fixed income: weekly strategy...michael blythe chief economist t. +612 9118 1101 e....

Fixed Income: Weekly Strategy 30 June 2011

Adam Donaldson Head of Debt Research T. +612 9118 1095 E. [email protected] Philip Brown Quantitative Strategist T. +612 9118 1090 E. [email protected] Alex Stanley Associate Analyst, Fixed Income T. +612 9118 1125 E. [email protected] Michael Blythe Chief Economist T. +612 9118 1101 E. [email protected] Richard Grace Chief Currency Strategist T. +612 9117 0080 E. [email protected]

Important Disclosures and analyst certifications regarding subject companies are in the Disclosure and Disclaimer Appendix of this document and atwww.research.commbank.com.au. This report is published, approved and distributed by Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945.

What to expect if the market can move past Greece

We have updated all our Central Bank, Bond and FX forecasts. We look for an elongated recovery.

The RBA is likely to keep raising rates. We expect the next rise in August, followed by one per 6M thereafter.

The market is still pricing rate cuts. A sharp sell-off and a curve flattening are likely in the short term.

The Greek sovereign debt crisis has been the dominant theme for the Aussie market over the last week. A substantial rally in the US last week took rates in Australia to fresh 2011 lows on Monday. The US 10y hit a low of 2.86%, while Aussie 3y and 10y yields hit lows of 4.52% and 5.00% respectively.

In recent days, optimism has improved and rates have pushed higher amid signs French and German banks are working with authorities to term out Greek liabilities. Last night, the Greek parliament agreed to an austerity package, which extended the sell-off. The backup in yields in the last two days has taken the Aussie 3y yield back in line with the cash rate. While market pricing for rate cuts has eased considerably, we think the Aussie market has a long way to go.

The ECB has stepped up its rhetoric on the need to raise rates in Europe to contain inflation. As Philip Brown explains on page 10, it’s an usual situation for the market to be pricing rate cuts in Australia because of problems in Europe, while simultaneously pricing hikes from the ECB.

The pricing for RBA rate cuts and a sharp widening of bill/OIS spreads led us to buy 1m bills and pay 6m OIS yesterday. The safe passage of the austerity vote has pushed this trade in the money, but we think it has further to go. Alex Stanley reviews this position on page 13.

On page 3, we outline the CBA Research Team’s updated forecasts for key global rates and currencies. We still view the direction for rates in Australia, the US, EU and UK as upward. However, recent downside risks to the global economy have tempered the pace that we expect monetary tightening in Australia and key global economies. This, in turn, moderates the pace of our expected increases in Australian and US bond yields and the degree of curve flattening.

After being relatively empty for most of June, the Australian economics calendar is busier next week. On Monday, May retail sales and building approvals data is released and we’re expecting monthly increases of 0.6% and 3.0% respectively. On Tuesday, the RBA are widely expected to keep rates on hold. We expect them to wait and see the CPI data in late July, before implementing another hike. For the May Trade balance, we expect a $0.1bn increase in the surplus to $1.7bn. On Thursday we’re looking for the Labour Force data to show jobs growth of 15k and no change in the unemployment rate of 4.9%.

In the US, after tomorrow night’s Manufacturing ISM (consensus 51.8), the market will look to the Non-manufacturing ISM (consensus 53.7) on Monday. The labour market is likely to be the next key focus, with the ADP survey (consensus +60k) on Thursday and Non-Farm Payrolls on Friday (consensus +90k).

Contents:

Key Positions......................................................................... 2 Key Trades ............................................................................ 2

Revising our forecasts for a more elongated global recovery ................................................................................ 3

Updating our bond forecasts ................................................ 6 Why is the Greek Crisis hitting Australia hardest? .............. 10

Taking advantage of rate cut pricing................................... 13

Key Views............................................................................ 15

CBA Forecasts: .................................................................... 17

Calendar – June 2011.......................................................... 18

Revised Swap & Bond Forecasts

Now Dec 2011

Jun 2012

Dec 2012

Official Cash 4.75 5.00 5.25 5.50 90-day BBSW 5.03 5.35 5.60 5.85 3-year swap 5.11 5.60 6.00 6.15 5-year swap 5.46 5.80 6.05 6.15 10-year swap 5.79 5.95 6.10 6.15 Aus 3y bond 4.76 5.30 5.60 5.75 Aus 10y bond 5.21 5.50 5.60 5.65 Aus 3-10yr Curve (bp)

45

20

0

-10

US 2yr bond 0.45 1.10 1.70 2.30 US 10yr bond 3.10 3.50 3.70 3.90 AUS-US 10yr spread (bp)

211

200

190

175

Source: CBA, Bloomberg

Global Markets Research

Fixed Income: Weekly Strategy

2

Key Positions

After sitting on the sidelines through much of last week, we have re-instituted shorts this week. Timing this kind of move is difficult and we have already missed some of the move higher. However, as we note throughout this report, even though the rate cut pricing is retreating it still has a long way to go before it matches the RBA’s (and our) expectation of higher cash rates in the medium term.

We have implemented two trades to capture a calming in the rates market. First, we have bought a 1M bank bill against the 6M OIS. This trade has already performed well but should go further as bank bill credit spreads tighten and OIS moves higher. The trade is mostly a slope trade – we do not expect the RBA to raise rates next week which makes the 1M bill maturity before our forecast rate rise in August.

Our second trade is an outright short in the Jun-16. As explained in the bond forecasts article on page 6, the Jun-16 has rallied the most since the previous peak and the mid-curve bonds capture our expected RBA rate hike cycle. These two observations make us believe the Jun-16 can sell-off most in coming weeks.

Key Trades

Trade Entry Curent Profit Target Stop Comment

Buy the NSWTC Jun-20 (Govt G’teed) as an ASW

-12bp (3-Feb-10)

-25.5bp +13.5bp -35bp 0bp Hold: A long-term buy-and-hold trade.

Buy an NSWTC Nov-20 Linker vs UST 1.25% Jul-20 linker

213bp (14-Mar-11)

228bp -15bp 150bp 235bp Hold: The real yield pickup is large. The US linkers are likely to underperform once QE ends. Has performed OK despite the rally in nominal bonds.

