The Antipodean Strategist: AUS & NZ interest rate research

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

• The RBA Governor stuck to the script this week, re-iterating the view that a rate rise is likely to be needed at some point. But the speech pre-dated events in Europe this week, meaning that its relevance for markets was somewhat short-lived.
• Domestic data in Australia this week revealed further declines in consumer and business confidence, and stable consumer inflation expectations. At the margin these data argue for a more benign rates environment, although we suspect the next key data releases for policy makers will be the labour force and retail numbers.
• The labour force data will be critical; another weak number and we think the RBA’s central case scenario for the economy might come under threat. However, leading indicators of employment growth appear to suggest the chance of this outcome to be low.
• In New Zealand, the run of better data has continued. The second quarter data have more relevance to the policy outlook, given that they are to be less affected by the earthquake. However, more aftershocks in Christchurch mean that the expected rebuilding effort has in all likelihood been pushed out. For the RBNZ, this implies less urgency to begin the rate normalization process.

Strategy Update
• The move towards higher front end yields in Australia post Stevens’ speech didn’t last for long; wide scale position capitulation on the back of European headlines saw the market pricing in some chance of a rate cut.
• Typically, investors have done well paying OIS at these levels (given cleaner positioning and a central bank that still sees upside risks to inflation). We recommend paying Dec-11 RBA meeting OIS, but acknowledge that the risk to this trade arises from further near term deterioration in the European sovereign debt saga.
• The European situation looks to be something of a game changer for the term rates outlook, given that the risks to financial stability across Europe look to have meaningfully increased. In this environment, we have turned neutral on duration and see a strong risk that 3-year yields move to 25bps under cash. The very front looks to offer the best risk/reward for shorts.
• Furthermore, it appears that the situation in Europe may be volatile for some time yet, and hence we define the near term range for 3-years as 95.10-95.45. 3-years have reached the top of the bullish channel in place since January 2011 and as such, might struggle to rally near term in the absence of any new information on the European situation.
• The recent rally has seen AUS 10-year bond yields converge to our estimate of long run fair value (around 5.10%). Since the financial crisis, 10-year bonds have not really traded below fair value; as such we think any move to the 5.0% level for 10-year bonds offers an attractive level at which to scale into short positions.

Trade Portfolio Update
• New trade: pay RBA Dec-11 OIS at 4.775%, and target a move to 4.95%. Place a stop at 4.72%.
• We remain short AUS 10-year bonds against US 10-year bonds (entered at a spread of 214bps). We have exited our short in AUS 3-year bonds against Dec-11 bill futures at flat. We continue to hold our AUS 3s10s curve steepeners.
• In New Zealand, we used the rally after the aftershocks in Christchurch to take profits on our received RBNZ Dec-11 OIS position. We remain paid the belly of the 2s3s5s swap butterfly.

ENDS

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