Throughout 2018, Australian 10-year interest rates have been relatively stable at 2.50 per cent, while in the US rates rose almost half a per cent to 2.90 per cent, causing Australian rates to fall below the US. We don’t see this often – the last time was 20 years ago.
Because of this long-term relationship and the fact that US Treasuries are often thought of as the world’s risk free asset, many believe that Australian interest rates need to rise in order to establish more ‘normal’ market conditions. However, two key factors suggest that the current environment could persist for some time.
The first of these factors is the cash rate differential between Australia and the US, which has recently moved in favour of the US. Cash rates are an important variable in fixed income markets as they create an anchor point for long dated bonds, which reflect estimates of the future cash rate path.
As investors have the choice between holding the cash rate and longer dated bonds, typically longer dated bond yields will rise as the cash rate does. Given Australia has historically had a higher cash rate than the US, ranging anywhere from -0.50 per cent to 5.25 per cent above the US, it has meant that most yields in Australia have traded above their US counterparts.
However, since the US Federal Reserve began increasing their cash rates in 2015, this gap has slowly closed and now sees US cash rates above Australia’s, taking the US 10-year yield above Australia’s.
The reason that Australia’s long-term yields can remain below that of the US is that these cash rate differentials are expected to continue to move in favour of the US. For example, over the next 12 months the market expects the Fed to hike their cash rate three times, while the Australian rate is expected to remain on hold.
As long as the US cash rate remains above Australia’s, we should not expect Australian bond yields to be meaningfully higher than the US, barring some large change in market expectations.
The second factor is that this is not just an Australian issue, but rather a global phenomenon. Looking at G12 interest rates shows that currently only Italy (3.15 per cent) has interest rates above the US, and this reflects concerns over a populist government. The other G12 countries all have interest rates below that of the US, ranging from a low in Switzerland (-0.10 per cent) to a high in Canada (2.25 per cent).
Taking the average G12 interest rate, excluding the US, shows that not only are almost all countries below the US, but they are also far below their historical norms. From 2000 to 2014, the spread between the US and the average G12 rate was approximately +/- 1.0 per cent. However, from 2016 onwards this spread has almost doubled as the US is now 1.75 per cent over the average G12 interest rate.
This means that the current situation observed in Australia is in no way unique, but rather part of a broader global phenomenon of interest rates being low compared to the US. Those in Australia who are thinking that our interest rates are too low may need to take a broader perspective, as we are still well above the average G12 interest rate of 1.1% and markedly better than some countries that have negative yields.
While many market participants continue to question why Australian interest rates are so low, perhaps a more interesting question to ask is, ”Why are US rates so high?”