My recent articles have been focused on the US bond markets and how the prevailing interest rate direction will affect mortgages as well as the continuing threat of the sub-prime credit crunch. There has been a recent break to the upside of the 30 year bond in the US as the Fed continues to increase liquidity in an attempt to avoid recession. Whether or not they have done enough remains to be seen, though further cuts are expected regardless of how a weakening US dollar and increased oil prices threaten inflation.
Now that the elections – and the use of interest rates as political fodder – are over and done with, it’s a good time to investigate the interest rate environment in Australia.
The fundamental situation in Australia has remained the same for most of 2007. Unlike the US, domestic energy price increases have been offset by currency appreciation and a fall in imported inflation. At the same time, wage pressure and low unemployment retain their bogeyman status and have the greatest effect on interest rates. Problems with the US economy and a slowdown in global growth may well be the only salvation for the beleagured over-leveraged Australian mortgage and debt holder.
Since June/ July 2006 the Australian 3-year bond (AYB-Spotv) has been tracking downwards in price, as can be seen from the chart below. Moving between a well defined channel, the direction and trend has been constant.
click chart for more detail
Some readers may be aware that there is an inverse relationship between price and yield. Income bearing instruments (such as bonds and bills) become less attractive when alternative investments (such as bank accounts) offer better returns. In anticipation of interest rate rises, therefore, bond investors sell bonds and the bond price drops.
If the current bearish resistance line holds, the three year bond chart could be telling us a few interesting things about interest rate direction and even equity market direction. Primarily, the interest markets look like they are about to begin a move back to the return line. This translates into higher interest rate expectations for the remainder of 2007 and well into 2008. Looking at this part of the bond yield curve, further tightening is evident beyond these dates. However, it is worth noting that the further out in time that estimates are made, the more speculation is increased!
Thus far, October and November have shown themselves to be mediocre months for the equity markets. In a situation where the 3 year bond continues within its channel pattern, there could be enough expectation that rates are continuing to rise because of excessive growth within the domestic economy. This growth may then be translated into higher share prices for those companies that benefit from internal growth (banks, consumer discretionary and staples). The remainder of this year and into very early 2008 could see a rise in equities as they again become flavour of the month.