Australia: Where now for front end spreads? – Westpac

Analysts at Westpac have often stated their belief that global influences can push AU valuations well away from domestic fundamentals and current pricing in the AU bond market reflects the fact that another phase of that type of price action is clearly underway. 

Key Quotes

“This is best observed in our favoured RV metric of 3yr bond yields less 6mth forward implied cash, which is currently at 68bp.”

“In the post GFC era 3yr yields versus cash have only once been higher than the current level. That was when the spread got to the low 70s at the peak of 2013's "taper tantrum". The lesson from that period was that it was an over-reaction and an excellent opportunity to go long outright or enter various carry trades.” 

“So is that the correct message to take from the current situation? There are contrasts and comparisons between the two periods. Perhaps the biggest contrast is that in 2013 the risk rewards favoured the RBA extending its easing cycle, which it subsequently did. In 2017, however, RBA Governor Lowe has been consistent in his messaging that he sees little value in delivering further rate cuts.” 

“So the real question is whether the spread is accurately reflecting the risks of the RBA off current levels? OIS-implied pricing is almost a 50% chance of a hike in December this year, rising to an 80% chance of a hike by April 2018. The market has heeded the RBA's message and removed rate cuts from its expectations. However, we believe that it is far too early and pre-emptive to factor-in rate hikes over the next 12 months.” 

“That is important because if a rate hike were a near term possibility, then there is scope for 3yrs to sell-off around another 20-25bps before a “buy on dips” tactical approach would be viable. Of course, discounting the huge valuations swings of the GFC, if the market does not think an extended tightening cycle is likely, it will cap any sell-off in 3yr bonds beyond one more hike. Indeed, the period highlighted shows just how quickly the market moved towards pre-empting the end of the easing cycle. It began following only the 3rd hike in 2003, when the hike cycle ended in 2008!” 

“So that suggests there is a buying opportunity at current levels, although, in line with our view that USTs could establish a higher upside in yield within the range, the opportunity is likely to get even better in coming days. We will keep monitoring price action for an appropriate signal to fade the current move.” 

“One positive is that the AU market appears to have cleared out a lot of risk, as stops on longs established 10 ticks higher have been triggered. In addition, last week's declines actually attracted good buyside support in physicals from a number of different counterparties. That is an encouraging sign of latent domestic and offshore demand.”