Fixed Income: Weekly Strategy

Transcription

1 21 June 211 Navigating European turmoil in Australian rates The Australian market has rallied and outperformed as the Greek situation simmers. There is relatively cheap insurance available by selling September IR futures against the OIS rate at 19bp. The bond yield curve has an unusual hump around the maturity. We recommend a flattener. The agonising wait for a Greek default continues. Australian bond markets rallied sharply late last week. The ACGB Jun-14 has rallied 14bp since last Monday to 4.64% (stopping us out of our freshly-minted short), while the 1Y has rallied 1bp to 5.8%. The Australian market has strongly outperformed the global moves. In the US, the 2Y bond has rallied 4bp since last Monday to.38%, while the 1Y bond has rallied 2bp to 2.95%. The German bond market has also been nearly perfectly flat since last Monday. The 2Y German bond has rallied 2bp and the 1Y bund has sold-off.5bp. The movement in Australian bonds has been accompanied by a change in market pricing for the RBA cash rate. Along with a sharp fall in bond rates the market has begun to discount risk of rate cuts, rather than increases. The RBA has not fuelled this change, twice in the past week expressing a view that the next move in rates would be up if current forecasts prove true. (Governor Stevens speech on Wednesday 15 June and the RBA minutes this morning.) The impetus for the move is definitely coming from offshore. We think the outperformance of Australian bonds has probably gone far enough for the moment. We take profit on our AUD to USD 1Y bond spread at the current level of 211bp, just short of our original target level. This week, Alex Stanley examines how the offshore news in Europe and the US is affecting the Australia market. Although the outright level of rates has already moved, many secondary indicators of financial distress have not yet moved that far. We recommend selling the September IR future against OIS at a spread of 19bp. The rally in Australia has also moved the curve out of shape. The 215 to 218 part of the ACGB curve is exceptionally steep and the curve is very contorted. Philip Brown discusses this in his article on page 8. There is very little data scheduled for the coming week in Australia. There are two leading indices scheduled for tomorrow and Wednesday, but these are going to be very secondary compared to the main story emanating from Europe. There remains very little clarity from Europe, but we remain more confident than the market as a whole seems to be. The likening of this situation to the Lehman collapse in particular seems a stretch to us, mainly because European policy makers saw what happened when Lehmans did collapse and will be working, hard, to prevent a recurrence. Contents: Key Positions... 2 Key Trades... 2 Transmission of global risk aversion to the Aussie market... 3 The shape of the curve is contorted after last week s spasm of a rally... 8 Key Views CBA Forecasts: Calendar June Spot and forward Bills/OIS spreads Today's Phys. Bill Source: CBA, Bloomberg 3M Bills OIS Spread Sep-11 Dec-11 Mar-12 In the US the FOMC decision on Thursday morning will be the most important release. The FOMC is likely to end QE2, though this will be mostly by stopping buying bonds. Little else should change. There will also be data on existing home sales (Tues night) and New Home Sales (Wed night). Philip Brown Quantitative Strategist T E. philip.brown@cba.com.au Adam Donaldson Head of Debt Research T E. adam.donaldson@cba.com.au Alex Stanley Associate Analyst, Fixed Income T E. alex.stanley@cba.com.au Important Disclosures and analyst certifications regarding subject companies are in the Disclosure and Disclaimer Appendix of this document and at This report is published, approved and distributed by Commonwealth Bank of Australia ABN AFSL

