MODERATING inflation is the trend of the year.
Across the globe, economies are seeing inflation come down as the resumption of supply chains eased price pressure on goods.
Central banks have taken the fight to services inflation — which has held on even as goods inflation eased.
In 2023, markets whipsawed on inflation and unemployment data releases, as investors try to pick the end of the rate-hiking cycle.
The latest US Consumer Price Index data came in much weaker than expected on Wednesday, sparking a Wall Street rally.
The US CPI increased 3.2% in the year to October — down from 3.7% annualised in September.
We can now see the light at the end of the tunnel.
US inflation cools
US inflation for October came in at a cool 3.2% year-on-year.
On a monthly basis, October was flat — the slowest since July 2022 — with core services handing out the biggest downside surprise.
Markets welcomed the news that this time around the inflation slowdown is much more broad-based, rather than just a goods-fuelled moderation.
With the US Federal Reserve’s July rate hike still working its way through the economy in the months ahead, markets swiftly took out most of the pricing for any future US rate hikes.
Investors now seem convinced that the last rate hike by US Fed is behind us.
The story back home
Back here in Australia, the picture does not look quite the same.
The most recent CPI (Q3, 2023) surprised to the upside instead, printing at 5.4% year-on-year.
Australia economic strength was confirmed with business conditions continuing to improve in the latest NAB business survey.
Headline capacity utilisation moderated to 84% but remains well above long-run average. Price pressure eased on business inputs but remains elevated at 1%.
We are probably six months behind the US.
US CPI last had a five-handle on it back in March.
Australian capacity utilisation remains stubborn at 84% while the US has dropped below 80%.
The US Fed has been on pause since its July rate hike while the RBA just raised ours.
Even though we may be lagging the US in the disinflation journey, inflation is on the same trajectory here.
Elsewhere, the UK CPI dropped from 6.7% to 4.6% this week.
Bond investors can be more assured that we are seeing the light at the end of the tunnel.
The gap between Australian and US front-end rates should narrow as US Fed starts a rate-cutting cycle ahead of the RBA.
That should buoy short-end US treasuries and weaken the USD against AUD.
For Australian investors, any gain in short-end treasuries should be largely offset by foreign exchange losses.
For long-end bonds, we believe the risk-reward of Aussie government bonds outweighs the US treasuries.
Firstly, Australian 10-year yields at 4.56% are more attractive than US 10-year treasuries at 4.45%.
Secondly, the steepness of the Australian yield curve gives investors good carry-and-roll versus the inverted US yield curve.
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Finally, the supply-demand dynamics work in Australia’s favour.
Australia is running a budget surplus while the US is running a budget deficit.
This means that on the supply side, the Australian government does not need to issue more bonds.
On the other hand, the US has raised its planned 10-year issuance size by US$2 billion to US$40 billion.
On the demand side, the number of captive audiences for US treasuries has dwindled.
US Fed — the biggest buyer — is now a seller, not a buyer.
The reliable Japanese have shied away due to the weakness of the Yen.
And US commercial bank — having learnt from the mistakes of Silicon Valley Bank — are rebalancing away from long-end US treasuries.
With moderating inflation as the trend of the year, investors can be more assured in their bond allocation.
On balance, we believe Australian bonds should provide better risk-reward ahead.
Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
With the goal of building the most defensive line of funds in Australia, the team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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