Deutsche has interesting note today examining why the Australian to US bond yield has blown out:
The 10Y ACGB/UST spread has widened sharply since the start of October to more than 140bp. Given the debt ceiling impasse in the US this seems counterintuitive.
- The widening also seems to be more than can be explained by any front-end underperformance. On previous occasions in 2013 when relative front-end pricing has been around its current level the 10Y ACGB/UST spread has been in a 120-130bp range.
- But we need to be careful about our time frame for comparison. On a longer-term horizon the 10Y spread looks to be in line with relative front-end pricing and the recent jump can be seen as ‘correcting’ a period of undershooting in the spread.
- But why the jump now, especially given the debt ceiling impasse in the US?
- It seems to us that the market has concluded that a US default is extremely unlikely and that even if the debt ceiling is not lifted in time any default will be ‘technical’ in nature and short-lived. In which case, does it really matter from the perspective of a 10Y UST? This may or may not be the right conclusion to make, but we suspect the UST market will hold to something like this view until a default actually occurs.
- On the question of why now, we don’t have a convincing answer other than to refer to flows in what is a ‘nervous’ market given the uncertain outcome of the US debt ceiling impasse. The NZ market has been similarly affected, with the 10Y NZGB/UST spread also moving quite a bit wider in the past few days. Perhaps there has been some selling to take advantage of the recent rally in the currencies of both.
- We don’t think the spread widening is evidence of a structural shift against AUD or NZD assets. It hasn’t gone far enough to support this conclusion and the currency strength referred to argues against it in any event.
- Does the recent underperformance present a trading opportunity? We think the unknowns flowing from the debt ceiling impasse make such a trade difficult to recommend, particularly when we don’t think the entry point for the 10Y ACGB/UST spread is too wide relative to the fundamentals as represented by the front-end spread. In the event we do get a meaningful default in the US (as against a short-lived technical default) we think the 10Y spread will compress as the AUD front-end prices in a series of rate cuts by the RBA and investors exit UST holdings to at least some extent. But if the impasse is resolved in a credible manner and not just delayed for a month or two then the spread could widen if the AUD front-end decides the RBA has definitely finished easing and the next move is up.
There is also the possibility that the US 10 year is over-performing on safe haven flows owing the shutdown. Lot’s of uncertainties here.