2 Key Positions Our positions were ravaged this week. The sharp rally on Thursday last week took out our outright short position and the IB spread trade. An RV trade based on the position of the Jun-16 and Jan-18 also suffered as the curve steepened. The strong rally in Australian bonds did benefit one of our trades the Aust to US spread. We take profit on that trade at 211bp. We implement two new trades today. First, an ACGB Oct-15 to Jan-18 spread at 27bp. This trade works best if the market regains confidence. Second, an insurance trade in case we are approaching GFC mark 2. We sell September bill futures against the 3M*3M OIS at a spread of 19bp. Key Trades Trade Entry Curent Profit Target Stop Comment Buy the NSWTC Jun-2 (Govt G teed) as an ASW Buy an NSWTC Nov-2 Linker vs UST 1.25% Jul-2 linker Buy a 6M*1Y receiver 2bp below spot yields (4.85%) Receive the 1Y Bills/Libor basis against the 3Y Buy the Jan-18 vs the Jun-16-12bp (3-Feb-1) 213bp (14-Mar-11) 7.5bp premium (11-Apr-11) 15bp (11-Apr-11) 11.5bp (18-May-11) Receive 1Y ZCS 3.% (2-May-11) Sell the KfW Dec-19 against the IBRD Oct-19 Buy the ACGB May-21 vs the UST Buy the Jul-11 IB contract against the Oct-11 IB contract 22bp (3-May-11) 228bp (2-Jun-11) 6bp (2-Jun-11) -25.5bp +13.5bp -35bp bp Hold: A long-term buy-and-hold trade. 25bp +8bp 15bp 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. 15bp 7.5bp n/a n/a Hold: We are still hopeful, but this trade s insurance value is looking better and better. 12bp +3bp 7bp 19bp Hold: We think the recent flow has steepened the curve too far. 15bp -3.5bp 4bp 15bp Stopped Out: The steepening following the RBA has hurt the trade. 2.78% +22bp 2.5% 3.2% Hold: We believe there is scope for headline CPI to snap back, which is not captured in the ZCS 21bp -1bp 4bp 15bp Hold: Despite the growing concern in Europe, there has not been any movement in the basis or in the credit spread. 211bp +17bp 21bp 237bp Take Profit: Exiting the trade before the FOMC meeting. 2bp -4bp 25bp 2bp Stopped Out: Current market pricing is now-or-never from the RBA. We disagree. Sell the Jun-14 ACGB 4.84% 4.7% -14bp 5.1% 4.7% Stopped Out: Savaged by a sharp rally in bonds. Buy the Jan-18 vs the Oct-15 28bp (21-Jun-11) 15bp 35bp New Trade: The shape of the curve is very strange at present Sell the September Bill Future against receiving the 3M*3M OIS 19bp 4bp (?) 1bp New Trade: 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 4bp just because it trades there once. 2

3 Transmission of global risk aversion to the Aussie market Alex Stanley Associate Analyst Fixed Income alex.stanley@cba.com.au Heightened European sovereign risk is occurring against the backdrop of a slower US economy. Both risk factors have contributed to a substantial rally across the Aussie curve and have led the market to price rate cuts. We don t think a rate cut is likely, but can see scope for the rally going further if news in Europe gets worse. We think the market is under-pricing a potential widening in Bill/OIS spreads. We sell the Sep bill futures against paying 3m*3m OIS. European sovereign risk is occurring at the same time as US growth has slowed. The Aussie market is pricing RBA rate cuts. A deteriorating macro environment has driven US stock and bond yields lower. Recently, market concerns over weakness in the US economy have driven a flight away from risk assets into bonds. In the last few weeks, the push into bonds has been exacerbated by heightened market tension over European sovereign risk. Aussie and US stocks fell over 4% in the last month and respective 1y yields are down around 2bp. As we highlighted in our Weekly Strategy note two weeks ago, we took the opportunity of a US led rally to enter a short term 1y spread tightening trade. This trade has performed well and we closed out at 211bp today. The large rally in Aussie rates over the last week was driven mostly by European debt concerns (though it s occurring against the backdrop of the US slowdown and some weaker economic data in Australia). The combination of weaker data and bad news out of Europe has led to rate cuts being priced in the front part of the curve. While we re cautious on the potential for the market to price in more financial system contagion risk, so we position for a wider Bills/OIS spread by selling the Sep bill futures contract against receiving 3m*3m OIS. US equities and bonds are losing confidence in the economic outlook QE2 led to a clear divergence in the relationship between US stocks and bonds. Figure 1 shows that, unusually, stocks and bonds have both done well since the beginning of QE2. Equities have fallen heavily in recent weeks, catching up with the drop in bond yields, but the two markets are still marching to a different beat. With the recent falls, US stocks look cheap on some fundamental measures. US Earnings have been strong and, for the S&P 5, have also exceeded analysts expectations. Of the 475 companies to release results in the latest reporting season, 344 featured positive earnings surprises. Figure 2 highlights that the gap between US bond yields and earnings yields has widened even further recently, pointing to a sharp out-performance in stocks Figure 1 US Equities and 1y Treasury yield Index S&P Figure 2 US Stock earnings yields versus bond yields (monthly) % US 1y Yield 1-Jan-7 = 1 Earnings yield (12m ahead) US 1y Yield

