Having been “out of the money” with our October RBA call prior to last week, market pricing has now moved back to an 80% chance of our 25bp rate cut forecast being delivered. There were two main catalysts for the re-pricing. First was the Minutes of the RBA’s September Board meeting in which the RBA returned to the narrative that “… the Australian economy could sustain lower rates of unemployment and underemployment”. Second, in line with that comment, was last Thursday’s employment report which saw the unemployment rate rise.
Westpac continues to predicts cuts in the cash rate of 25bp in both October and February. That forecast, which would take the cash target to 0.5% is again all but fully factored-in. Indeed the market’s terminal rate is slightly lower than 0.5%, which suggests the recent thematic of the potential for unconventional policy remains an important aspect of the risk reward environment.
Combined with our UST view, all of this continues to underwrite the “lower for longer” scenario as our base case for Australian bonds and rates markets.
From an outright perspective, however, we would expect the rapid rally over the past week or so to slow. We expect 3yr futures to trade a 99.10-99.35 range in coming weeks and for the 3-10yr curve to again come under flattening influences as the outright trading range is consolidated over coming weeks.
How low can AU bond yields they go?
There is little reason to expect a material and extended selloff. Tactically buy dips.
Australian bonds have corrected off their all-time lows, but last week’s rally again begs the question, how low can yields go? 10yr yields are back below 1% and below the
prevailing cash rate. That certainly reflects the market’s pessimism around domestic growth prospects, the effectiveness of traditional monetary policy and its ability to drive
unemployment lower and inflation expectations higher. So how much lower can yields go? While the long end will be largely a factor of UST price action, it is perhaps more
apposite to assess relative value at the 3yr maturity (left chart). The black solid and dotted lines show the terminal rate and the projected cash rate profile over the next year
respectively. Basically, Westpac’s view of a 0.5% terminal rate is largely priced in, as is the profile in which the RBA gets there. So does that mean that 3yr bonds are a sell? They
are certainly not cheap, however the chart shows that relative to the terminal cash rate, they were around 20bps MORE expensive in the 2015-2016 period. Given that a lot of the
drivers of market sentiment today are similar to that period, we think that is a valid comparison, supported further by the prospects of QE. The chart at right shows how the yield
curve has evolved. We think it will be largely directional based on long end yield shifts, but we remain of the view that any US-led bear steepening would be short-lived and should
be faded.
In our last weekly, we recommended an AU OIS trade: receive Feb-20 RBA at 0.70%. The trade has performed well (chart at left) and we have moved our stop to capture some of
that profit ahead of this week’s risk events, namely Governor Lowe’s address on Tuesday evening. There is a risk that Dr Lowe uses the address to signal that the RBA does not
intend to move as quickly as the market anticipates, though we see that as highly unlikely. Instead, we think that the Governor may use the speech as an opportunity to signal for
an upcoming move (as he did on May 21 before the June 4 Board meeting), focusing on the recent rise in the unemployment rate and the downwards pressure on wages growth.
That would be supportive of our relatively long held view that the RBA will cut rates to 0.75% in October and again to 0.50% in February. A realistic question is whether the follow
up to the October move could come earlier than we expect. We think that the response of the Westpac Consumer Sentiment Index (down 4% in July as households seemed to be
unnerved by consecutive moves) precludes another back to back move so going in October leaves available the flexibility to move in December. We also think the RBA would see
the move to 0.5% as the low point in the cycle after which unconventional policies might be required. A prudent wait for that last move until early next year seems the most likely
option. We will therefore hold our receive Feb-20 position, and see good value in putting on curve flatteners around end of year meeting dates – pay Dec-19 vs. rec Feb-20.
That all makes complete sense to me. A don’t see the RBA going under 50bps unless there is a full blown shock. It may nudge into some more unconventional policy instead. As well, with a corrupt APRA having overly-loosened macroprudential policy, if there is no further external shock then house prices are going to become an RBA concern before too long, despite Josh Recessionberg’s fiscal tightness. There may be a little curve steepening but the long end still has room to rally anyway.
That said, I put the odds of the full blown shock next year at 50% so we could well see lower yields. The other risk is a substantial trade deal which would trigger material curve steepening but I only put a risk of 10% on that.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
