By Raymond Chan
 
On 3rd February 2015, the Reserve Bank of Australia (RBA) decided to cut rates by 0.25% to 2.25%, citing weak domestic demand growth and high unemployment. In our first edition of Latte with Ray, we would like to draw your attention to the Australian yield curve.

Latte with Ray believes the inverted yield curve is in fact the reason why the RBA will make another early move.

Yield Curve: “A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.” Investopedia.com

Inverted Yield Curve: “An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.” Investopedia.com

As shown in Chart 1, Phillip Anderson (phillipanderson.com.au) demonstrated how the rate differential between the 90-day bank bill and 10-year bond can be used as a guide for the nation’s economic health and more importantly (sometimes) the direction of the economy. When the short-term interest rate is below the long-term rate, the yield curve is said to be positive. A positive yield curve indicates an economy that will grow (or continue growing) in the near future. When short-term interest rates are higher than long-term rates the yield curve is said to be negative or inverted. An inverted yield curve may suggest the economy may go into recession. This happened in 1974, 1983, 1991. Having said that, we also had inverted yield curves in 2008 (during the GFC) and 2012 (during the European Banking Crisis) without going into recession. In 2008, our former treasurer, Wayne Swan, followed our G20 counterparties and boosted the economy through fiscal stimulus (which resulted in a massive budget deficit). In 2012, the European Banking Crisis was resolved by Super Mario’s “Whatever it takes”.



In Chart 2, shows that in Jan 2015, the yield curve has again turned negative (or inverted) with the short-term yield (2.53%) running higher than the long-term yield (2.44%). This sparks the talk of Australian going into recession. We all know the RBA cut rates in its first meeting but the future market is now factoring in a 40% chance of another rate cut as shown in Table 3.



Table 3 – Probability of Rate Cut in March’s meeting

Source: ASX

In the past, the futures market has been pretty accurate at pricing in RBA action. The RBA will need to address the issue of the inverted yield curve over the next few months. As such, we see a good chance of another rate cut before June.

Australia is fortunate to have the official cash rate still way above zero. This buffer will provide Glenn Stevens with sufficient firepower to stop us from going into recession.

Further, we noted that the inverted yield curve is caused by ‘Bull Flattening’ as shown in Chart 4. The Bull Flattening means the long-term rates are decreasing at a rate faster than short-term rates. This causes the yield curve to flatten as the short-term and long-term rates start to converge.



In the period of “bull flattening”, the following sectors usually outperform:

  • Banks
  • Media and entertainment
  • Utilities
  • Retail
  • Real estate
  • Consumer goods

while the following sectors usually underperform

  • Building construction
  • Oil and gas
  • Mining
  • Small caps



PS. In November, we called ELD (Elders) as our preferred exposure in agricultural. Since then, ELD stock price has rocketed from $1.80 to  $3.20 (on stock consolidation basis) - one of the best performing stocks on Australian Market.