4 European sovereign risk is pushing equity and debt market volatility higher. relative to bonds when confidence in the economic outlook recovers. Lack of confidence and weak US growth clearly explain the current divergence between earnings yields and bonds. The equity market doesn t have much confidence that recent strong earnings results will be sustained. And while US equity analysts have been positively surprised by company earnings, recent economic data has been a source of bad news. European Sovereign risk rising Arguably, bond markets are still pricing much worse economic outcomes than stocks. If the US economy is indeed facing a period of very slow or even negative growth, we would expect equity market volatility to trend higher, earlier than has been the case. Only in the last week has implied equity volatility started to rise noticeably, moving from 18% to 23%. This move appears to have been driven more by uncertainty over a default by Greece, than by a bearish US economic outlook. US corporate CDS spreads have also jumped wider in the last week, largely following the moves in the VIX. Yet Figure 3 also shows that both equity market volatility and US corporate credit risk are still quite low compared with the last episode of heightened European sovereign default risk. Figure 3 VIX Index and US investment grade CDS % Figure 4 European and Australian financial CDS spreads bp 25 2 VIX (LHS) US IG CDS 5Y (RHS) Episodes of elevated European sovereign risk European financials bp bp 25 2 The impact of European debt troubles is also been felt in credit markets. Figure 4 shows that European Financial CDS spreads are starting to discount a higher contagion risk from a potential sovereign default by Greece. Moodys decision to place four French banks on a negative outlook (with ratings implications) supports the market s assessment on the rising risk of contagion from a Greek default. However Figure 4 also shows that the market isn t making that same assessment on Aussie banks, which aren t as directly exposed to a sovereign default by Greece Big 4 Australian banks Apr-8 Jan-9 Oct-9 Jul-1 Apr Figure 5 compares a long run estimate of US equity and bond market volatility. Since the extremes of 28, equity volatility has declined significantly compared with bonds. A key cause for this difference is the Fed s commitment to keeping rates low and the purchase of Treasuries under QE2. These extreme monetary policy settings seem to be causing more uncertainty for bonds than for stocks. But the rise of equity market volatility on safe-haven flows, driven by the Greek debt crisis, could see this volatility gap converge. A QE3 outlook without QE3? As we highlighted recently (FI Daily June 8), the US 1y yield is now behaving much the way it did prior to the implementation of QE2. Figure 6 illustrates the term premium on the US 1y Figure 5 US equity and bond volatility (rolling annual standard deviation, daily returns) S&P 5 (rolling st dev) US 1y yield (rolling st dev)

5 The US 1y term premium is behaving the same way it did at the time of QE. The Fed are unlikely to implement QE3 because financial conditions are already at exceptionally accommodative levels. Safe haven flows are less pronounced in the 1y part of the Aussie bond curve. bond, which at 44bp, is only eclipsed by past periods where the Fed was hinting at or strongly suspected of implementing QE. Note that our preferred measure for the term premium is the spread between the nominal 1y bond yield and the 1y ZCS. We prefer not to use the TIPS yield, as it s also bought by the Fed in the QE program. The drop in the US 1y term premium is also consistent with rising risk aversion and a flight away from risk assets. As noted in the preceding section, a significant driver of the uncertainty in markets is the slow US recovery and the ongoing European debt crisis. The US economic recovery is, in the words of Fed Chairman Bernanke a fortnight ago, frustratingly slow. It s reasonable that a sharp slowing of growth in Q1 and a lacklustre looking Q2 justifies lower yields. It also means that the Fed won t be in a hurry to tighten policy. The recent weakness in US growth doesn t suggest to us that the Fed is in a hurry to implement further easing, such as QE3. But it s certainly likely to reduce the speed at which the Fed needs to tighten policy. Financial conditions in the US are already at very accommodative levels. The Fed funds rate is at zero, the 1y Treasury yield is below 3% and the USD is near its all time lows on a tradeweighted basis. With such accommodative conditions, the benefits of further monetary stimulus would be limited and could place risks to the Fed s credibility on the inflation mandate. Also, there are some FOMC members that oppose QE2 and would be highly unlikely to support QE3. For example, on June 13, Dallas Fed President Richard Fisher said the Fed has done enough to support the US economy and he won t support an extension of the QE program. Linkages to Aussie bonds Typically, US and global growth concerns, alongside periods of heightened risk aversion, lead to lower long end Australian bond yields. This impact has certainly been evident of late, with the Aussie 1y yield falling over 4bp since mid-april (see Figure 7). If we consider the implications of higher global risk aversion on long end bond yields, it s hard to see the same patterns in Australia as in the US. Figure 8 illustrates the spread between the Aussie 1y nominal yield and ZCS. Aside from the drop at the onset of the financial crisis in late 28, the spread has been relatively stable. While the premium has declined to a new postrecovery low, the relative stability of the Australian premium compared with the US suggests to us that Aussie bonds don t attract Figure 6 US 1y term premium (UST-ZCS) bp UST less ZCS QE1b Jan-8 Jan-9 Jan-1 Jan-11 Figure 7 Australian and US 1y bond yields % Figure 8 Australia 1y term premium (nominal ACGB yield less ZCS) QE1a QE2 US 1y Aus 1y % Jun-7 Jun-8 Jun-9 Jun-1 Jun-11 5