Buy a 6M*1Y receiver 20bp below spot yields (4.85%)

7.5bp premium (11-Apr-11)

Current forward is 4.89%

n/a n/a Hold: We are still hopeful, but this trade’s insurance value is looking better and better.

Receive the 10Y Bills/Libor basis against the 3Y

15bp (11-Apr-11)

11bp +4bp 7bp 19bp Hold: We think the recent flow has steepened the curve too far.

Receive 1Y ZCS 3.00% (20-May-11)

2.78% +22bp 2.50% 3.20% Hold: We believe there is scope for headline CPI to snap back, which is not captured in the ZCS

Sell the KfW Dec-19 against the IBRD Oct-19

22bp (30-May-11)

21bp -1bp 40bp 15bp Hold: Despite the growing concern in Europe, there has not been any movement in the basis or in the credit spread.

Buy the Jan-18 vs the Apr-15 28bp (21-Jun-11)

24bp +4bp 15bp 35bp Hold: The shape of the curve is very strange at present

Sell the September Bill Future against receiving the 3M*3M OIS

19bp (21-Jun-11)

16bp -3bp 40bp (?) 10bp Hold: An insurance trade. If there is a global bank contagion, 19bp looks very cheap. If the trade works, we are facing a serious issue and might not want to necessarily be exiting at 40bp just because it trades there once.

Sell the Jun-16 ACGB 4.81% (29-Jun-11)

4.84% +3bp 5.25% 4.65% New Trade: The body of the curve will likely move furthest in a sell-off.

Buy a 1M bill against paying the 6M OIS

-23bp (29-Jun-11

-17.5bp +5.5bp +4bp -30bp New Trade: We believe the 1M bil spread should tighten while the 6M OIS is still pricing rate cuts.



3

Revising our forecasts for a more elongated global recovery

Michael Blythe – Chief Economist – 61 2 9118 1101 – [email protected]

Adam Donaldson – Head of Debt Research – 61 2 9118 1095 – [email protected]

Richard Grace – Chief Currency Strategist – 61 2 9117 0080 – [email protected]

The re-emergence of downside risks to the global economic outlook and related issues have led to a reassessment of some of our calls. The changes are mainly to timing rather than our underlying themes, which we believe remain intact.

RBA Call

RBA forecasts published in May highlighted an extended period of above trend growth and inflation bumping along at the top end of the 2 3% target range or higher. More recent RBA commentary has largely endorsed these forecasts. While markets have moved to price in some chance of a near term rate cut, the clear message from the RBA is that they expect to have to lift rates at some point.

As such, we are happy with our call that the next move will occur in August, particularly if the QII price readings published in late July confirm that the inflation cycle has turned. And our forecasts still envisage a terminal cash rate for this cycle of 5¾%.

What is also increasingly clear is that the timeframe for moving to the peak cash rate may prove quite elongated. The revealed preference from recent RBA actions is to allow an extended period after a move to assess the impact. A move in August would, for example be some nine months after the last move in November 2010. Persistent global uncertainties and risks probably add to the case for a cautious approach.

We have incorporated this preference into our projections. Our revised forecast profile envisages further moves in February and August 2012 and a peak for the cycle by early 2013.

Figure 1: Implied RBA profile

Source: CBA

Other central banks

We have pushed out the timing of the Fed’s tightening cycle following a softening in the US economy and the Fed’s downward revision to 2011 US real GDP growth earlier this month. We now anticipate the Fed will begin lifting interest rates in June 2012.

We have also pushed out the timing of the Bank of England’s (BoE) tightening cycle to June 2012. The stalling in UK GDP growth earlier this year, the moderation in forward looking indicators and the reluctance of the BoE to raise interest rates despite high and persistent inflation has forced us to make a change. We have also pushed back the timing for when we expect the Bank of Canada (BoC) will resume its interest rate tightening cycle. We are now looking for only one more 25bpt rate hike by the BoC this calendar year. Previously we had anticipated two rate hikes. The next BoC rate hike is forecast to take place in QIV 2011. The European Central Bank (ECB) is expected to raise rates again in July, the second rise for this cycle. We also expect a hawkish ECB to deliver another rate rise in QIV 2011, bringing the cash rate to 1.75% by year end. We have not made any changes to our Reserve Bank of New Zealand (RBNZ) cash rate forecast profile. We continue to see the RBNZ taking back its post earthquake 50bpt rate cut in two 25bpts increments during QI 2012.

30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12RBA Cash Rate 4.75 5.00 5.00 5.25 5.25 5.50 5.50

We still look for RBA to raise rates, but more slowly than before

We look for the first Fed move in mid 2012



4

Figure 2: Central Bank Profiles

Source: CBA

Interest rates

The bond market has rallied strongly amid evidence of weaker US growth and a flight to defensive assets amid the growing sovereign crisis in Europe. These influences and the soft patch in the domestic economy have also seen the market discount a chance the RBA cuts the cash rate before the end of the year. If the RBA does raise rates in August, the market will need to rethink (and reprice) the front end of the yield curve. We expect a sharp sell-off in the 3Y rate to 5.1% by September and a steady grind higher in yields after that, as the RBA slowly tightens policy.

We expect the 10Y to sell off as well, but less quickly and so flatten the curve. We think the 10Y yield should reach 5.5% by year end, and to drift a little higher in 2012. The 5.65% end point for 2012 is 25bp lower than previously forecast, primarily reflecting downward revisions to our US 10Y forecasts due a later and more gradual Fed tightening cycle than previously assumed. We nevertheless forecast a sharp jump in yields in 2H 11 as fears over the sovereign crisis abate and the US economic recovery gains traction.

Australia’s more advanced economic cycle and the shift to restrictive policy settings mean the domestic yield curve should flatten markedly over the next year, and possibly invert toward the end of the forecast period. AUS US bond spreads will narrow in this environment given greater scope for US yields to rise. However, we expect spreads to remain relatively stable in the near term because domestic markets need to incorporate greater risk of RBA tightening. (For full discussion see page 5.)

