Pimco Says Slow Growth Cuts Neutral Rate by 2%: Australia Credit

May 26, 2014 7:07 pm ET

May 27 (Bloomberg) -- Australia’s two-decade-long boom is showing its age, making Pacific Investment Management Co. bullish on bonds due in three-to-five years because the central bank will be slower to raise interest rates.

The cash target’s neutral level, which neither spurs nor slows growth, is closer to 3.5 percent, compared with 5.5 percent previously, because the economy is slowing and the additional costs borrowers like mortgagees now pay above the benchmark have risen, said Adam Bowe, a Sydney-based money manager at Pimco. The present Reserve Bank of Australia rate of 2.5 percent “roughly” matches policy settings during periods when the country has grown slowly without entering recession, he said.

“The current rate certainly isn’t emergency, it’s not recessionary, it’s just stimulatory,” Bowe said in a May 23 interview. “Any adjustment back to neutral for rates is going to be gradual and finish at a lower level than has historically been the case.”

The RBA will hold its benchmark until it sees sustainable declines in unemployment, which will only happen when growth is above trend, considered to be about 3 percent, Bowe said. He predicts a growth pick-up toward the latter half of next year. The fund manager said risks from China, Australia’s largest trading partner, had increased as the housing market there slows and threatens the steel-consuming property industry.

Record Pause

A Credit Suisse Group AG index shows swaps traders have practically erased rate-rise bets for the year ahead, after seeing as much as an 88-percent chance of a quarter-point increase in April, amid lower-than-expected price pressures and a federal budget that cut consumer confidence to its lowest level since 2011. The RBA reiterated in minutes released May 20 that the benchmark will remain low for “some time yet.”

The last policy change was a rate cut in August, so markets are pricing in a pause of at least 21 months, which would be the longest on record for the central bank in data going back to 1990. Australia’s last recession ended in 1991.

To the extent that potential growth rates for emerging and developed economies converge, Australia will lose the “windfall gain” of higher export growth and prices seen in recent years, said Sydney-based Robert Mead, a Pimco money manager.

“So, we have to slowly move back to the pack and start to experience more developed-market-like growth characteristics,” he said.

Growth Struggles

The economy will struggle to grow “meaningfully” above 3 percent till a pick-up in resource exports, Bowe said. The capacity expansion of the past few years will translate into higher exports, particularly of natural gas, in the second half of 2015, he said.

The Australian economy is forecast to expand 2.8 percent this year, compared with 3.6 percent in 2012 and 4.6 percent in 2007. The U.S. will grow 2.5 percent in 2014 and the U.K. 2.9 percent, according to estimates compiled by Bloomberg.

China’s expansion will slow to 7.3 percent, the weakest since 1990, the data show.

Pimco prefers bonds in the three-to-five year area given its outlook for the RBA and after a substantial rally in longer- maturity securities, said Bowe.

Bonds Rallying

The nation’s sovereign securities are poised to return 8.6 percent this year, the biggest annual advance since 2011, according to a Bank of America Merrill Lynch index. Debt due in three to five years has risen 5.3 percent while notes maturing in five to 10 years returned 10.5 percent on an annualized basis, the data show.

Three-year yields were at 2.77 percent yesterday after falling to a near eight-month low of 2.71 percent on May 22. The 10-year yield was at 3.74 percent following a drop to 3.65 on May 21, the least since Aug. 6.

The local dollar bought 92.41 U.S. cents as of 5 p.m. in Sydney yesterday after falling 1.4 percent last week, the biggest weekly drop since January.

The risks of a more meaningful slowdown in China have grown at the margin as the focus shifts from defaults in shadow banking and wealth-management products to a general slump in the property sector, Bowe said. “Any dramatic slowing in Chinese investment in their housing stock certainly has meaningful consequences for us,” he said.

China Risks

China’s new-home prices rose in April in the fewest cities in a year and a half and home sales fell 18 percent from March. The central bank on May 13 called on the biggest lenders to accelerate the granting of mortgages as developers including China Vanke Co. and Greentown China Holdings Ltd. cut property prices to lure homebuyers.

Chinese President Xi Jinping said this month the nation needs to adapt to a “new normal” in the pace of economic growth and remain “cool-minded” amid a slowdown that analysts forecast will lead to the weakest expansion since 1990.

Prices of iron ore, Australia’s biggest export, dropped 27 percent this year to $97.50 on May 23, the least in 20 months. They have averaged about $130 since the end of 2012.

“Australia’s terms of trade haven’t really adjusted because we keep getting these iron ore spikes and it eventually needs to settle lower,” Mead said, referring to a measure of the nation’s export revenues relative to its import bill. “We expect a policy response from China but we don’t think it’s going to have the same traction, because history shows that the traction of these policy moves is getting weaker and weaker.”