6 Aussie 1y inflation expectations are relatively stable and are within the RBA s 2-3% band. Bills/OIS and swap spreads have started pushing wider on European tensions. Bills/Libor basis spreads have fallen and we maintain our view for a flatter Bills/Libor curve. the same level of safe haven bid in periods of heightened risk aversion as US bonds. The USD status as reserve currency, as well as the greater depth and liquidity in the US Treasury market means that safe-haven flows are more pronounced in the US market, than in Australia. The nominal-zcs spread in Figure 8 also represents inflation expectations. The relative stability in the Aussie spread also reflects market confidence in the RBA s commitment to keep inflation at 2-3%. On the inflation outlook, Glenn Stevens re-enforced the RBA s position last week when he said: The degree of slack in the economy overall does not seem large in comparison with the apparent size of the expansion in resources sector income and investment now under way. Stevens speech also implied that the RBA aren t backing away from the stance on raising rates at some point. Yet one day after the speech, rates across the Aussie curve were driven sharply lower on concerns over the Greek debt crisis. ACGB yields remain below the cash rate out to 216. Aussie market spreads are showing a few signs of financial contagion risk The main risk of a European sovereign default on the Australian economy is via contagion in the financial system. Benchmark yields seem to be considering this scenario, with rate cuts priced. But market-based measures of systemic financial risk aren t too alarming yet. In late 28, during the worst part of the financial crisis, money market spreads around the world skyrocketed. Spreads were elevated again in May 21, during the last bout of European sovereign problems, though to a much lesser degree than 28. Spreads have been relatively well contained this time around though. Figure 9 shows that the Australian bills/ois spread has pushed wider in recent weeks, though it remains low compared with the last episode of European sovereign tension in May 21. The rise in swap spreads last week was more pronounced. After falling on the futures roll last Wednesday, the 3y EFP jumped 7bp wider to 35bp. There s some scope for swap spreads to widen further if conditions in Europe continue to deteriorate. The bills/libor basis swap spreads have also fallen sharply last week and have moderated since. As Figure 1 illustrates, the whole basis curve has shifted lower as the market discounts the potential for Aussie offshore issuance. In April, we recommended a 3/1y basis curve Figure 9 Bills/OIS and Swap Spreads 5 3Y EFP 3M BBSW/OIS Jan-1 May-1 Sep-1 Jan-11 May-11 Figure 1 Bills/LIBOR Spreads bp 4 2yr 3yr 5yr 1yr Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Figure 11 IB Futures implied cash rate % Jun Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 6

