Bond yields keep falling

Yesterday’s article on the record low Government bond yields in Australia (here http://tiny.cc/vp6jt ) was given a bit of a boost overnight and this morning with yields hitting fresh record lows.

Early this morning, the 3 year yield is at an eye-watering 2.98%, while the 10 year yield is tracking at 3.69%. These are figures never before seen. The interesting issue is how much more will they fall?

My guess is that poor market positioning (investors caught on the hop by the RBA interest rate cuts, the collapse in inflation etc), further downside inflation pressures and Australia’s rolled-gold AAA sovereign credit rating will spur yet lower bond yields in the months ahead.

How low is always difficult (impossible) to get a grip on but if inflation tracks towards 1.5%, the RBA cuts official rates towards 3.0% and global conditions continue to fracture, 10 year yields could drop a further 30+ basis points. Maybe more.

It should be noted that Australian 10 year yields are still around 190 basis points above those in the US and frankly, given the relative economic fundamentals, would investors prefer to lend money to the US government for 10 years for a nominal return of 1.8% or to the Australian government for a return of 3.7%?

I think I know what I’d prefer.

Another issue standing out with these market moves is the official cash rate. While the RBA has surprised almost the entire bunch of market economists by cutting rates in November and December, the 4.25% cash rate is 125 basis points above the 3 year yield and some 55 points above the 10 year yield.

Which is another reason why the RBA will seriously consider a 50 basis point rate cut when it next meets in February. The current 4.25% cash rate is inconsistent with the information in bond pricing. The inverted yield curve beyond the cash rate is screaming “recession” and while a recession in Australia is a very, very low probability, that assumes the RBA does its bit and cuts rates quite aggressively through 2012.

I was thinking that a 3.5% trough would be the low point for the cash rate in this current interest rate easing cycle. But the more the Chinese economy slows, commodity prices fall, inflation dives, local house prices drop and the labour market softens, the more open I am to all of the risks to this projection being to the downside – ie, the RBA may well have to go to 3.0%.

The market is pricing in a 2.75% cash rate for the second half of 2012. It might just be right – again!