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Australian bond yields and a hard landing

Data Flash (New Zealand)

Australian bond yields and a hard landing - Data Flash New Zealand November 2000

Summary The short end of the ACGB yield curve is already anticipating a significant easing in monetary policy. While the market may have got ahead of itself, continuing signs and concerns of weakness in the US will support the market. If there is a global hard landing, then the experience of 1998 might suggest a 10Y ACGB target of perhaps 5%. However, the relative absence of leverage in financial markets and the supply premium in the US long end suggests that this target might be too ambitious. In the event there is no hard landing, bond yields may already be close to their cyclical lows. In terms of trades, we have a medium term preference for curve steepening trades since these should “work” in both hard and soft landing scenarios. However, in the near-term we believe the front end is expensive given any RBA easing is not yet imminent. Given the negative carry on bonds, short end asset swap spreads should narrow.

The bill strip and short bonds seem to differ on the likely extent of RBA easing The AUD bill strip on 29 November implies the market is pricing one rate cut by the end of 2001. However, the short bonds seem to be telling us something different. Break-even analysis reveals that almost 3 rate cuts of 25 bp each are required by the middle of next year to justify the cost of holding short bonds. Rates implied by the AUD bill strip Source: DB Global Markets Research, Bloomberg It would appear that the bond market has a much harder landing in mind for the global and Australian economy than the bill strip. From a relative value perspective, this means asset swap spreads at the short end are too wide given the negative carry on bonds. This is especially so now that the widening pressure caused by the introduction of the GST and the larger tax receipts has taken place and is now fully priced. It is notable that the Australian bond market is much more aggressive in its outlook than the other peripheral $-bloc markets. For instance, the yield gap between Australian and Canadian short bonds is less than 10 bp. This is despite the fact the cash rate differential between the two countries is presently 50 bp and according to the bill and BAX strips is still expected to be in Canada's favour by the end of next year. Cash/short bond gap in the US and Australia Source: DB Global Markets Research Of course, the difference between the Australian cash rate and short bond yields looks less unusual when the US market is considered. The chart above gives the clear impression that the US curve has been a major driver of the Australian curve in 2000. Given this, shifts in US sentiment present the greatest risk to the Australian market. As noted, however, the other peripheral $-bloc markets have not been as keen to follow the US market. It could be that the Australian market has more readily factored in a central bank easing than the other markets as a result of weakness in the domestic activity numbers. However, even in mid-October when the Canadian BAX strip was beginning to price in an easing the 2Y CAN bond was only just over 10 bp through the cash rate. Lingering concern over the role of the CAD$ in setting interest rates may be partly responsible.

How low might yields go

Given the present shape of yield curves, both in Australia and the US, the outlook for bond yields is not simply a matter of saying rate cuts will bring about a further rally. For instance, our Global Strategy team believes that even if the Fed delivers a series of rate cuts it is possible that US long bond yields could actually rise. This reflects their assessment of the extent of the supply premium built into the US yield curve. As we have commented in previous research, it appears to us that long bonds within the peripheral $-bloc have also benefited from this supply premium. Given this, an unwinding of the supply premium in the US market would almost certainly be negative for the absolute level of bond yields in the rest of the $-bloc. So where might long bond yields in Australia go in the year ahead Before considering this it is useful to review the record for interest rates over the past decade. The low point for 10Y ACGB yields in the first part of the decade came in late 1993/early 1994 when the 10Y yield fell to as low as 6.4%. At the time the cash rate was 4.75% and the spread to the US was around +100 bp.

10Y ACGB yield and the cash rate since 1991 Source: DB Global Markets Research

The next low in the interest rate cycle was during the 1998 Russian debt crisis. In December of that year the 10Y ACGB yield fell to around 4.75%. At the time the cash rate was also 4.75% and the spread to the US was less than +50 bp. By way of comparison, the equivalent cyclical lows in the US 10Y bond yield were just under 5.2% in October 1993 and just below 4.2% in October 1998. The low point in Fed funds during the past decade was in September 1992 when it hit 3%. It remained at that level until February 1994, when the Fed began to tighten policy. Several observations can be drawn from this review. First, the lows and highs in the interest cycle have shifted downward over the past decade. Second, the spread between cash rates and bond yields has narrowed. Third, the gap between US and Australian bond yields has narrowed. A key issue for investors to consider is whether these trends are ongoing, or whether markets have “finished” the adjustment to a low inflation environment For instance the process of adjustment to a low inflation environment may be largely complete. In which case we would be surprised to see interest rates make notably lower lows than the last cyclical bottom. This would seem to answer the question posed at the start of this note - namely, around 5% or a little less could be as low as 10Y ACGB yields go if the global economy has a hard landing. If only things were so simple! Given the relative absence of leverage in financial markets compared to 1998, we suspect yields would not fall as far as in 1998. There is also the question of the supply premium built into the US long end. A hard landing in the US could raise questions about the fiscal position and see this supply premium unwind. However, there is clearly scope for a rally in bond yields if a hard landing takes place. This prospect will keep a bid tone in the bond markets until the data at least show signs of stabilising. In looking for signs of a hard landing, we would take particular note of US consumer confidence and employment. We would also be much more concerned about the outlook for the US economy if the non-tech stock indices began to show significant weakness.

What if there is no hard landing

Perhaps a more interesting question for investors is what if a hard landing does not take place The mid-cycle slowdown in 1995/96 saw 10Y UST yields fall to a low of around 5.5%, with Fed funds reaching a low of 5.25%. If the present cycle turns out to be similar to this then as far as bond yields are concerned we may already be there. Further, if one of the reasons for a soft landing is a large fiscal easing then the supply premium in the US long end may fall and thus bond yields could rise even if the Fed eases somewhat. However, given the present tone of the US data it seems a little too early to conclude the markets will give up on looking for a hard landing. So we think UST yields could well head lower. We do, however, have a bias toward curve steepening trades. As far as Australia is concerned, positioning (with domestics marginally short and global investors largely absent) should support the long end. Hence we are buyers on weakness. We also believe the Australian curve should steepen markedly once the easing cycle is underway. Fixed Income Strategist (64 9) 351 1234

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