Foreign Exchange

Following the decision to push back the timing of the first Fed rate rise, we have made some minor adjustments to our currency forecasts. We had previously expected the USD to firm during QIV 2011 as the Fed started to move. We now expect the period of USD softness to extend into the early part of 2012, consistent with a more delayed Fed rate response.

We maintain our long held view that once the Fed starts its tightening cycle, US bond yields and the USD will increase. The strengthening in the USD is likely to occur at the beginning of the Fed’s “exit strategy” on 13 March 2012, somewhat earlier than the Fed’s first rate rise. However, the momentum in USD strength should accelerate following the first Fed rate hike at the 20 June 2012 meeting.

We have subsequently made some minor alterations to our other currency forecasts. Most currencies are now forecast to be marginally firmer vis à vis the USD over the March 2012 and June 2012 quarters. While we are anticipating a firmer USD during this period, the delayed Fed starting point means it should take longer to have an impact on the USD. Hence, a mild upward adjustment to the forecasts was necessary. The broad direction for all currencies is unchanged from our previous forecast profile.

The end March and end June 2012 AUD forecasts have lifted to 1.02 and 0.97 from 0.98 and 0.95 respectively. We have also trimmed our end September 2011 forecast from 1.12 to 1.08 because there are mild downside risks developing in the global economy. The Fed’s downward revision to US growth, the ECB’s tightening cycle and higher inflation in non Japan Asia suggest global growth may be being slightly lower than previously expected. Recent movements in global equity markets, the oil price and base metal commodity prices support the altered profile.

Cash rate 30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 0.25 0.25 0.25 0.25 0.50 1.00 1.50Australia 4.75 5.00 5.00 5.25 5.25 5.50 5.50New Zealand 2.50 2.50 2.50 3.00 3.50 4.00 4.50United Kingdom 0.50 0.50 0.50 0.50 0.75 1.00 1.25Eurozone 1.25 1.50 1.75 2.00 2.00 2.25 2.25China 6.31 6.56 6.56 6.56 6.81 6.81 7.06Japan 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Australian rates markets will need to reprice substantially to take account of an August move

Our new Central Bank forecasts have altered our FX forecasts too



5

Figure 3: Key Foreign Exchange Forecasts

Source: CBA

.

Current29-Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13

MajorsAUD 1.0593 1.0800 1.0400 1.0200 0.9700 0.9500 0.9500 0.9800

EUR 1.4386 1.5000 1.4700 1.4300 1.3800 1.3500 1.4000 1.4500

JPY 81.14 80.00 82.00 83.00 85.00 88.00 90.00 88.00

GBP 1.6011 1.6700 1.6300 1.6400 1.6000 1.5800 1.6200 1.6500

CAD 0.9787 0.9500 0.9800 1.0000 1.0500 1.0600 1.0600 1.0400

NZD 0.8191 0.8500 0.8200 0.8000 0.7600 0.7500 0.7500 0.7900

CHF 0.8318 0.8100 0.8200 0.8500 0.8800 0.9000 1.0000 0.9700

AUD Cross RatesAUD-NZD 1.2932 1.2706 1.2683 1.2750 1.2763 1.2667 1.2667 1.2405

AUD-EUR 0.7363 0.7200 0.7075 0.7133 0.7029 0.7037 0.6786 0.6759

AUD-JPY 85.95 86.40 85.28 84.66 82.45 83.60 85.50 86.24

AUD-GBP 0.6616 0.6467 0.6380 0.6220 0.6063 0.6013 0.5864 0.5939

AUD-CAD 1.0367 1.0260 1.0192 1.0200 1.0185 1.0070 1.0070 1.0192

AUD-CHF 0.8811 0.8748 0.8528 0.8670 0.8536 0.8550 0.9500 0.9506

AUD-CNY 6.8467 6.8808 6.5266 6.3371 5.9662 5.7847 5.7269 5.8487

AUD-SGD 1.3086 1.3176 1.2792 1.2852 1.2610 1.2350 1.2160 1.2348

Australia TWI 76.9 77.70 75.49 74.99 72.18 71.26 71.15 72.77

End-Period Forecasts



6

Updating our bond forecasts to reflect more elongated cycles

Philip Brown – Fixed Income Quantitative Strategist – 61 3 9675 7522 – [email protected]

Adam Donaldson – Head of Debt Research – 61 2 9118 1095 – [email protected]

The RBA is poised to raise rates. The market is not yet ready for that and a sharp sell-off is likely.

A more elongated cycle does lower our rate forecasts though. We expect the AUD curve to invert in 2012.

We expect the US market will sell-off from here, though systemic issues will keep rates comparatively low.

Overview

Bonds rallied strongly in May and June amid evidence of weaker US growth and a flight to defensive assets due to the sovereign crisis in Europe. These influences, and the soft patch in the domestic economy, have also seen the market imply a chance the RBA cuts the cash rate this year. This has contorted the shape of the domestic bond curve and prompted an update to our bond forecasts yesterday (summarised in Figure 1).

Australia’s economy is still in very good shape. Inflation pressures are building. The retail sector, and perhaps even housing, is starting to show signs of life. This resilience, combined with an investment boom of unprecedented proportions, points to more monetary tightening (see page 3). If the RBA does raise rates in August, the market will need to reprice the front end of the yield curve. We expect a sharp sell-off in the 3Y bond to 5.1% by September and a steady grind higher in yields after that, as the RBA slowly tightens policy.

Our new forecasts are nevertheless for lower yields than previously expected. This reduction is for two main reasons. First, although we still expect a peak of the cash rate of 5.75%, we now expect the RBA to deliver those rate hikes more slowly. We expect one cash rate rise every six months, starting in August. Second, the US recovery has proved “frustratingly slow”. Slower increases in yields there will see yields in Australia rise more slowly too, all else equal.

The situation in Greece is obviously serious. While its economic importance is limited, there is a risk that contagion and liquidity problems radically alter the global economic outlook. However, we believe policy-makers are better equipped to deal with liquidity problems. This week’s news that French and German banks are working with authorities to structure a ‘voluntary’ work-out bodes well, even if they can’t avoid a technical default. Passage of the austerity measures through the Greek Parliament last night was obviously good news. We expect some of the recent flight to quality to be further unwound in the coming weeks.

