The Antipodean Strategist: June 10

The Antipodean Strategist:

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

The less hawkish statement from the RBA this week left the market scratching its head. The key change in the statement was the more toned down commentary on inflation, relative to the quarterly Statement on Monetary Policy and the May Board meeting statement.

The reason why the change of commentary on inflation was significant is because it suggests the possibility that the recent data has impacted the degree of confidence in the growth and inflation forecasts published in the May quarterly Statement on Monetary Policy. The latest employment data – in conjunction with a run of weak data over the past month – provide additional impetus to this story.

Our strategic risk scenario for monetary policy has been that the data would not be strong enough to justify the sort of growth forecasts that the central bank had pencilled in for this year. In contrast to the consensus outlook for the RBA cash rate, market pricing currently reflects a benign policy outlook. J.P. Morgan economists expect 2 further rate hikes by year end.

In New Zealand, the RBNZ’s OCR announcement prompted a re-pricing of the front end as the market digested more upbeat than expected commentary. While the timing of the first rate hike will be highly dependent upon the pace of the rebuilding efforts, we think the market currently places too little weight on the impact of (i) the elevated NZD and (ii) the prospect of significant fiscal consolidation.

This week was a challenging one for short positions in the AUD front end, with weaker employment data and a less hawkish RBA statement driving yields sharply lower. Over the next year, the market is currently pricing in around 13bps of tightening.

The next key event will be the RBA Governor's speech on Economic Conditions and Prospects on 15 June. Even if the commentary is hawkish, we doubt the market will listen. And despite the front end richening further this week, we are neutral at current levels and acknowledge the risk of still lower yields driven by position capitulation.

Moreover, we believe the market will be extremely sensitive to any hint of less hawkish rhetoric or more weak data. With consensus reflecting short duration and curve flattening trades, any shift in the economic fundamentals could prompt a significant re-think of portfolios. The judgment call is how long this takes to play out.

Further out the yield curve, we are running tactically short positions, expressed via a long position in Dec-11 bank bill futures against a short in 3-years. Our tactical short reflects (i) near term directional views in the UST market and (ii) the potential for an unwind of heavily populated short bills vs. 3-years positions and (iii) the fact that this spread will struggle to flatten further until policy is taken to a genuinely restrictive level.

This week, we think 3s10s curve steepeners (basis futures) offer attractive risk/reward. Skewed positioning (a strong bias towards flatteners) and the prospect of higher 10-year UST yields could pressure the curve steeper.

Also this week we introduce a model of 10-year breakevens. Our model suggests that breakevens are currently close to fair value at present and furthermore, on J.P. Morgan forecasts, fair value should be reasonably stable around 3% over coming quarters.

We recommend entering steepeners at a spread of +40.0bps, and target a move to +55.0bps. Place a tight stop at +35.0bps.

We remain short AUS 10-year bonds against US 10-year bonds (entered at a spread of 214bps), and short AUS 3-year bonds against Dec-11 bill futures (entered at a spread of -22.0bps).

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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