 But CAST is now starting. All attendees are in listen-only mode. Hello, my name is Elizabeth Moran. I'm Director of Education and Research here at Fixed Securities. Today I have with me Warren Hogan, ex-cheap economist at ANZ with an illustrious career. We have just delivered a webinar on the miracle economy this morning, but wanted to give you an additional extra adjunct to it on the implications for interest rates and bond yields. So, this morning we talked about the economic environment and some of the risks. And while we touched on interest rates, we thought that a bit more of a focus would be interesting for you. So, without further ado, Warren, over to you. Thanks, Liz, and thanks for having me on today. It's very exciting, the first webinar. I talked about the big picture risks facing us now. We want to talk about what that all means for interest rates and bond yields, which is a topic dear to all of us. So, just a few points to start with. First of all, the US will continue to remain very, very critical to the global interest rate structure. So, the US has been the benchmark interest rate market for decades, and that, I don't think, is going to change anytime soon. In the short term, everything's pointing to higher US interest rates and yields over the next year or so. And a critical element of that is what the Fed does with monetary policy. So, the traditional monetary policy, the Fed funds rate is obviously the anchor interest rate at the short end of the yield curve that affects all money market rates and then bond yields out for longer maturities. But we've also got this issue of QE, which is now being withdrawn by the Fed. So, that's critical. I want to talk about that. Back here in Australia, we seem to be a little bit more vulnerable than the US to economic shocks just because of this miracle economy. The expansion has been going for, as we talked about, 27 years, whereas the US has had a lot more problems in the last decade or so. And that's going to probably mean that Australian interest rates are going to sort of either remain below or at best stay about where US interest rates are for the next year or two. Now, that's certainly not our expectation beyond that time horizon, and it certainly hasn't been the experience in the past. Australian interest rates have tended to have a premium over US interest rates, both in terms of the short-term interest rate and in terms of bond yields. But we're at a particular point in the economic cycle where that sort of normal condition is not in play. But that being said, over the longer term, Australian interest rates will probably reemerge. We'll see that premium reemerge. But I wanted to touch on the fundamentals. How do you link the economy with the bond yield? And it's all about nominal growth. So this chart here that you can see is nominal growth in the United States versus the US 10-year Treasury yield or the nominal bond yield. And that's 50, 60 years of history. And you can see just how sort of correlated the two are. Now, there's a few timing issues and I won't go into detail about the sort of inflation of the 70s and the disinflation of the 80s. But you can just see the average nominal growth rate for the US in the last 50 years or so has been 6.58%. And the average 10-year Treasury yield has been 6.25%, incredible alignment. And it really makes sense because the return on the economy is the nominal growth rate. That is real growth plus inflation. And the US 10-year bond yield is essentially what the government yield is. And then that reflects the return on the economy. So there's a lot of sound theoretical underpinnings to that relationship. But what it means is that what your view is on nominal growth is going to determine what your view is on bond yields. And this also could be applied to the Fed funds rate with a few sort of other factors involved. But that's essentially the backdrop for thinking about the interest rate outlook, both in terms of the next year or two, as well as over the longer term. So the first theme that we really drew out of our big webinar about the risks facing Australia and the world economy is that growth is probably going to remain low or might even be a little bit lower over the medium term. And that's because there's more economic risk. There's a lot of debt in the system. Population growth, a key element of real economic growth is slowing in just about all countries. And so I would expect that we've seen this big fall in US nominal interest rates, or the US 10-year bond yield over the last 40 years from the high in the 70s. And I wouldn't expect to see sort of a big sudden shift back up. I'm convinced we've reached the low point. I'd hate to think of the sort of economic situation that would mean that US bond yields fall a lot. But at the same time, I don't think they're going to suddenly go up a lot. There's a short-term cyclical sort of impulse in the US right now for yields to rise. But on average, over the next sort of five years or so, bond yields are going to remain sort of pretty low by these historical standards. So we're not going to get that 6%, that nice average 6% return in the foreseeable future. No chance would be my sort of basic response. And look, the reason amongst many of the key reason is there's just so much debt out there in the global economy, in the US economy, in household balance sheets, corporate balance sheets, government balance sheets that this world we're operating can't handle those levels of interest rates. The economy will actually break, for lack of a better word, before we get to those levels of interest rates, because we won't be able to service the existing debt. The reason there is so much debt out there in most of the advanced economies and increasingly in the emerging economies is not just because of access to credit, technology around finance and capital markets and all that, but it's actually what we're staring at right now. It's this big fall in inflation and interest rates in the last 30 years that has allowed people, individuals or businesses to take on more debt, which by