Figure 1: Revised Swap & Bond Forecasts

Now Dec 2011

Jun 2012

Dec 2012

Official Cash 4.75 5.00 5.25 5.50 90-day BBSW 5.03 5.35 5.60 5.85 3-year swap 5.11 5.60 6.00 6.15 5-year swap 5.46 5.80 6.05 6.15 10-year swap 5.79 5.95 6.10 6.15 Aus 3y bond 4.76 5.30 5.60 5.75 Aus 10y bond 5.21 5.50 5.60 5.65 Aus 3-10yr Curve (bp)

45

20

0

-10

US 2yr bond 0.45 1.10 1.70 2.30 US 10yr bond 3.10 3.50 3.70 3.90 AUS-US 10yr spread (bp)

211

200

190

175


Figure 2: RBA forecasts and implied market prices


4.00

4.25

4.50

4.75

5.00

5.25

5.50

Jun-11

Jul-11

Aug-11

Sep

-11

Oct-11

Nov-11

Dec-11

Jan-12

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Mar-12

Ap

r-12

May-12

Jun-12

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%CBA Forecasts

30-Jun-11

We have updated our bond forecasts

A sharp sell-off as the RBA is repriced

Lower forecasts than previously

Greece a concern, but outlook appears to be improving



7

Australian Rates: Up, not down

The market is currently discounting some risk of a rate cut in Australia. That is surprising, even given the global context. The RBA has consistently said the next move in rates will be up. We think the RBA will have little tolerance for a pick-up in the household sector given limited spare capacity and the need to make room for the investment boom.

Now that data and our internal indicators are suggesting “consumer caution” is fading, concern over global conditions probably remains the only barrier to tightening. We expect that concern to ease and expect the RBA to be responsive to the inflation data due out on July 27.

Our economists believe the RBA will raise rates in August. However, the market is pricing risk of a rate cut (see Figure 2). The reversal of this pricing should cause a sell-off nearly as sharp as the recent rally. As we demonstrated in the weekly of June 16, the 3Y bond can really only stay well below the cash rate if the market is pricing rate cuts. If the RBA raises the cash rate to 5.0% in August, the current 3Y bond yield is simply too low to be sustained. We expect a sharp sell-off in 3Y rates.

We expect the 3Y rate will rise to 5.1% by September (after the rate rise in August) before slowly working its way to 5.3% in Dec-2011 and 5.75% in Dec-2012. Although a 40bp sell-off by September is a sharp move in rates, it is only taking the bond yields back to levels they were at as recently as May this year. Our forecast is for a reversal of the recent rally and not much more. (See Figure 3.)

There should also be a reasonable sell-off in 10Y rates, though not as sharply as the front-end sell-off. We expect the 10Y to reach 5.5% by year end and 5.65% by the end of 2012. We expect the slope to fall towards 20bp by year end and invert slightly in 2012.

The latter call does not mean we anticipate a more serious economic slowdown in 2013. External conditions and the impact on capex and exports mitigate that risk. But the expected move to quite tight monetary policy means influential domestic sectors of the economy should remain soft and that the market will price some chance of a policy mistake. The back end of the yield curve should also be held down by still-low global interest rates and strong demand for Aussie bonds. This influence may wane in 2013 and 2014 as global yields keep edging higher and the RBA cash rate settles at 5.75%. The same rationale drives our forecast for AUS-US bonds spreads to narrow over time (Figure 5).

Figure 3: Bond forecasts only a reversion to previous levels


Figure 4: Curve to slowly flatten over time


Figure 5: AUS-US 10Y spread to narrow


2.50

3.00

3.50

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2003 2005 2007 2009 2011

Cash Rate 3Y10Y 3Y FC10Y FC

-100

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Aus 10-yr

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US 10-yr

Aus 10-yr

%

Market continues to price cuts, despite the RBA saying hikes

Shifting to a market pricing hikes will mean a sharp sell-off

3Y rates will sell-off more than 10Y, flattening the curve



8

US yields: Inching higher

As Chairman Bernanke has eloquently put it, the recovery in the US is “frustratingly slow”. We continue to expect the US yields will rise as the Fed slowly withdraws extraordinary stimulus measures and eventually raises the cash rate. We have pushed out the timing for the first increase in the Federal Funds rate to mid 2012 and expect a gradual increase over the next few years.

We continue to forecast increases in US bond yields. We look for an initial spurt higher in yields as concern over the soft-patch in US growth abates. At the same time, the sell-off should also be helped by the influences of high oil prices and Japan also abating and the safety bid from Europe’s sovereign crisis reversing. But we then expect yields to rise at a slower rate than we had previously forecast.

The weaker economy is not the only reason to reduce our bond forecasts. US politicians appear to be making tough work of the debt ceiling increase. The situation is still fluid, but it appears likely the deal to raise the ceiling will include massive spending cuts and a comparatively small proportion of tax increases. Such a move could further dampen the already tepid recovery. There is, however, obviously some risk that the lack of a deal to lift the debt ceiling leads to a default and consequent ratings downgrades that could send yields soaring.

Our forecasts are for the US 10Y rate to rise towards 3.4% by the end of 2011 and 3.9% by the end of 2012. Our levels are deliberately low by historical standards. Fiscal tightening and the large slack in the US economy should prevent domestic inflation taking hold in the US (particularly now that commodity prices are easing). We still expect interest rates to remain relatively low for a number of years.

The rest of the world

We have lowered our bond forecasts in most other jurisdictions. As detailed on page 3, we have pushed out and moderated the extent of monetary tightening expected for most of the major countries. Most notably, we have reduced the forecasts in the UK significantly to reflect the slowing of growth there. (See figure 7.)

