The Antipodean Strategist: May 6

The Antipodean Strategist: May 6

J.P. Morgan interest rate strategist, Sally Auld, provides a weekly Australian & New Zealand rates strategy update:

This week has been all about central bank rhetoric, with the market rallying because it was disappointed by the RBA board meeting statement but selling off later in the week as the RBA’s quarterly Statement on Monetary Policy revealed upward revisions to the core inflation forecasts.

In addition, some commentators have started to highlight the chance of a rate hike as soon as June. In our view, the case for a rate hike in June is far from proven. There is key data scheduled for release over the next few weeks which could make or break the June rate hike story. Specifically, employment and wages data will be critical. J.P. Morgan economists expect the next 25bp tightening of policy to be delivered in August. The market currently ascribes a 75% chance to this outcome.

The broader case for a tightening by year end remains intact, given there has been no change to the medium term investment/terms of trade and national incomes growth story. But tactically, the outlook is more complicated, with a high real exchange rate, a soft consumer and some question marks about the global growth environment.

We think the AUD front end is close to levels at which it offers attractive risk/reward. At current levels, 12-month OIS looks like it is about fully priced for a 25bp rate hike in Q3 ’11 and a 25bp rate hike in Q1 ’12. We struggle to see a scenario in which the RBA would tighten more aggressively, especially given the elevated currency and more subdued housing and consumption data.

Our broad range for 3-year yields is 94.80 to 95.25. We would look to add to longs on any move sub 94.85 in 3-years and believe that the broad bullish uptrend remains intact. Range volatility in AUS 3-years remains extremely low, but with domestic investors holding short duration and curve flattening trades with conviction, it seems hard to envisage how the range will break any time soon..

The fortunes of our curve steepening trade in 3s10s have been mixed of late; we favour holding the position in the expectation that sentiment around policy tightening be pared back in coming weeks. We would look to convert the trade into a 3s10s swap/efp box flattener on any move in this spread back to the high 20s (currently 26.5bps).

In contrast, our AUS-US 10-year spread trade has performed well as the US 10-year yield has ground lower over the past week or so. The positive carry on the trade is still reasonable and we are targeting a move to the 230bps level in the first instance (currently 224bps). This week’s US payrolls announcement is probably the near term risk to the trade, but we think that interest to pay AUD 5y5y swap (currently at six month yield lows) is likely to help near term under-performance of the AUS 10-year sector.

In New Zealand, it has been the cash bond market which has driven most of the price action in NZ yields. We have taken profits on our Dec-17 asset swap position, with the asset swap moving from -32bps to -8bps. Elsewhere in New Zealand, we continue to hold a received Dec-11 RBNZ meeting OIS position, and are paid the belly of the 2s3s5s swap butterfly.

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