RBA Wins Room to Hold as Tighter Budget Seen

Australian bonds are generating the strongest demand in three years on speculation the central bank will be able to extend a period of record-low interest rates as Treasurer Joe Hockey’s first budget targets deficit reduction.

Investors bid for an average 4.14 times the amount of sovereign debt auctioned from January to April, the strongest start to a year since 2011, data from the Australian Office of Financial Management show. A sale of June 2016 notes on April 4 had a so-called bid-to-cover ratio of 5.79, a level unseen since November 2012. Government bonds have gained 2.7 percent in 2014, set for their best annual performance in three years.

Hockey said last week he would adopt a prudent fiscal strategy for Australia, whose debt burden is the smallest after Estonia among developed nations. The government hasn’t confirmed or denied if it will impose a deficit levy on higher earners that the opposition has derided as a breach of an election promise not to introduce new taxes. The Reserve Bank said today public spending is scheduled to be subdued, in a statement after it held the cash target at 2.5 percent.

“Seeing strong action on the fiscal front provides even greater levels of confidence in Australia,” Adam Donaldson, the head of debt research at Commonwealth Bank of Australia, said in a May 2 phone interview. “There’s widespread expectation that tightening of fiscal policy will mean the Reserve Bank will remain sidelined for even longer than they might otherwise, and that’s a key factor lending support to the Aussie bond market.”

Bonds Rally

Australian government notes are heading for an annualized 7.9 percent return, which would be the most since 2011, according to Bank of America Merrill Lynch Index data. Debt due in 10 years or longer led gains, having returned 5.3 percent since Dec. 31.

Benchmark 10-year bond yields fell 23 basis points in the past month to 3.85 percent today, the biggest drop after New Zealand among 25 developed sovereign markets tracked by Bloomberg. The yield touched 3.84 percent, matching the lowest since September. The Australian dollar bought 92.77 U.S. cents as of 3:20 p.m. in Sydney, down 0.2 percent from a month earlier.

Australia’s funding arm said in December it expects net issuance of bonds due in a year or longer and inflation-linked notes to total about A$57 billion ($53 billion) in the year ending June 30, 2014. The equivalent figure for the 12 months through June 2013 was A$30.4 billion.

Debt Sales

CBA predicts net sales of such debt will total A$36 billion in the coming fiscal year, Donaldson said. National Australia Bank Ltd. expects A$35 billion in net issuance, according to Peter Jolly, the lender’s Sydney-based head of market research, while Australia & New Zealand Banking Group Ltd. sees a range from A$30 billion to A$35 billion, said Tony Morriss, the head of interest-rate research in Sydney.

“You’d be thinking that with fiscal repair, there’ll be fewer bonds being issued going forward,” Morriss said by phone on May 2.

Prime Minister Tony Abbott said in a May 4 statement that Australians need to share the burden of reducing the country’s debt, after an opinion poll found most voters think he’s broken a promise on tax. The Adelaide Advertiser reported April 29 the government will impose a levy of 1 percent on income of more than A$80,000 a year, without saying where it got the information.

Pension Age

Hockey said May 2 the nation will raise the pension age to 70 by 2035 from 65 at present, after the National Commission of Audit included an age increase among recommendations that could save as much as A$70 billion a year within a decade. It also recommended selling off rail and postal assets and reductions to family welfare payments.

Under the scenario recommended by the commission, Australia’s federal net debt would peak at 15.1 percent of gross domestic product in 2016-17 and subsequently decline to just over 5 percent of GDP. Without policy changes, the budget would remain in deficit until 2023-24 and beyond, with net debt rising to about 17 percent.

The nation’s gross debt was 28.8 percent of GDP last year, the smallest outside of Estonia among advanced economies, according to International Monetary Fund data. That compared with 105 percent for the U.S. and 243 percent for Japan, according to the IMF.

Investors are paring expectations for tighter monetary policy on prospects a decline in government spending will prompt the central bank to hold rates.

Inflation Subdued

After data last month showed first-quarter consumer prices stayed within the RBA’s 2 percent to 3 percent average annual inflation target. Policy makers today left the cash rate unchanged, as predicted by all 33 economists surveyed by Bloomberg News.

“What the budget tightening means is it creates a case for the RBA rate to be lower for longer,” NAB’s Jolly said in a May 2 phone interview. “If we’re going to be punching into fiscal headwinds for the next two or three years, the RBA will need to keep a more accommodative monetary policy stance as an offset.”

A Credit Suisse Group AG index based on interest-rate swaps shows traders expect officials to lift borrowing costs 12 basis points over the next year, near the least in 1 1/2 months.

Diminishing bets for rate increases have driven the extra yield investors demand to hold Australian government debt to the lowest this year relative to U.S. Treasuries.

Australian securities due in a decade yielded 123 basis points more than similar-maturity Treasuries on April 28, the least since Dec. 31. The South Pacific nation holds the top rating from all three major credit assessors, while the U.S. was stripped of its AAA score by Standard & Poor’s in 2011.

“Australia’s in a really sweet spot for risk versus reward,” Damien McColough, the head of Australian rates strategy in Sydney at Westpac Banking Corp., said by phone on May 2. “You get enough returns for very little risk, and I think that will remain the case for some time.”

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