Westpac’s RBA forecast means its too early to take profit. Source: Bloomberg, Westpac Given Westpac’s altered RBA and Fed outlooks, we have a very different forecast for the benchmark AU-US 10yr bond spread than is currently factored-into the forwards (left chart). Indeed, forward pricing suggests that the 10yr spread has already bottomed, while we expect it to move as much as -90bp inverse once the RBA resumes its easing cycle in in August. However we do not expect a quick shift to that scenario in coming weeks. The centre chart shows the 1yr forward cash spread lead 12 months (red line) versus our own forecast spread. Given that we see the expected cash spread as the major driver of the bond spread performance, it will need a significant re-evaluation of relative policy outcomes before the bond spread will resume its shift lower. We would expect forward expectations to evolve similarly to the period highlighted on the middle chart, which corresponded with expectations for a domestic rate hike. The importance of these expectations is obvious from the relationship between 12m forward cash and the 10yr bond spread seen in the chart at right. With that in mind the chart suggests that the spread is slightly too inverse for current implied cash, but would be significantly lower under our forecasts. So, it is too early to expect any sustained underperformance from AU rates. Fade any such moves, especially if the spread moves back above -50bp.
Too right. As for the implications for the Australian dollar, WBC is bearish:
Our flows analysis shows a return to net selling throughout the month of February, following a three month period of net buying. With buying support remaining from sovereign accounts, it was funded account pay-side flow that initially pushed our aggregate figure in to selling territory. The charts at top right and bottom left confirm this, though it can also be seen that buying support from real money accounts fell away over the last week of February, deepening the selling trend. Looking to the bottom right chart, it was securities with a maturity in less than 2 years that dominated the selling flow. Flow for securities further along the curve was more balanced. The net selling of the <=2yr maturity bucket was the largest in more than 2 years, which marries with the overall curve flattening.
AUD/USD has been trapped in a tight 0.7070 to 0.7200 range over the past month, despite the 1-2-3 punch of Westpac’s RBA rate call change, rumours about coal exports into China being ‘banned’, materially weaker than expected Q4 construction work data. Westpac now expects only a 0.2% Q4 GDP growth rate, which should leave the A$ on the back foot this week, with downside risks as the Federal Election comes into view in May. A break below 0.7070 would be technically important.
I think the Fed is done hiking but there is little prospect of easing and a good risk that the RBA will be forced to cut four times over the next 18 months so the AUD pressures emanating from a wide yield spread will remain.
David Llewellyn-Smith is chief strategist at the MB Fund and MB Super which is long international equities and local bonds that will benefit from a weakening Australian economy and dollar so he is definitely talking his book.
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