The Australian bond market (as measured by the UBS Composite Bond Index 0+YR) returned 1.01% in August. Over the month, 3-year government bond yields fell to 2.63% from 2.71%, while 10-year yields fell to 3.29% from 3.51%. Short-term bank bills dropped over the month: the 1-month bank bill swap rate (BBSW) fell to 2.61% from 2.65%, the 3-month rate to 2.63% from 2.66%, and the 6-month rate to 2.64% from 2.68%. The Australian dollar rose slightly over the month, starting at USD 0.930 and ending at USD 0.934.

At its 2 September meeting, the Reserve Bank of Australia (RBA) again left the official cash rate on hold at 2.50%. The Australian Industry Group’s Performance of Manufacturing Index (PMI) slipped back into negative territory in August, following a brief stabilisation in July. The index fell by 3.4 points to 47.3 points (seasonally adjusted), indicating a mild contraction in conditions across the manufacturing sector. Many respondents to the survey expressed ongoing concern about the persistent strength of the Australian dollar, which has increased import competition and lowered both domestic and overseas demand for locally made products. Manufacturers remain cautious about the outlook and continue to focus on reining in their costs, as they battle very weak trading conditions across most sub-sectors.

The RP Data-Rismark home value index rose solidly in August, up 1.1% across all capital cities, taking the aggregate capital gain to 10.9% year-on-year. According to RP Data research director Tim Lawless, considering the ongoing high rate of auction clearance rates, a generally rapid rate of sale and the ongoing low interest rate environment, it’s likely that dwelling values may rise even further over the next three months.

According to the Australian Bureau of Statistics (ABS), capital expenditures (capex) for the June quarter 2014 registered a surprise seasonally-adjusted 1.1% lift over the quarter, beating analysts’ expectations for a 0.9% fall, although there was a 4.0% decrease over the year. Although manufacturing continued to deteriorate and mining was flat, capex in other parts of the economy continued to strengthen moderately throughout the first half of 2014.

Australian Market Outlook

The Australian economy seems to be struggling to achieve traction as the mining boom transitions from a capital expenditure phase (which is labour-intensive) to a shipment phase (which is good for net exports but less labour-intensive). As we move into the shipment phase, iron ore volumes are increasing dramatically, which is helping to hold up the value of exports despite the iron ore price decline. In coal, volumes are increasing but prices are declining, lowering the value of the gross exports.

The RBA cut rates to help revive interest rate sensitive sectors (such as housing, overseas education, and tourism) which had suffered from the high rates of the mining sector’s capex phase. Although we are seeing improvements in housing, construction and consumer spending, it is uncertain whether they are growing strongly enough to offset the decline in mining. Although employment growth at 0.9% is positive, it isn’t sufficient to offset increases in the participation rate or population growth so employment remains weak. The high Australian dollar is another headwind which adds to our view that the RBA is likely to keep rates on hold at 2.50% for some time and that the next move in rates will be upwards at some point in 2015.

Australian bond prices have been increasing, tied to the German bund rate, with the market losing its historically high correlation to US rates. This can be attributed to the fact that the nature of our market has changed in the last five years with a deeper, more liquid market attracting a wider range of investors. Demand for higher yielding assets from offshore investors are likely to continue to keep Australian bond yields lower than they would otherwise be.