- Australian 10-year yield spread over U.S. forecast to narrow
- Higher yields may tempt those who see RBA forced to cut again
The biggest Australian bond selloff in 10 months may spur the appetite of investors who remain unconvinced the central bank can bury its disinflationary demons without dropping the record-low cash rate further.
Bonds in Australia have been caught in a global market rout, with the yield on the benchmark 10-year note on Monday topping 2 percent for the first time in almost two months. The rate has climbed 22 basis points since Aug. 31, more than any full-month increase since November. At the same time, Australia is the only major developed bond market to see inflation expectations slide over the past month -- with investors signaling annual consumer-price gains will stay well below the 2 percent lower bound of the Reserve Bank of Australia’s target range.
A policy divergence between the RBA and the Washington-based Federal Reserve is seen compressing the yield premium that Aussie 10-year notes offer over equivalent U.S. paper to just seven basis points by mid-2017, according to analyst forecasts compiled by Bloomberg, from 39 as of 11 a.m. Tuesday in Sydney. While the RBA judges its current policy is “consistent” with inflation rising back to its targeted level, traders are pricing in about a 50 percent chance that incoming chief Philip Lowe will have to cut the cash rate from 1.5 percent by June.
“The recent rout in Australian government bonds offers opportunities to establish long positions,” said Jarrod Kerr, a senior rates strategist at Commonwealth Bank of Australia in Sydney. “The fundamentals, such as benign inflation and a stronger currency, have not changed for Australia. The RBA is still more likely to ease, and possibly to 1 percent. The Fed is still more likely to hike, at an absurdly gradual rate.”
The following charts illustrate the state of inflation expectations in Australia, the scale of this month’s bond rout and the scope that Aussie bonds have to rally from their current position.
CHART 1: The weak consumer price pressures within the Australian economy have helped drive down both the five-year inflation swap and breakeven rates. These market measures of inflation have continued to drop in the face of two separate quarter-point reductions to the borrowing benchmark this year from the RBA. The central bank itself has said that price gains are likely to remain muted “for some time.”
CHART 2: The slump in bond prices has pushed the Australian 10-year sovereign rate up to 2.04 percent. The differential over the equivalent U.S. yield, which in August slipped to a 15-year low of 22 basis points, this week rebounded to the highest level in a month. The growth in that gap means that Australia’s bonds are becoming more attractive, according to CBA’s Kerr.
CHART 3: The Bloomberg AusBond Treasury Index has delivered a loss of 1.2 percent since Aug. 31, a scale of decline that’s rarely been seen in the midst of a monetary policy easing cycle. The last two times the market delivered worse full monthly results than that were in May 2009 and April 2015. The former was between the final reduction of RBA Governor Glenn Stevens’s previous cutting cycle and the increases that he implemented later that year. The latter came after the RBA wrong-footed markets by leaving the benchmark unchanged, while traders had been pricing in a 75 percent chance of a cut.