The key theme of the past few years has been quantitative easing (QE). Although the US has come to the end of its version of this experiment, QE programmes have begun or are about to begin in Japan and Europe. The purpose of these QE programmes is to ward off deflation and stimulate growth in these economies as has occurred in the US (although how much of this is attributable directly to QE is debatable). QE is largely a foreign exchange-orientated policy which should help both Japan and Europe by devaluing their currencies.
2014 saw burgeoning strength in the US economy. An increasingly robust labour market and other anecdotal evidence suggests that wages should be increasing and, based on history, that Federal Reserve (Fed) policy should be tighter. However, the Fed doesn't want to tighten monetary policy too quickly if there is any chance that it could stifle the US recovery. Since US inflation remains below the Fed's 2.0% target, there is no great urgency for them to increase interest rates on that basis. With Europe/Japan driving their currencies down, the US dollar has been and is likely to continue to appreciate, which may start to negatively affect growth and should in due course start to push down US inflation.
US bonds rallied in 2015 partly due to the delay in Fed monetary policy tightening, plus lower pricing of inflation and the large spread differential between US Treasuries and German bunds. Although we should still see the first increase in US rates in mid- 2015, US Treasuries may not experience as large a sell-off as one might expect with German Bund yields still so low. We expect that any significant US bond sell-off will require a sell-off in European bonds also. A major theme in 2014 was German bunds outperforming US Treasuries, while US equities outperformed European equities. January 2015 has already seen a major reversal in the spread between US Treasuries and German bunds, with US bonds outperforming (along with European equities).
US 10-year Treasury spread to German bunds (%)
In terms of commodities, we see China as a source of uncertainty rather than strength. Commodity prices have been affected by the fact that its economy is gradually transitioning to a more consumption-driven model. Going forward, oil prices should be positive for US growth in terms of consumer spending, but low prices won't do anything directly to increase core inflation. It is likely that we will continue to experience volatility as prices adjust and it is possible that lower prices will be with us for some time.
Australia outlook: Economic transition intensifying
Australia's economic transition will intensify as the mining boom moves to a production/shipment phase and 2015 will likely see a further fall in mining capital expenditure, particularly in the gas sector, and employment. Although employment growth is positive, it isn't sufficient to offset increases in the participation rate or population growth so employment remains weak. Unless the participation rate falls or employment growth picks up, unemployment will probably continue to rise. Over the past six months, annual growth in the labour force averaged 1.6%, while employment growth only averaged 1.2%, leaving a shortfall that has led to an increase in the unemployment rate.
The fall in Australia's terms of trade was sizeable in 2014 and although the AUD has fallen significantly against the USD, it has rallied vs. the Yen, Euro and Canadian dollar. The Trade Weighted Index (TWI) is a weighted average of a basket of currencies that reflects Australia's exports/imports to different countries. It's often used as an indicator of Australia's international competitiveness and is a useful gauge of the value of the AUD. Although the AUD is depreciating against the USD, this is mainly due to the fact that the US economy is performing strongly and the USD is appreciating against most currencies. However, the TWI indicates that the Australian dollar isn't depreciating against other currencies. This means that the TWI has not depreciated by as much as the terms of trade and the AUD remains higher than the Reserve Bank of Australia (RBA) would like.
Australia terms of trade vs. Commodity index
The fall in the terms of trade means that the income side of GDP is in a technical recession. The fall in oil prices has helped incomes but has not offset the income fall. The reduction in mining capital expenditure is expected to accelerate this year. However, Australia will be helped by larger export volumes of iron ore and LNG next year as the mining boom transitions from the investment to the production stage. In addition, the somewhat weaker currency should help to offset lower prices.
Iron ore volumes vs. values
At Nikko AM Australia, we now believe that the RBA is likely to make two further rate cuts this year, with the first potentially in February. If the RBA does cut interest rates, it is highly unlikely that they will make only one cut, so we could see Australia's official cash rate at 2.00% by the second quarter of 2015. However, the effect of this on the bond market is likely to be muted since recent price action shows the bond market has largely priced two rate cuts in already.