The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) returned -0.33% in September. Over the month, 3-year government bond yields rose to 2.71% from 2.63%, while 10-year yields rose to 3.48% from 3.29%. Shortterm bank bills all rose over the month: the 1-month bank bill swap rate (BBSW) rose to 2.67% from 2.61%, the 3-month rate to 2.74% from 2.63%, and the 6-month rate to 2.78% from 2.64%.

The Australian dollar depreciated significantly over the month, starting at USD 0.934 and ending at USD 0.874. On the penultimate day of September, the Australian dollar touched as low as USD 0.869, representing almost a 7% drop from the start of the month. Reasons for the recent weakness include a fall in the iron ore price, the rally in the US dollar ahead of potential interest rate rises, weaker Chinese data, and indications that the Reserve Bank of Australia (RBA) is considering macroprudential controls to help cool the housing market and rebalance investor demand without having to resort to tightening monetary policy.

The Australian Industry Group’s Performance of Manufacturing Index (PMI) showed a continuing contraction in manufacturing activity in September. The index fell by 0.8 points to 46.5 points (seasonally adjusted), with only the large food and beverages and the smaller wood and paper products sub-sectors expanding, while all other sub-sectors remained in contraction. Respondents to the survey indicated that despite a welcome depreciation in the Australian dollar since early September, it remains high and continues to support intense import competition and weigh heavily on exports. The winding down of Australian automotive assembly and the ongoing downturn in mining construction activity are also affecting demand for locally-made products and components.

The RP Data CoreLogic home value index rose only slightly in September, up 0.1% across all capital cities, taking the aggregate capital gain to 9.3% year-on-year. After three months of strong gains, five of the eight capital cities recorded falls in the month, with only Sydney, Brisbane and Adelaide seeing gains. The RBA has been increasingly worried about housing bubbles in Sydney and Melbourne so this slowing should come as some relief. Head of RP Data research Tim Lawless said that “a moderating annual trend, as well as the relatively flat September result, is likely to be welcome news to policy makers and potential buyers after the winter months recorded the largest capital gain since 2007”. According to the Australian Bureau of Statistics (ABS), retailers posted the weakest sales in three months during August. Sales rose just 0.1%, following a 0.4% gain in July. Cafes, restaurants and food retailers saw sales growth of 0.3%, but department store sales dropped by the most in half a year, with household goods retailing falling by 0.8%, and clothing, footwear and personal accessories sales shrinking by 0.1%.

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.

We are seeing improvements in housing, construction and consumer spending, but it is uncertain whether they are growing strongly enough to offset the decline in mining. Although employment growth is positive, it isn’t sufficient to offset increases in the participation rate or population growth so employment remains weak. Although the RBA has been concerned about potential housing bubbles in Sydney and Melbourne, the slowing in growth in September is likely to be welcome. In addition, the bank is more likely to implement macroprudential controls to help cool the housing market rather than resorting to monetary policy tightening given the weakness in the rest of the economy.

In our view, 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. The recent depreciation in the Australian dollar is unlikely to affect this forecast unless it plunges to unexpected lows. With a soft economy and further weakness in China, rate rises are unlikely any time soon.