Positioning for a sell-off

The ACGB bond yield curve is still quite contorted. (See Figures 8 and 9.) The market has removed some of the rate-cut risk it was discounting over recent days. But it is still

Figure 6: US forecasts


Figure 7: 10Y bond forecasts in multiple currencies

Current

Dec-11

Jun-12

Dec-12

US 3.09 3.40 3.70 3.90 Australia 5.15 5.30 5.40 5.50 New Zealand 5.02 5.70 5.80 5.60 UK 3.32 3.40 4.00 4.10 Eurozone 2.98 3.70 3.90 4.00 Japan 1.13 1.30 1.40 1.50


Figure 8: Bond yields still contorted


0

2

4

6

03 04 05 06 07 08 09 10 11 12

%

CBA(f)

2-yr

Fed Funds

10-yr

4.50

4.75

5.00

5.25

5.50

2011 2012 2014 2016 2018 2019 2021 2023

Actual Yield Fitted Yield

US recovery is slow

Again, we expect US rates to rise, but more slowly than previously expected

Further fiscal tightening still seems likely

Lowered bond forecasts for most jurisdictions



9

pricing an elongated period of relatively steady rates. (See Figure 2.) The change in the medium-term RBA expectation led to a very large rally in mid-curve bonds, not just at the front end. As Figure 10 shows, the largest moves have in this cycle have been in the 2016 and 2017 bonds.

We think the market will, eventually, shift back to pricing RBA rate hikes. It might take an actual RBA rate hike to shake the market pricing, but that is a real possibility. Our economists continue to forecast a rate rise in August.

We expect the curve to sell-off and flatten, in general, over coming weeks. However, if the movements in Figure 10 are reversed, the largest moves are likely to be in the belly of the curve.

Of those bonds, the Jun-16 stands out as being far too dear compared to the rest of the curve. We positioned for our expected sell-off on June 29 with an outright short in the Jun-16 bond at a yield of 4.81% (see Fixed Income Daily of 29 June).

As discussed overleaf, we have also moved to position for a steeper money market curve, while also maintaining protection against the risk of contagion on bank bill spreads.

Figure 9: Bond yields still contorted


Figure 10: Bond movements since peak yield


-5.00-4.00-3.00-2.00-1.000.001.002.003.004.005.00

Nov-12

May-13

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Jun-14O

ct-14A

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Jun-16Feb

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Nelson-Siegel Cheap/Dear Resultbp

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Move since 11 April

The mid-curve has rallied most in this move, it stands to sell-off most



10

Why is the Greek Crisis hitting Australia hardest?

Philip Brown – Fixed Income Quantitative Strategist – 61 3 9675 7522 – [email protected]

The Australian market has reacted much more strongly to European problems than, for example, Europe.

We believe the Greek crisis will be resolved in a comparatively benign fashion.

The Australian market, having rallied a long way, is prime for a correction higher in yields.

Australian bond yields have started to reverse the rally that has dominated the last few weeks. Earlier this week all bonds up to and including the Feb-17 were below the 4.75% cash rate. The recent sell-off has taken the mid-curve bonds back above cash. We think the nascent sell-off can continue for a significant period if the Greek problems continue to fade into the background. The Australian market had been hit disproportionately in the rally and so stands to sell-off hard in the reversal.

We consider the Greek crisis serious, but are not convinced it will significantly hamper the Australian market. Yet, for some reason, the Australian market has reacted more strongly than many markets to Europe’s sovereign crisis.

Curve around cash, and contorted

Figure 1 shows the shape of the curve retains the contortion we observed last week. There is a flat section, out to the 2016, followed by a sharp rise, followed by another flat section.

The sell-off since Tuesday has increased the yields and undone the contortion a little, but there is still a fair bit of work to do before the curve is back to normal.

As we note in the article updating our bond forecasts on page 6, we think the market is likely going to sell-off fairly quickly. In particular, the front of the curve seems likely to sell-off hard.

Views on a Greek default

We have been relatively confident that Greece would not be able to pull down the world economy. The proposals from France and Germany’s willingness to consider them (as demonstrated by Joseph Ackermann’s comments last night) are a very positive sign. Passage of the austerity bill through the Greek Parliament reinforces our view that the powers that be will keep the crisis relatively contained.

We are not suggesting that this will turn out well for Greece – nothing of the sort – but we don’t think contagion will take hold.

Figure 1: Many ACGB yields well below cash


Figure 2: Bills/OIS spreads


4.50

4.75

5.00

5.25

5.50

2011 2012 2014 2016 2018 2019 2021 2023

Actual Yield Fitted Yield

0

5

10

15

20

25

30

35

40

45

50

1-Jan 1-Mar 1-May 1-Jul

AUD Bills/OIS USD Bills/OIS

EUR Bills/OIS NZD Bills/OIS

After a large rally and a moderate retracement, the AUD curve remains around cash and seriously contorted

We believe the Greek crisis will not cause an international contagion



11

Greek impacts on Australian risk measures

The rally in Australian rates (up to Monday) coincided with a rise in Australian risk-measures too. The 3M Bills/OIS spread has risen to around 30bp from a recent average around 15bp.

There have been some moves in Europe and the US too. However, as Figure 2 shows, the movement in Australia has been much higher and sharper than the movements in spreads elsewhere. That doesn’t seem to make much sense to us. If Greece really is the next Lehman’s and the world is about to go through another round of contagion, shouldn’t it be, well, contagious? Why should Greece affect Australia more than elsewhere?

There is a similar story to be found in the 1Y OIS rates. Figure 3 shows the 1Y OIS for AUD, USD, EUR and CAD. The two axes are both 200bp long, so there is no visual distortion. The AUD 1Y OIS has rallied far more than the CAD or USD and the EUR has barely moved at all. If the market is to be believed, then the ECB will be raising rates even as Greece defaults and causes a global meltdown.

We understand global scepticism of Australia’s growth story and housing market. And the attraction our high rates and yields offer, particularly in a deteriorating environment. But we simply don’t believe that there is any reason for Australia to be more affected by European sovereign issues than Europe is. This adds to our confidence that the recent rally in Australian bonds will be reversed in a large way.

Possible Domestic Drivers?

Although the most common explanation for the rally has been “Greece” there are a couple of other, purely domestic, drivers to consider. We don’t find any of these domestic drivers able to explain the entirety of the situation we have seen, but they do provide partial explanations.

June 30: Obviously, today is June 30, which is financial year end in Australia, but very few other places in the world. This could provide some explanation for the rise in the Bills/OIS spread. However, it should not be affecting the outright level of OIS.