7 flattening trade at 15bp, with a target of 7bp. The trade has performed reasonably well and the curve has fallen slowly to 1bp. Our rationale at the time was that a combination of greater offshore issuance flow from Aussie banks and corporates could occur alongside a pick-up in Kangaroo issuance. The flare-up in sovereign default risk could slow Aussie offshore issuance. But arguably, it won t slow Kangaroo issuance as much (at least not in the high-grade sector). So we maintain our bias for a flatter bills/libor curve and we keep our 3/1y flattening trade on. Figure 12: Australian exports to Europe EXPORT SHARES % % (% share of annual exports) EU Positioning amid heightened risk aversion 5 5 We don t think the RBA will cut rates We were stopped out of our outright short position in the Jun-14 ACGB with the big rally last Thursday. We maintain our view that the 3y bond yield shouldn t stay under the cash rate for long (though the sharp rally demonstrates that sentiment in the Aussie market, even out to 3 years, is now particularly sensitive to news about European Sovereign debt issues). We don t think the RBA are likely to cut rates. Australia has very little direct exposure to a Greek default. And while severe negative shifts in financial conditions could conceivably lead the RBA to cut rates, we don t see this scenario as likely in the near term. A more plausible worst-case scenario is for the RBA to keep rates on hold. Our central scenario is that the RBA will raise rates at some point. In our view, Glenn Stevens comments last Wednesday and today s RBA minutes show that the RBA remains biased towards another rate hike.. Figure 13: Spot and forward bills/ois spread Today's Phys. Bill 3M Bills OIS Spread Sep-11 Dec-11 Mar-12 New Trade Sell Sep bill futures versus OIS Although the rally could extend further. We position for a wider 3m bills/ois spread by selling September bill futures and receiving 3m*3m OIS. If the situation in Europe deteriorates further and a default by Greece looks more likely, then the market could conceivably price in more rate cuts. And Australia s very high bond yields certainly stand out amongst AAA developed economy peers and could rally further. However, as Figure 12 shows, Australia s direct trade linkages with Europe aren t strong and they ve been declining for quite some time. The market s pricing for rate cuts reflects a small probability of a very big cut by the RBA in response to a severe financial system risk. Much like we saw in 28. In the scenario bills/ois rates are likely to rise sharply. As we said above, the spread has already started to widen and, at 25bp today, is some 1bp higher than where it s averaged for the last three months. Although we don t think it s likely to return to 28 peaks, we can more easily see a scenario where it returns to at least the 4bp level seen when Greek debt first became an issue last May. Forward pricing suggests that the market isn t quite positioning for this scenario yet. As Figure 3 shows, the market is pricing a slight decline in the spread to 19bp. We sell the September IB futures at their current level of 95.1 (implied bill rate of 4.9%) against receiving 3m*3m OIS at 4.71%. We enter the spread at a level of 19bp with a target level of 4bp and a stop of 1bp 7

8 The shape of the curve is contorted after last week s spasm of a rally Philip Brown Fixed Income Quantitative Strategist philip.brown@cba.com.au The curve is pulling out of shape as the market rallies in response to the Greek crisis. All bonds out to the Jun-16 are below cash, but the yields rise steeply thereafter. We recommend a flattener between the Oct-15 and the Jan-18 at 27bp. Australian markets rallying as market prices rate cuts We still expect the next move will be up, but the market pricing is harder to predict On Thursday last week Australian bond yields, briefly, rallied a huge amount. The 3Y bond yield fell as low as 4.64%, taking us through our stop on our newly-initiated short. We observed last week that the 3Y bond yield could (and had) dropped under the cash rate comparatively often during the period of However, for the front end bond yields to get noticeably under the cash rate requires an expectation of an imminent rate cut. Last week s rally did include expectations of a rate cut at various times. As we write the market is expecting the RBA cash rate to remain at the current level for the foreseeable future with just a bias towards a rate cut later in the year. (See Figure 2). We disagree with the notion that the RBA will be cutting rates. This morning s RBA minutes again included the line a further tightening of monetary policy would be necessary at some point. There has been a worsening of European issues since the RBA meeting. That might have changed the RBA s thinking. But the tone of the statement is very much focussing on the outlook over the coming twoto-three years, rather than months. If the economy evolved in line with the staff forecasts, GDP growth would be somewhat above trend over the next few years, led by growth in the resources sector. A gradual pick-up in inflation could be expected under this scenario. [Our emphasis.] Figure 1: Performance of the September 3Y bond future Source: CBA, Bloomberg Figure 2: RBA Cash rate pricing % Jun 14-Jun 17-Jun 2-Jun 21-Jun Jun-11 Sep 3Y Future The RBA is clearly thinking that the next move in rates is up. They are, however, less clear on the timing of the move and it seems unfolding events in Europe could delay a move but not change its direction. 4.5 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 So why are all bonds out to 215 below the cash rate? Source: CBA, Bloomberg A very good question and one we can t entirely answer. We think the market is trading slightly away from the fundamentals in this case (and savaging our short positions in the process, but that s another story that includes a chapter on 8

