By what measure are long-dated bonds more alluring..?

Assuming the Reserve Bank (RBA) does cut the official cash rate by another 25 basis points to 1.5% in August, and then possibly as low as 1.25% in November, long dated government bonds – especially those maturing in 10-plus years – could start looking increasingly more attractive to income investors, given they’re a relatively safe-haven against the rising risk of deflation.

The recent rate cut is quite staggering given that only a few weeks ago economists were priming the market for a rate increase.

What’s fuelling investor angst is Australia’s weaker-than-expected inflation figures, and talk of interest rates ultimately heading below 1% and into a territory that’s been deployed by more troubled economies than Australia.

Unsurprisingly, when the RBA cut its cash rate by 25 basis points (bps) to an all-time low of 1.75%, – on the back of low inflation readings for the first quarter – Australian government bond futures took off, with the three-year bond contract touching a record of 98.450, while the 10-year and 20-year contracts contract rose 11 ticks to 97.7200, and 6.5 ticks to 97.0750 respectively.

What we’re also witnessing is a narrowing of the rate gap between Australia and its developed-market peers. For example, the premium between Australian and US two-year cash bonds also dropped to its lowest in a decade at 86 bps, while local two-year yields recently dived to reach an all-time low of 1.57%.

But while further budget slippage will likely drive another year of record bond issuance, the risks to yield and spread forecasts does appear to be skewed to the downside.

Like it or not, compression is likely to be the order of the day when it comes to Aussie and particularly at the long end of the curve.

Assuming the cash rate is heading for 1%, forecasts for benchmark 10-year Australian government bond yields are likely to be cut.

There’s a prevailing view by some brokers that for 10 years, 2016 will end up at 2.30% (previously 2.50%), with a spread compression to US Treasuries ending up at 30bp.

Similarly, for end-2017, despite the Fed’s rate hikes and rising US yields, Australian 10-year bonds are likely to remain lower for longer at 2.40%, as the spread tightens further to 10bps, while the 2-year spread between Australian and US rates is still more than 140bps.

Meantime, it is also worth watching whether improving manufacturing data in the US, a suspected increase in industrial commodities – plus strong signs of US inflation, and further quantitative easing – can close the gap between falling bond yields and rising cyclicals – which typically move in the same direction.

KEY BOND MOVEMENTS:

Government bond yields:

* CGS 5.25pct March 2019, 1.569pct, from 1.571pct on Thursday

* CGS 4.25pct April 2026, 2.295pct, from 2.297pct

Sydney Futures Exchange prices:

* June 2016 bill futures, 98.030, from 98.040 on Thursday

* September 2016 bill futures, 98.160, from 98.170.

(*Closes taken at 1630 AEST previous local session)

Source: IRESS