RBA repricing: There is some possibility that the market has repriced the RBA expectation at the same time as the Greek crisis, but not because of the Greek crisis. However, we find this view hard to credit. Some data, including key labour market figures and housing arrears, have been softer. But the RBA-speak over the last few weeks has consistently been hawkish

Figure 3: 1Y OIS rates


Figure 4: Phil Lowe on CPI estimates

Source: RBA: Philip Lowe speech on 24 June

4.00

4.20

4.40

4.60

4.80

5.00

5.20

5.40

5.60

5.80

6.00

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Jan-11 Mar-11 May-11 Jul-11

EU US Canada Aust (rhs)

But Australian markets have been hugely affected by the crisis

Bills/OIS spread have widened and OIS have rallied

Some domestic drivers possible, but none are particularly convincing



12

and there is no real evidence that the economy has turned a corner.

For a flavour of the RBA’s view on medium term inflation can we suggest Phil Lowe’s speech from 24 June. In summary, it explained that the RBA is forecasting CPI to be at the top of the band. And that the RBA tends to underestimate inflation at the mid and late stages of the cycle.

Flows: This is a fairly week explanation in some ways, but we have heard of significant flows in the repo markets. We have also seen the contortion in the bond markets being focused on the 3Y and 10Y points, while the body lags. The corollary of this has been that the bond futures have been very dear to physical bond baskets (see Figure 5). As the positioning changes, the basis in the futures market should ease. We are already seeing some movement in the basis back towards zero, particularly in the 10Y basket.

Conclusions

Our basic conclusion is that, for reasons not entirely clear, the Greek crisis has resonated with Australian markets in a way it has not resonated with European or American ones. This over-reaction by Australian markets gives extra weight to our belief that the front end of the Australian market is due a sharp correction. We are very comfortable with our short positions at current levels.

Figure 5: Futures Cheap/Dear


-30

-20

-10

0

10

20

30

Jan Feb Mar Apr May Jun

bp

6m OIS - 1m Bill

6m OIS - 1m OIS



13

Taking advantage of rate cut pricing

Alex Stanley – Associate Analyst Fixed Income– 61 2 9118 1125 – [email protected]

Market pricing for the risk of rate cuts looks excessive in our view.

To take advantage of the relatively high 1m bill rates and unrealistic rate cut pricing over the next 6M, we bought 1m bills and paid 6 month OIS at a spread of -23bp, with a target of 4bp and a stop of -30bp.

We keep our short Sep bill versus OIS trade on as insurance, given limited downside to the forward spread.

The Aussie market moved to price some risk of rate cuts at the front end of the curve because of fears over a Greece default (Figure 1). As we noted in our Fixed Income Daily Wrap yesterday (June 29), we positioned for higher rates by paying 6m OIS and buying the 1m bank bill. We entered the trade at -23bp, On current OIS and bank bill rates (physical bills) the trade is 5.5bp in the money at -17bp. We think the spread can go further and target a level of +4bp, with a stop at -30bp.

Since the successful passage of the Greek austerity package overnight, the Aussie market has sold-off. But, as Figure 1 illustrates, the market is still pricing rate cuts, albeit less-so than yesterday.

Our main views on the outlook for Aussie rates are summarised in detail in the other articles this week (see pages 3, 6 and 10). In brief, we:

don’t believe there will be a widespread financial contagion risk from a Greek default.

expect the RBA will raise rates over the medium term.

Positioning for our view

As the crisis has evolved in recent weeks, the OIS curve has fallen markedly and bills/OIS spreads have widened. When we implemented a paid 6m OIS/buy 1m bank bill trade yesterday, the curve was inverted out to 6 months. After the sell-off last night and today, OIS rates have risen. But the current 6 month OIS rate of 4.73% is still pricing a rate cut. Today the trade has pushed further in the money and is currently at -17.5bp. We think it can rise further and we maintain our target of +4bp, with a stop at 30bp.

Figure 2 illustrates that Bills/OIS spreads have pushed markedly wider in recent weeks, as risks in Europe have intensified. The push wider in the one month bill/OIS spread to 16bp from 5bp two weeks ago is particularly striking. The lower liquidity in 1 month bills, compared with 3 month bills, partly explains the sharp widening in the 1 month spread. The end of month effect (which is also end of financial year) could also

Figure 1 – The OIS curve over recent weeks

Source: Bloomberg, CBA

Figure 2 – Bills/OIS spreads


4.65

4.70

4.75

4.80

4.85

4.90

4.95

1m 2m 3m 4m 5m 6m 7m 8m 9m 10m11m12m

%

15-Jun

22-Jun

29-Jun

30-Jun

0

10

20

30

40


bp

1m Spread

3m Spread

The Aussie front end is still pricing rate cuts

The 6m OIS still looks like a good paying opportunity



14

be exerting an impact.

An easing of bank contagion fears should pave the way for a normalisation of bills/OIS spreads and a re-pricing of RBA rate expectations. If the market returns to pricing no rate hikes for 6 months, then the 6 month OIS rate should rise to 4.81% (once you take compounding into account). The 6M OIS was around this level two weeks ago. We think a return to rate hike pricing will add considerable value to a paid 6m OIS position. The 1 month bill rate should fall as the spread to 1 month OIS tightens back to around 10bp. This spread contraction also boosts the attractiveness of the trade.

Complicating the matter slightly, we entered the trade yesterday, so we have a late July bill. The spread between that and 6M OIS is currently 17bp. If you were to execute the trade today, you would have an early August bill and the spread would be 12bp. In both cases, we think this spread should push back up to zero and into positive territory as fears over global financial contagion risks ease.

We’re holding onto our insurance trade

Last week, we concluded that there was sufficient uncertainty in the market to warrant a forward bills/OIS spread widening trade. We sold Sep bill futures and received 3m*3m OIS at a spread of 19bp, as insurance in the event that bank risk fears rise. That spread is currently at 16bp (see Figure 4), which is 3bp lower than our entry level. Further downside is limited on this trade, probably to a loss of 5-10bp in total. In contrast, there is ample upside benefits if European fears take off further. We’re quite confident about banking risks being contained. But we would still like keep that trade on as insurance.