implication means it's going to be very hard for those interest rates to go up. My best guess is the nominal growth is probably going to average around 4% over the next five years in the US, something like that, and therefore that the bond yield is going to average, I think just a little bit below that, but I'll come to that in a minute. But this is the fundamentals. The absolute core of economic growth and the absolute core of nominal growth and therefore the interest rate structure is population growth. And all around the world we know the population growth is slow, whether it's in the advanced economies where you're actually seeing negative population growth, actually population shrinkages in places like Japan and parts of Eastern Europe or Central Europe to just outright declines in the rate of growth, but also in the emerging economies. I mean China is actually going to have a shrinking population within 10 years or so. So that fundamental that has been supporting high rates of growth in the last sort of 50 years is continuing to slip away. So that's going to keep rates sort of a downward pressure on rates. This is the Australian nominal growth rate and the Australian 10 year bond yield. Now you can see that relationship is not as strong as what we had in the US and the reason is the US is the benchmark, everything prices off it. So there are times when the US economy is doing something that might be different to Australia or the UK or Canada or Germany. And the bond yield will be torn by the pricing for US interest rate markets which will be priced off their economy versus the fundamentals in Australia. Obviously the currency is also a key part of that adjustment. But the idea is the same that there is an anchor there that nominal growth is going to tell us where the Australian 10 year bond yield should broadly be and weak nominal growth in times in the last half decade in Australia has facilitated these low bond yields that we're seeing here in Australia. I expect that to be shifting right now as we're seeing and I'll come back to that in a second but let's talk about QE because it's critical because QE is unconventional monetary policy which is essentially the central bank going in and entering the bond market and buying securities. And it wasn't just government bonds although that was the bulk of it for most central banks including the Fed but it was also RMBS and some corporate bonds and I think even some central banks are now buying equities which is pretty crazy but they were focusing on the bond market. And you can see here this same analytic, it's nominal growth versus the 10 year treasury yield and you can see that even in the 90s and the 90s they were pretty well aligned. They certainly over the cycle averaged out. They're never going to be perfectly aligned month in month out. But since QE has come in we've seen the 10 year treasury yield structurally below the nominal rate of growth and that's exactly what QE is trying to achieve. It's trying to push down that long term yield. Once the short term rate gets to zero they want to push the long term rate down provide that stimulus to the economy. Now why is all this important? Well QE has been unwound. The Fed is taking QE away. It's not just that they're not doing more. They're actually allowing the bonds that they own to mature and they're not reinvesting. But of course the U.S. Treasury is reissuing. Not least because of Trump's fiscal stimulus. Even without that they'd have to reissue. The fiscal stimulus is they're going to put more bonds into the market because it's growing U.S. budget deficit. And what that means in the most simplest terms is that those two lines the nominal growth rate and the 10 year treasury yield should probably come back together again. Because that's the normal operating environment. So look better growth outcomes in the U.S. right now and probably next year. I'm pretty confident how the U.S. is going. It's been a long slow recovery but it's really I think building some momentum in the last few years. Nothing that'll carry right through. The Fed is raising rates. They're doing it gradually. They're taking out QE but this is all putting up with pressure quite rightfully on both interest rates. The short term rate with Fed rate hikes and longer term bond yields with the withdrawal of QE. So I'm expecting U.S. 10 year bond yield which has got to 3%. It's sort of run into a lot of support there. A lot of investors are buying it there. And it's quite high by the standards of the last three years. People think that 3% 10 year bonds are high yield in the U.S. all of a sudden when it used to be as you alluded to 4%, 5%, 6% was the normal operating environment. But I'd expect that to actually continue to rise. Now whether it gets to 3.5% or 4%, it's not clear. I think if this momentum continues in the economy, the Fed goes another 100 to 150 basis points on the fund rate. It could easily get to 4%. But in the context of this bigger picture story I was talking about and that is that that's a cyclical uplifting growth. It's a cyclical uplifting rates. They're the best yields you're going to get. That's the time to invest. And that's when you want to put duration on to you want to be buying those high yields because they're probably going to be as good as you're going to get for quite a number of years. So that's my key sort of strategy, if you will, around interest rates and bond yields. And it obviously should form part of a broader investment or portfolio strategy. But from an interest rate and fixed income perspective, the next few years are going to offer you some good yields to be invested in. So now's the time to be buying in the fixed income. We should always have some fixed income, as we know that's good portfolio management. But in the next year or so, we're going to be really thinking long and hard about being overweight fixed income and long duration. We're going to get some good yields. So immediately though, should we be looking at like floating rate securities until those yields start to rise and then switching back