9 swaption protection also). The market is pondering the fallout from a Greek default and rallying. Although we emphatically do not expect that the RBA will cut the cash rate, we are less convinced the market won t temporarily price such an outcome. Figure 3: ACGB bond yields 5.25 Actual Yield Fitted Yield All bonds out to Jun- 16 are below the cash rate Three possibilities: Long the 217 area A 15/18 flattener A 15/17/21 fly The slope trade seems most attractive to us In the meantime, all bonds out to the Jun-16 are currently below the cash rate. Figure 3 shows, the front end of the curve is well below the 4.75% cash rate, and that there is a sharp increase in yields between 215 and 219, before a distinct flattening. The final tick up in yields is the new April-23 (which is liquidity-driven but provides good reason to think the new 15-year bond will be some way off). However, we are also curious about why the shape of the curve seems to be so unusual at the moment. Normally, our Nelson-Siegel fit mimics the ACGB curve very closely, but today it does not. There are three obvious trades we see from the results in Figures 3 and 4. First, if you remain highly bullish on bonds, it seems relatively clear that the 217/9 part of the curve is where you should be looking to buy. (Though, if the RBA does cut, the front end would outperform). Second, we could sell a bond in the 215 area against buying a bond in the 217 area. Thirdly, we could look at butterfly of approximately 215 / 217 / 221 maturities. Both a flattener and a butterfly would be, we expect, more profitable in a generally bearish rates environment (a clear path in Greece would be a great start). We have been burnt before assuming the rally was finished, however, and are slightly nervous to initiate a trade that profits mostly in a sell-off. Of the three we are probably most attracted to the flattener. The spread between the Apr-15 and Jan-18, for example, is 27bp. That seems a lot when you consider the totality of the 3Y/1Y slope is only about 43.5bp at the moment. The flattener should work in both a sell-off and in a scenario where little outright move in rates is seen. We believe the Nelson- Siegel curve shows that he slope of the curve is too steep over the 215 to 218 section. So, although it is with some trepidation, we move to buy the Jan-18 against the Apr-15 at the current spread of 27bp. What Europe s Lehmans Moment might really be like We have seen a number of commentators refer to Greece s potential or likely default as a Lehmans Moment. We are not entirely happy Source: CBA, Bloomberg Figure 4: Nelson-Sigel Cheap/Dear bp Apr-23 Jul-22 May-21 Apr-2 Mar-19 Jan-18 Feb-17 Jun-16 Apr-15 Oct-14 Jun-14 Dec-13 May-13 Nov-12 Source: CBA, Bloomberg Figure 5: Australian bond yields over Source: CBA, Bloomberg Nelson-Siegel Cheap/Dear Result Aug-8 Aug-1 Apr-15 Mar-19 Sep-9 May-13 Feb-17 May-21 Jan Mar May Jul Sep Nov Jan 9

10 This isn t quite a Lehmans Moment just yet The RBA is still talking about rate hikes, admittedly without the urgency they used to be Our swaption insurance trade has gone well, but we would insure with a bills/ois position now instead with this usage, because the very fact that the European policy makers observed the Lehmans collapse (and its continuing aftermath) will change the way they approach the question of a Greek default. However, we thought it was worth recapping exactly what a Lehman s Moment meant for Australian bonds. Figures 5 and 6 shows the Australian bond market over 28. Lehmans filed for Chapter 11 on 15 September and there was a pretty significant rally including nearly 7bp in the front end bonds in just one month. However, the curve steepened in a fairly consistent way not with the strong mid-curve behaviour we have observed recently. The situation in Greece is, of course, very serious. We just don t think it is likely to be as destructive as the some of the hyperbole is currently suggesting. The RBA today confirmed that they are still expecting to raise rates, despite the very obvious issues in Greece. (The minutes do predate the worst of the current flare-up, to be fair, but not all of it). In part, it is the very obvious nature of the Greek issues that makes us relatively confident they will be dealt with. A Greek default will not be an issue provided and this is a huge proviso that there is not widespread secondary contagion. We took our protection against that risk with a 6m*1yr receiver swaption back in April. That insurance trade is now profitable, worth 15bp compared to the original cost of 7.5bp. It s now too late to position with our insurance trade, of course. You could position with a swaption that was further out of the money, but that would only be useful in a true catastrophe scenario. Instead, for those looking for insurance at the moment, we prefer to use the pseudo-insurance of the September bank bills/ois spread at 19bp. If there is a real contagion problem, the Bills/OIS should widen significantly. There is also a natural floor at around 1bp. Figure 6: What a Lehmans Rally really looks like Change Between 1 Sep and 1 Oct 28 Sep-9 ACGB Aug-1 ACGB May-13 ACGB Source: CBA, Bloomberg Jun-14 ACGB Apr-15 ACGB Feb-17 ACGB Mar-19 ACGB May-21 ACGB 1

