RBA Seen Tolerating Inflation as Index-Linked Bonds Gain

Australian inflation-linked bonds rose the most in two years, fueled by speculation the central bank will delay raising interest rates to curb currency gains.

Linkers returned 2.9 percent in May, beating a 1.7 percent advance for conventional government debt as well as Bank of America Merrill Lynch indexes that track corporate, state and other quasi-sovereign bonds. The notes tied to the consumer price index are up 4.6 percent in 2014, versus a 4.2 percent return for the S&P/ASX 200 index of shares.

Consumer prices climbed 2.9 percent in the first quarter from a year earlier, the most since 2011, posing a conundrum for the Reserve Bank of Australia as it seeks a weaker currency to foster exports. The currency is above its 20-year average, even after tumbling 14 percent last year, as near-zero benchmark rates in the U.S., euro-area and Japan spur a hunt for yield.

“That makes it harder for the Reserve Bank to put up interest rates and fight inflation,” said Ben Alexander, a Sydney-based principal at Ardea Investment Management Pty, which manages the equivalent of $4.2 billion. “It may have to tolerate higher inflation.”

Australia’s corporate bonds returned 1.1 percent in May, state debt gained 1.7 percent and quasi-government bonds including supranational securities advanced 1.6 percent, based on the Bank of America indexes.

The Aussie dollar traded at 93.87 U.S. cents at 1:54 p.m. in Sydney. It has averaged about 77 cents over the past 20 years.

Aussie High

Reserve Bank Governor Glenn Stevens said in a statement June 3 that the currency “remains high by historical standards.” He also said inflation should be consistent with the central bank’s target over the next one to two years, reiterating “stability in interest rates” is likely. The RBA aims to keep inflation in a range of 2 percent to 3 percent.

Australia is the world’s fourth-most expensive country, the World Bank reported in April. Only Switzerland, Norway and Bermuda are more expensive, according to the organization’s report.

From fruit to tobacco to furniture, rising costs pushed the TD Securities – Melbourne Institute Monthly Inflation Gauge up 2.9 percent in May, the most since July 2011.

Swap traders are betting on 10 basis points of increases to the cash rate over 12 months, according to a Credit Suisse Group AG index. That’s down from 22 basis points on April 10.

Linker Demand

At a sale of four-year inflation-indexed bonds yesterday, investors bid for 5.34 times the amount of debt available, versus 4.28 at an auction last week of nominal bonds maturing in 2025.

“Real yields have been declining across most developed markets as the market comes around to the fact that neutral rates around the world are a lot lower than they would have been in previous cycles,” said Altaz Dagha, a London-based rates strategist at Westpac Banking Corp. “On a cross-market basis, it’s still much more attractive moving into Aussie real yields, so there’s scope for further outperformance.”

The benchmark rate’s neutral level is considered to be one which neither spurs nor slows growth, while real yields take into account the impact of inflation.

The real yield on Australia’s 2022 inflation-linked bond was 1.2 percent, compared with 0.2 percent in the U.S. for debt of a similar maturity.

Australia’s record-low benchmark of 2.5 percent compares with near-zero rates set by the Federal Reserve and Bank of Japan. The European Central Bank’s unprecedented package of stimulus measures introduced last week, including its decision to cut the deposit rate to minus 0.1 percent, is also helping make Australia’s yields more attractive on a relative basis.

On Steroids

While Australia is expensive, wages will keep inflation pressures in check and help nominal bonds rally, said Yusuke Ito, a bond investor at Mizuho Asset Management Co. in Tokyo. Mizuho has preferred Australia’s 10-year notes this year, and yields will fall to 3.2 percent by Dec. 31 from 3.85 percent today, Ito said.

“Inflation is mild,” he said in a telephone interview June 4. “The growth rate in wages has been decelerating.” Mizuho oversees the equivalent of $38.9 billion.

Wage costs rose at an annual 2.6 percent pace in the fourth quarter of 2013 and again in the first three months of this year, the smallest gains in government data that started in 1998. The number of people employed rose by 14,200 in April, compared with a monthly average of 13,000 over the past five years, statistics bureau data show.

Bill Bovingdon, the chief investment officer at Altius Asset Management Pty in Sydney, said Australian linkers have outperformed during the rally due to their long maturities. They will also underperform during declines, he said.

“They’re bonds on steroids,” Bovingdon said in a telephone interview yesterday. “May was a very strong month for bonds. They’re the longest securities in the Australian market. They have the highest sensitivity to rate moves.”

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