Via Westpac:
1. What does a global “reflation” trade look like in Australia?
• It would not be a 2021 Outlook piece without a recommendation to position for the global “reflation trade”.
• Given that global central banks are committed to anchoring cash rates, and in the case of the RBA, also adopting YCC out to 3 years, holding curve steepeners appears to be a near universal recommendation.
• We do question, however, whether the market already has this trade on and whether the current optimism will be sufficiently matched by the economic outcomes in Q1 for there to be satisfaction in holding steepeners off current levels. Indeed, we think that the larger part of any “reflation”-style curve steepening will occur in the second half of the year, when there will be more evidence around the speed in which global economies are reducing excess capacity.
• In the meantime, we expect that 10yr bond yields in the US and AU will remain largely rangebound into mid-year and we expect there will be sufficient volatility within that range to establish short duration and bear steepening positions at better levels. While it might be worthwhile to maintain a small steepening position off current levels in order to maintain exposure to the medium reflation trade, we would definitely not have maximum risk on the trade at present. Await better levels.2. What would an extended QE program mean for AU bond yields, yield curves and cross market performance?
• It will absolutely embed the RBA as the dominant player in the market and could alter the demand profile of these securities going forward. While there is ample scope for the RBA to expand its balance sheet, we are concerned about what this could mean for the “free float” of ACGBs and Semis. While the RBA would be very focused on not creating market distortions, this might be the inevitable consequence if these policies evolve as we suspect. So, what does an extended QE mean for:
• Outright bond yields? The RBA’s QE program would eventually gain traction, but it might not been reflected in lower outright bond yields. In an outright sense, the policy will merely weigh on the market, keeping government borrowing costs as low as they can possibly be in the context of a global rise in yields. We think that AU bond yields will remain capped around the 1.2% level on any global led shifts higher throughout most of 2021.
• Yield curve? Can the RBA influence the curve flatter from current levels, or merely limit the degree to which it steepens? We think it can flatten the 5-10yr curve by as much as 20bp over time and in the 10-20yr space, by a similar amount. The latter would be supported by some importing of global QE into our market as the excess liquidity that has been, and will continue to be, pushed into the global financial system looks to find a home and yield enhancement strategies continue to play their part.
• Cross market performance? We need to weigh the medium term economic outlook, which suggests that this spread should remain wider than the US, against market imperatives and the balance of flows and positioning. With that in mind, we think that weight of money will eventually see AU 10yr nominal bonds back below the US in the 1st half of 2021.3. When will the RBA provide guidance on the next rounds of QE?
• If the RBA keeps to a rigid 6 months timetable for its current QE purchase program, then it will be largely finished by the end of April 2021. If that is the case, and we are correct and the RBA rolls into anther QE program basically immediately, then they will probably need to begin preparing the market for that eventually as early as the February Board meeting.
4. How steep can the curve get given all time low yields and also the risks around inflation?
• The AU 5-10yr swap curve has already steepened off its flattest levels of 2020 at the same pace and magnitude as the entire curve moves at the end of the 2013, 2015 and 2016 easing cycles. So should that be enough for now? Or because cash rates are effectively zero, is it right to have a much steeper curve? The answer to the latter question is yes, the curve should be steeper, on average, but by how much and what is the relationship between pre-empting future policy success versus the current reality?
• The term structure is already exhibiting a “hockey stick” shape. Flat out to 2 years and gradually rising beyond that. We suspect that will remain the case, unless the economy goes through another slump. Hence, the question is, what is the “angle” of the hockey stick beyond that point. We think that the 5-10yr curve segment will be slightly flatter in 1H2021, the 10-20yr curve will benefit most, while the 20-30yr curve will remain steep and be the first to move steeper by mid-year.
• The big game changer for the curve would be if the RBA were to decide to buy beyond 10yrs.5. When will the market begin to shift the dial on the YCC target?
• Westpac’s view that the RBA will be required to adjust the target rate on the 3 year bond around mid-2022, seems reasonable but the risks around the forecasts will have the potential for significant market speculation around this issue throughout the 2nd half of 2021. A major re-pricing, even then, would not be likely.
6. Will there be a supply driven “tipping point” in market valuations?
• Continuing the discussion on the curve, the other major driver is ongoing bond issuance and whether we are anywhere near a tipping point that would see the market charging governments a significantly higher price for borrowing.
• We do not think we are anywhere near that stage at present. Indeed, the RBA’s QE program is in place to assist with keeping these borrowing costs as low as possible.
• However, when we look at the recent budgets and note that there is around $1trn in gross issuance expected in ACGBs and Semis over the next 4 years, then any major shift in investor expectations will be important, although this supply profile is largely in the current price. We don’t think this will be a major factor in 2021.7. How will the demand mix for AU bonds evolve in 2021?
• The RBA is now one of the main actors in the Australian bond market and under its current QE buying, the RBA could own more than 50% of the “free float” of ACGBs and Semis. So adding to that is a potential game changer.
• Which part of the demand profile could change? Of the key players, we anticipate that offshore will continue to add to their portfolios, but at a slower rate than gross issuance. So their % ownership will fall, but that won’t be a major negative.8. Could Australia lose its Sovereign credit rating and what would it mean?
• We think not given that government policy and health successes have Australia in a much better place relative to other AAA countries, which have been hit far worse by the virus. That should put us in a good position for a faster recovery, which will offset to some of the massive debt burdens that have been put in place by the Commonwealth and States. The RBA support of the latter should be a crucial offset in ratings agency’s thinking.
9. Can swap and bond term structures shift in different directions?
• The swap curve is likely to be a better indicator of fundamental curve relativities in coming years. With that in mind, we think that long end swap spreads will, after months of being abnormally inverse, shift back positive in 2021. That is one of the best ways, in our view, to benefit from QE while also maintaining exposure to the “reflation” trade.
10. Can BBSW turn negative?
• While it is only a couple of basis points away, our base case is that 3m BBSW does not more materially or sustainably negative, unless the RBA decides to introduce a NIRP, which is, according to Dr Lowe, “extraordinarily unlikely”.
11. Will the current deterioration in Australia’s relationship with China impact market pricing?
• We would expect the currency to feel the initial impact, more so than bonds, which would factor a delayed economic recovery. Beyond that, of course, the market would assess the term risk premium to be higher, and that would likely see a steeper curve and higher funding costs for the government. Especially if China was to exit our market altogether. But that is not our central scenario.
12. Where to for Semi Spreads? Is there any further performance likely? Are further downgrades likely? What could trigger large-scale corrections?
• We do not expect any further downgrades.
• As to semi spreads, we think that the ongoing price tension will be dominated more by demand (RBA, ADI) vs supply (large borrowing profiles) trade-offs than anything else, including state-by-state idiosyncracies.
• It is very difficult to expect a major correction, even despite current historically narrow levels. At the 10yr maturity, we would expect spreads to widen, by a maximum of 10bps from current levels, on updated supply at the time of the May budgets, but this will be taken back in the 3rd quarter of the year.