11 Key Views United States Tactical (<1 mth) Strategic (>3 mths) Concern about an imminent Greek default are reverberating around the financial system. However, the underlying US data has also been comparatively poor in recent weeks. The FOMC meets this week and is almost assuredly going to formally announce the end of QE2. 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. We expect a stronger economic recovery to take hold in mid or late 211 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. Bernanke confirmed that the Fed would cease buying new bonds at the end of June, but would continue to reinvest coupons. Later, once the Fed starts raising the Fed Funds rate, we see room for the curve to flatten markedly. Policy rate.1%.1% 1yr bond 3.4% 3.8% 2/1 curve 28bp 27bp USD/JPY EUR/USD The EUR is proving resilient to public debt issues in its periphery. EUR resilience in part reflects currency markets focusing their attention on the slow US economic recovery. The softness in the data means the US Federal Reserve will likely remain on the sidelines for an extended period. In contrast, the ECB is likely to tighten at its next meeting, given its desire to ward-off the second round effects of high headline inflation. In addition, as a by-product of the robust global growth outlook reaffirmed by the IMF last week, US residents continue to invest offshore. These capital outflows should provide an additional channel through which the USD will weaken over the medium-term. 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 Governor Stevens reiterated the rates move higher comment in a speech last Wednesday 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 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 tighten quickly when the Fed starts to raise rates. The AUD is showing a great degree of resilience to the ongoing public debt issues in Europe. 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 lift back above 1.1 in coming months. Policy rate 4.75% 5.% 1yr bond 5.5% 5.8% 3/1 curve 4bp 3bp 1yr EFP 52bp 55bp 1yr v US 21 2 AUD/USD New Zealand Tactical (<1 mth) Strategic (>3 mths) The RBNZ has recently changed tone and embarked on the slow path to actually raising the cash rate. The NZ economy is starting to slowly recover after the Christchurch earthquake. We do not expect the RBNZ to raise rates until early January 212, though there is potential for a delay to March 212 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 (.8219). With Eurozone debt issues not undermining the outlook for global growth, we expect the NZD to move towards.85 over the coming months. Confidence among New Zealand consumers and businesses appears to be recovering, driven by the RBNZ's March insurance rate cut. The significant rebuild effort yet to come online should compound the current economic momentum. This reversal and continued export growth should push NZD higher. AUD/NZD should consolidate further; our year-end targets are being achieved early. Policy rate 2.5% 2.5% 1yr bond 5.5% 5.8% 2/1 swap curve 21bp 2bp 1yr v US yr v AUS -1bp bp NZD/USD AUD/NZD

12 Cash Rate Pricing Australian Cash Rate Pricing New Zealand OCR Pricing US Fed Funds Pricing Cum. % chance Cum. % chance Cum. % chance Rate of +25bp Rate of +25bp Rate of +25bp Current 4.75 Current 2.5 Current.11 5-Jul Jul Jun Aug Sep Aug Sep Oct Sep Oct Dec Nov Nov Jan Dec Dec Mar Jan Feb Apr Mar Mar Jun Apr Apr Jul Jun AUD Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun NZD Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun USD Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun Candian Rate Pricing EUR EONIA Pricing UK SONIA Pricing Cum. % chance Cum. % chance Cum. % chance Rate of +25bp Rate of +25bp Rate of +25bp Current.94 Current 1.25 Current Jul Jul Jul Sep Aug Aug Oct Sep Sep Dec Oct Oct Feb Nov Nov Apr Dec Dec Jan Jan Feb Mar Mar Apr CAD Implied Cash Rate 2. EUR Implied Cash Rate 1. GBP Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun. Jun Aug Oct Dec Feb Apr Jun. Jun Aug Oct Dec Feb Apr Jun Source: All data sourced from Bloomberg. Rates displayed are calculated using IB Futures (Australia), FF Futures (US) and OIS in all other currencies. 12

