As the New Year gets under way, uncertainty continues to hold sway throughout the asset classes. Australian equities are likely to feel the effects of a squeeze in consumer and corporate credit availability and the possibility of a consumer-led slowdown in the US. Property and cash (including foreign exchange fluctuations) are at the mercy of interest rates. The popular press tells us that these will go through the roof with a Labour government that cannot control wage push inflation.
To shed further light on this sobering economic outlook, it is worth revisiting the analysis of my last article on the 3-year Australian Government bond. The state of the 3-year bond aptly illustrates the short end of the yield curve and can give us some insight into interest rate fluctuations. The 5-Wave Elliott pattern (in this case a bearish impulse pattern) has now completed to a low of 93.36. The final day of this pattern illustrated the power of form reading with a lovely reversal signal on January 4th – a candlestick ‘hammer’. The shadow of the hammer coincided with a slight deviation outside of the return line of the bearish resistance line channel that has predominated the last 15 months.
click chart for more detail
From this reversal the chart is pointing to a rise in bond prices – back into the channel on the chart. The flipside of a rise in bond prices is a fall in bond yields. The market, which has until now been pricing in at least one more quarter point increase in base rates, is beginning to suggest that the increase is no longer a done deal. Economic news is beginning to have an effect on short-dated fixed income securities.
Of course, this is the expected reaction to the downtrend in prices that we have been experiencing for so long. A rise in bond prices does not signal a shift in the Australian macroeconomic outlook, however if prices test the bearish resistance line in the future (or maybe even break that line) the expectations for interest rate rises will not be as high as they were in late December 2007 for a very long time. If prices get near the resistance line you can expect the Australian dollar to weaken across the major FX pairs, at which point – in the absence of any further sub-prime related problems – housing prices should begin to stabilize. Equities will be slower to react and could remain depressed for an extended period.
Falling bond yields will ease pressure on credit and lending. As lower yields filter through the economy, it becomes cheaper for companies (and individuals) to begin replacing capital or reinvesting in projects and enterprises. In preparation for this, investors should begin to look for opportunities in yield and leverage into that yield whether it comes from dividends or longer-term fixed income products.