets where there remains an easing bias such as Australia and underweight regions such as the US, UK and Japan and limiting exposure to the European-periphery.

Jonathan Baird is an Investment Specialist at UBS.

Published on: Friday, May 20, 2016

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