into the fixed when we think they're at a good level, perhaps at 4% with the US Treasury? That's exactly the right strategy, but that of course relies on some really good market timing. And I think right now, buying more shorter duration, floating rate, one or two year bonds, especially when you're talking about say US market where they have quite long duration securities, is the right way to go. But averaging in is a great concept in investing, especially when you've got a long-term horizon. You definitely want to be sort of not super long duration right now if you have a view that long-term won't go up because that will. That's not the best strategy, but you want to be averaging in as long as you can. So I think that's exactly right. We don't know the timing. And the one thing that history shows us is that the 10-year bond yield, which is what you want to buy at the peak, you want all that duration at the peak of the cycle, it will peak when the Fed funds rate peaks. And that's why everyone pays such close attention to what the Fed's doing. Yeah, and look it might even peak six months before. So the thing is, yes, you want to be cautious and averaging, but at the same time, if you miss it, when the bond market looks through the Fed tightening, it looks through the QE withdrawal, if the US economy starts to slow, the bond market will rally quickly and everyone will be wanting to buy it. And so I'd say start averaging in because you're getting some much better yields now than you have for a while, and I don't think yield is going to go up two percentage points. No, no, yep. So in Australia, we're in a slightly different environment. The previous webinar talked about a little bit more risk here, and that's been reflected in pricing in our interest rate markets. Now, A, the RBA has got their cash rate below the Fed funds rate, which is a very rare event. And we've actually got many about bond yields or the Goldman bond yields, which are the benchmark for pricing in the broader market up below as well. Now, I think actually that's sort of as far through as we're going to trade. I think I've heard a few views that Australian interest rates are going to go well through the US. The only way that the RBA cash rate is going to get a percentage point or one and a half percentage points through the Fed funds rate or the Aussie 10-year government bonds are going to be a percentage point or more through the US is if we have a really big economic problem here and the US is okay. Now, look, for those who listened to the webinar, I did point out some pretty substantial risks we're facing here around household debt, around geopolitical disruption, this sort of thing. But I don't think you can invest for those sort of tail risks or for those big events. I think the history shows that as a capital-importing country with the current account deficit where we rely on money coming in the country, our bond yields really go below the US yields for a long period of time. So I think as the US market yields rise over the next year, ours are going to go with it. In fact, the debate in Australia right now is that the RBA is not moving there out of the game, even though the Fed's moving. And look, I think that's sensible. But I actually think this economy in the second half of the year is going to look a little bit better than it has in the last six months. And I also believe the housing market will look stable. More importantly, I think wages inflation will go up and the RBA will be forced to follow the Fed. So I think the strategy that I outlined for the US is not too dissimilar to here. No. That is we should be, if Australian rates start to rise over the second half, you should be starting to get invested in fixed income and start to extend duration. Bigger picture, again, you can look at this is the long-term history of the Australian short-term interest rate. And we really are really low right now. It will take an economic disaster for that cash rate to go to zero. In fact, the RBA won't take it to zero. We're not a country that can do QE effectively. We won't function well with a zero interest rate in QE, and the RBA has hinted at that. I mean, look, there remains to be seen, but the short-term rate can only fall maybe a percentage point in my view. And look, I think there's a good chance it does at some stage in the next five years, but not right now. I think of anything, it's going up as the governor said. The next moves up. Just don't know when we're in that rush. But again, we're in a world where going back to sort of five to 10% interest rates is very unlikely anytime soon. So I think the Australian strategy similar to the US next year or so, look for those higher interest rates to come through. Now, I don't think the RBA will need to raise rates by much. We have a lot of household debt. They're right now not raising rates because they're very worried about the effect of higher rates on consumers. And that household debt is sort of something like 85% to 90% floating rate debt. So those interest rates flow right through to the Australian consumer. They sort of get a bit worried. So I think if the RBA starts tightening, given expectations right now, either they're not going to tighten, it's essentially, especially from the commentators, the bond market will move, interest rates will go up, and that's the time to really start looking to invest. The Australian story could play out very quickly. So you want to be investing in fixed income for a riskier world. You want to be investing in fixed income and longer term bonds for a world where interest rates and investment returns generally are low over the long term. And I think there's going to be a great opportunity to get a better than average return in both Australian globally or in the US in the next 12 months or so. Fantastic. Well, thank you. I hope that gives you a sort of a sharper view of some of the interest rate dynamics around that global economic story. It certainly does. Thank you for being here today, Warren. We really appreciate it. Thanks, Liz. That now concludes the webinar.