Figure 3 – 6m OIS-1m bank bill and 1m OIS spreads


Figure 4 – Forward bills/OIS spread

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6m OIS - 1m Bill

6m OIS - 1m OIS

0

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Today's Phys. Bill

Sep-11 Dec-11 Mar-12

3M Bills OIS Spread

We keep our forward bills/OIS trade on as insurance.

Tighter bill/OIS spreads should help our paid 6m OIS, buy 1m bill position.



15

Key Views

United States

Tactical (<1 mth)

Strategic (>3 mths)

Concern over an imminent Greek default has been reverberating around the financial system, though the passage of Austerity measures and a recent French proposal have calmed markets a little. We expect the recent flight to quality to fade and for global bond yields to push higher.

The underlying US data has also been comparatively poor in recent weeks. The FOMC officially ended QE2 this week, but continued to invest coupons and US policy remains highly stimulatory. US policy makers are still discussing plans to increase the debt ceiling, with pressure for a longer-term fiscal deal intensifying following an S&P revision to the AAA rating outlook and recent warning comments by Moody’s. Greece has been distracting the headline writers, which is probably be a good thing as it lets these negotiations take place in a less media-heavy environment. A deal is needed soon, however, particularly if the Greek problem fades and attention turns to the US.

We expect a stronger economic recovery to take hold in later in 2011 and for bond yields to head higher as the situation becomes clearer. The Fed remains concerned about the slow recovery in the labour market and the low level of (underlying) inflation. We expect the Fed to first stop investing coupons March 2012. Later, once the Fed starts raising the Fed Funds rate, we see room for the curve to flatten markedly as US 10yrs push toward 3.5% this year and 4.0% in 2012.

Policy rate 0.1% 0.1%

10yr bond 3.30% 3.50%

2/10 curve 280bp 270bp

USD/JPY 81.00 82.00

EUR/USD 1.47 1.50

The EUR is set to appreciate again following the passing of austerity measures through the Greek parliament. EUR resilience in part reflects currency markets focusing their attention on the slow US economic recovery. The softness in the US data means the US Federal Reserve will likely remain on the sidelines for an extended period and keep the USD weak. In contrast, the ECB is likely to tighten next week, given its desire to ward-off the second round effects of high headline inflation.

Australia

Tactical (<1 mth)

Strategic (>3 mths)

Australia’s economy remains in robust health on a medium term outlook, but the consecutive poor jobs results emphasise the soft-patch the data is currently in. RBA officials have reiterated the ‘rates move higher’ comment in recent speeches and the phrase appeared again in the minutes for the June RBA meeting.

We see the fundamental strength exerted by high commodity prices and booming investment as dominating over the year and pushing the RBA to continue to tighten rates over the course of 2011-13. The RBA has noted that the recent spike in CPI should be temporary, but appears to be ready to raise rates on any indication the spike is becoming a trend. Our bias is toward a flatter curve over time. Australian spreads to US should narrow slowly in 2011 before tightening quickly when the Fed starts to raise rates in 2012.

The AUD is showing a great degree of resilience to the ongoing public debt issues in Europe. The passing of austerity measures by the Greek parliament is likely to lift global financial market sentiment and the AUD. The soft US economy, contained volatility, and Australia’s economic out-performance continues to support the AUD. When coupled with broad USD weakness, the AUD we expect the AUD to remain around 1.08 in coming months.


10yr bond 5.40% 5.60%

3/10 curve 40bp 20bp

10yr EFP 50bp 45bp

10yr v US 210 200

AUD/USD 1.0800 1.1000

New Zealand

Tactical (<1 mth)

Strategic (>3 mths)

The NZ economy is starting to slowly recover after the Christchurch earthquake. We do not expect the RBNZ to raise rates until early January 2012, though there is potential for a delay to March 2012 following the latest earthquake. The destruction in Christchurch is considerable and the recovery will be a very long, slow one. Recent data has been improving, though there is a long way to go before rate rises are a real possibility.

The NZD touched a record post-float high vis-à-vis the USD on 27 May (0.8219). With Eurozone debt issues not severely undermining the outlook for global growth, we expect the NZD to move towards 0.85 over the coming months. Confidence among New Zealand consumers and businesses is recovering, driven by the RBNZ's March ‘insurance’ rate cut. The significant rebuild effort yet to start and the upcoming Rugby World Cup should compound the current economic momentum. New Zealand’s economic recovery, firm commodity prices and continued export growth should push NZD higher. AUD/NZD should ease modestly.


10yr bond 5.20% 5.50%

2/10 swap curve

170bp 180bp

10yr v US 200 200

10yr v AUS -10bp -20bp

NZD/USD 0.8200 0.8500

AUD/NZD 1.2800 1.2700



16

Cash Rate Pricing

Source: All data sourced from Bloomberg. Rates displayed are calculated using IB Futures (Australia), FF Futures (US) and OIS in all other currencies.

Australian Cash Rate Pricing New Zealand OCR Pricing US Fed Funds PricingCum. % chance Cum. % chance Cum. % chance

Rate of +25bp Rate of +25bp Rate of +25bpCurrent 4.75 0 Current 2.50 0 Current 0.05 05-Jul-11 4.74 -6 28-Jul-11 2.50 -1 9-Aug-11 0.14 382-Aug-11 4.71 -15 15-Sep-11 2.49 -5 20-Sep-11 0.15 406-Sep-11 4.69 -25 27-Oct-11 2.50 0 2-Nov-11 0.17 464-Oct-11 4.67 -33 8-Dec-11 2.62 48 13-Dec-11 0.18 521-Nov-11 4.67 -32 26-Jan-12 2.73 92 25-Jan-12 0.21 646-Dec-11 4.68 -28 8-Mar-12 2.91 165 13-Mar-12 0.24 777-Feb-12 4.69 -23 26-Apr-12 2.98 191 25-Apr-12 0.28 926-Mar-12 4.69 -24 14-Jun-12 3.74 497 20-Jun-12 0.32 1083-Apr-12 4.70 -22 28-Jul-12 3.74 497 31-Jul-12 0.41 142

Candian Rate Pricing EUR EONIA Pricing UK SONIA PricingCum. % chance Cum. % chance Cum. % chance

