Over the past week Australian government bonds have sold off which was led by overseas markets. In this article we analyse the events that have led to this and the wider implications at play for Australian bond market returns over the next 12 months. While markets have been waiting since mid-2014 for the US Federal Reserve to increase interest rates, they have only managed to do so once (by 0.25%) in December 2015. Due to the US’s large global economic influence, other central banks have been forced to manage their respective economies by accelerating easing monetary policy. As a result, we can expect global monetary divergence to continue into 2017 (see Figure 1). Figure 1.  Monetary Policy Expectations from Current Rates mpe Source: BondAdviser, Bloomberg This early policy divergence has helped fuel the recovery in asset prices across multiple asset classes over much of 2016. However, news that both the Bank of Japan (BoJ) and the European Central Bank (ECB) have put their Quantitative Easing (QE) operations under review (in order to assess how to improve the transmission of expansionary monetary policy) caught the market by surprise and challenged future demand expectations. This sparked a sell-off in sovereign bonds in most developed nations including Australia. The 10-Year Australian government bond yield rose to a high of 2.15% on Wednesday (from 1.96% on Friday), the highest level since Brexit in July. As a result, our yield curve has shifted up and steepened (see Figure 2). Figure 2. Australian Yield Curve yield-curve Source: BondAdviser, Bloomberg Part of the reason why shorter dated bonds have outperformed longer dated bonds is that they remained anchored by the expectation that the Reserve Bank of Australia (RBA) will either remain on hold at 1.50%, if the Fed does manage to increase rates, or remain poised to reduce the cash rate once more, if the Fed does not. So what does this mean for the Australian 10-year bond rate? Whilst the short end is influenced by RBA cash rate expectations, the Australian 10-year bond rate is influenced by US 10-year bond rate expectations. Historically the Australian/US 10-year bond spread has been around half that of the short term (~2-year) rate spread. Currently the US government 10-year bond yield is 1.73% whilst the Australian 10-year bond is 2.15%. This equates to an Australian/US 10-year bond yield spread is 0.41%. Similarly, the 2 year Australian 2-year bond rate is 1.59% with the US 2 year at 0.79%, giving a short term rate spread of 0.80%. Thus the historical relationship remains intact. So, if the Fed do eventually hike the US Federal Funds Rate to 1.00% (from 0.50%) and the RBA remain on hold at 1.50% (as the need to reduce the cash rate will dissipate if the Fed does hike) the short term rate spread should compress to 0.50%. This in turn infers that the Australian/US 10 year spread should be 0.25%. As a result, the US 10-year bond rate would rise to 2.00-2.25% and the Australian 10-year bond rate would be 2.25-2.50% (an Australian/US 10-year spread of 0.25%). As the Australian 10-year bond rate is already trading at 2.15%, this means that there should only be another 0.10% – 0.35% rise in yield from here if the Fed raise rates by 0.50%. Considering that the US 10-year bond rate over the past week has risen from a low of 1.52% to 1.73% it is not unreasonable to conclude that a Fed Funds hike of 0.25% has somewhat already been priced in by markets. For this reason, we believe that the Fed should ignore equity market volatility and increase the Federal Funds Rate by 0.25% at their next meeting on 20th of September 2016. If this turns out to be the case, then Australian bond investors should not be overly fearful of future US interest rate increases as most core Australian fixed income funds are benchmarked against the Bloomberg AusBond Composite +0 Years Index. The index currently has a yield to maturity of 2.10% and an average duration profile of ~5 years. This means that interest rates have to increase by 1% over a 12-month period for the index to decline by approximately 3%. Overall, we anticipate that the Federal Reserve will begin tightening monetary policy again soon, although we generally expect rates to rise progressively. This gradual process should ultimately allow investor expectations to shift and as a result we expect bond market volatility to remain limited relative to equity markets.