Rate of +25bp Rate of +25bp Rate of +25bpCurrent 0.90 0 Current Target 1.25 Current 0.53 019-Jul-11 1.04 19 7-Jul-11 1.20 -19 7-Jul-11 0.53 07-Sep-11 1.01 10 4-Aug-11 1.33 34 4-Aug-11 0.52 -325-Oct-11 1.10 45 8-Sep-11 1.37 49 8-Sep-11 0.55 96-Dec-11 1.18 74 6-Oct-11 1.46 83 6-Oct-11 0.59 2529-Feb-12 1.34 142 3-Nov-11 1.50 101 10-Nov-11 0.54 311-Apr-12 1.35 144 8-Dec-11 1.49 95 8-Dec-11 0.59 25

12-Jan-12 1.54 117 5-Jan-12 0.58 217-Feb-13 1.75 199 8-Mar-12 0.68 61

7-Mar-13 1.75 199 5-Apr-12 0.78 99

4.62

4.64

4.66

4.68

4.70

4.72

4.74

4.76

Jun Sep Dec Mar Jun

AUD Implied Cash Rate

0.00

1.00

2.00

3.00

4.00

Jun Sep Dec Mar Jun

NZD Implied Cash Rate

0.00

0.10

0.20

0.30

0.40

0.50

Jun Sep Dec Mar Jun

USD Implied Cash Rate

0.00

0.50

1.00

1.50

2.00

Jun Aug Oct Dec Feb Apr Jun

CAD Implied Cash Rate

0.00

0.50

1.00

1.50

2.00

Jun Sep Dec Mar Jun

GBP Implied Cash Rate

0.00

0.50

1.00

1.50

2.00

Jun Sep Dec Mar Jun

EUR Implied Cash Rate



17

CBA Forecasts:

Cash rate 30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 0.25 0.25 0.25 0.25 0.50 1.00 1.50Australia 4.75 5.00 5.00 5.25 5.25 5.50 5.50New Zealand 2.50 2.50 2.50 3.00 3.50 4.00 4.50United Kingdom 0.50 0.50 0.50 0.50 0.75 1.00 1.25Eurozone 1.25 1.50 1.75 2.00 2.00 2.25 2.25Japan 0.10 0.10 0.10 0.10 0.10 0.10 0.102-yr bond yield 30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 0.45 0.80 1.10 1.40 1.70 2.00 2.30Australia 4.74 5.00 5.20 5.40 5.55 5.70 5.80New Zealand 3.19 3.40 3.70 4.00 4.20 4.40 4.60United Kingdom 0.81 1.00 1.20 1.40 1.70 2.00 2.20Eurozone 1.55 1.90 2.20 2.40 2.60 2.80 2.80Japan 0.18 0.25 0.25 0.30 0.35 0.40 0.4010-yr bond yield 30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 3.11 3.30 3.50 3.60 3.70 3.80 3.90Australia 5.23 5.40 5.50 5.55 5.60 5.60 5.65New Zealand 5.04 5.20 5.30 5.40 5.50 5.60 5.60United Kingdom 3.33 3.40 3.50 3.60 3.80 4.00 4.20Eurozone 2.98 3.30 3.60 3.80 3.90 4.00 4.00Japan 1.15 1.25 1.30 1.40 1.40 1.50 1.50

Currencies 30-Jun Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12AUD/USD 1.07 1.08 1.04 1.02 0.97 0.95 0.95AUD/JPY 86.39 86.40 85.28 84.66 82.45 83.60 85.50AUD/EUR 0.74 0.72 0.71 0.71 0.70 0.70 0.68AUD/GBP 0.67 0.65 0.64 0.62 0.61 0.60 0.59

AUD/CAD 1.04 1.03 1.02 1.02 1.02 1.01 1.01AUD/NZD 1.29 1.27 1.27 1.28 1.28 1.27 1.27USD/JPY 80.42 80.00 82.00 83.00 85.00 88.00 90.00EUR/USD 1.45 1.50 1.47 1.43 1.38 1.35 1.40

GBP/USD 1.61 1.67 1.63 1.64 1.60 1.58 1.62USD/CAD 0.97 0.95 0.98 1.00 1.05 1.06 1.06NZD/USD 0.83 0.85 0.82 0.80 0.76 0.75 0.75



18

Calendar – July 2011

Note: Figures in brackets represent previous result (if available). All information is preliminary and subject to revision. Chief Economist: Michael Blythe ph: 9118-1101 Economist: James McIntyre: 9118-1100



19

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20

Research

Commodities Telephone Email Address

Luke Mathews

Lachlan Shaw

Agri Commodities

Mining & Energy Commodities

+612 9118 1098

+613 9675 8618

[email protected]

[email protected]

Economics Telephone Email Address

Michael Blythe

Michael Workman

John Peters

James McIntyre

Chief Economist

Senior Economist

Senior Economist

Economist

+612 9118 1101

+612 9118 1019

+612 9117 0112

+612 9118 1100

[email protected]

[email protected]

[email protected]

[email protected]

Fixed Income Telephone Email Address

Adam Donaldson

Philip Brown

Alex Stanley

Michael Bors

Steve Shoobert

Winnie Chee

Tally Dewan

Kevin Ward

Head of Debt Research

Fixed Income Quantitative Strategist

Associate Analyst, Fixed Income

Credit Research Analyst

Credit Research Analyst

Securitised Product

Quantitative Analyst

Database Manager

+612 9118 1095

+612 9118 1090

+612 9118 1125

+612 9118 1108

+612 9118 1096

+612 9118 1104

+612 9118 1105

+612 9118 1960

[email protected]

[email protected]

[email protected]

[email protected]

[email protected]

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Foreign Exchange Telephone Email Address

Richard Grace

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Chief Currency Strategist

Currency Strategist

FX Economist

Asian Currency Strategist

+612 9117 0080

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+65 6349 7056

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Delivery Channels & Publications Telephone Email Address

Monica Eley

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+612 9118 1097

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New Zealand Telephone Email Address

Chris Tennent-Brown

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Jane Turner

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CBA NZ Economist

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Economist

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+64 9374 8819

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+44 20 7329 6266

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Syd

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fixed income: weekly strategy...michael blythe chief economist t. +612 9118 1101 e....

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