13 CBA Forecasts: Cash rate 21-Jun Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 US Australia New Zealand United Kingdom Eurozone Japan yr bond yield 21-Jun Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 US Australia New Zealand United Kingdom Eurozone Japan yr bond yield 21-Jun Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 US Australia New Zealand United Kingdom Eurozone Japan Currencies 21-Jun Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 AUD/USD AUD/JPY AUD/EUR AUD/GBP AUD/CAD AUD/NZD USD/JPY EUR/USD GBP/USD USD/CAD NZD/USD

14 Calendar June 211 Monday Tuesday Wednesday Thursday Friday Central Bank Meetings Budget dates AU RBA (7 June) AU SA Budget (9 June) AU AI-Group PMI, May, Index, (48.4) AU Trade balance Apr, $bn, 2.5, (1.74) AU CBA/Ai-Group PSI, May, (51.5) EZ ECB (9 June) AU QLD Budget (14 June) AU HIA new home sales Apr, m%ch, (4.3) AU Retail trade, Apr, m%ch,.6, (-.5) NZ Building permits, Apr, m%ch, (2.2) UK BOE (9 June) AU Tas Budget (16 June) AU GDP, QI, q/y%ch, -.1/2. (.7/2.7) UK PMI construction, May, Index, (53.3) CH Non-Manuf PMI May, Index, (62.5) NZ RBNZ (9 June) AU NSW Budget (6 September) NZ Terms of Trade Index, QI, q%ch, (.6) US Factory orders, Apr, m%ch, (3.) EU PMI services/composite, May, Index, (55.4/55.4) JP BoJ (13/14 June) CH PMI Manufacturing, May, Index, (52.9) GE/UK PMI services, May, Index, (54.9/54.3) US FOMC (21/22 June) JP Vehicle sales, May, y%ch, (-51.) US Avg hrly earnings, May, m/y%ch, (.1/1.9) CA Bank of Canada (19 July) EU PMI manufacturing, May, Index, (54.8/58.2/54.6) US Non-farm payrolls, May, ', (244) US ISM manufacturing, May, Index, (6.4) US Unemployment rate, May, %, (9.) US Total vehicle sales, May, mn, (13.14) US ISM non-manufacturing, May, Index, (52.8) AU Ai-Group PCI, May, Index, (37.9) AU NAB Bus conf/cond, May, Index, (7/5) AU MI/WBC Consumer Sent, Jun, Index, (13.9) AU Labour Force, May NZ Credit card spending, May, m%ch, (1.7) AU TD inflat gauge May, m/y%ch, (.3/3.6) AU RBA cash rate, %, 4.75, (4.75) AU Housing finance, Apr employment, ', 25, (-22.1) CH Trade balance May, US$bn, (11.4) AU ANZ Job ads, May, m%ch, (1.) AU AOFM CEO Rob Nicholl speaks in Sydney No. of own-occupiers, %, 4., (-1.5) participation rate, %, 65.6, (65.6) JP Domestic CGPI, May, m/y%ch, (.9/2.5) EU PPI, Apr, m/y%ch, (.7/6.7) JP Leading / Coincident index CI, Apr, (1.1/13.5) Value of all loans, %, 7., (-1.1) unemployment rate, %, 4.8, (4.9) GE CPI, May, m/y%ch UK New car registrations, May, y%ch, (-7.4) EU Retail sales, Apr, m/y%ch, (-1./-1.7) JP Curr a/c total/adjusted, Apr, bn, (1679.1/752.7) NZ RBNZ official cash rate, %, 2.5, (2.5) UK Industrial production, Apr, m/y%ch, (.3/.7) CA Building permits, Apr, m%ch, (17.2) GE Factory orders, Apr, m/y%ch, (-4./9.7) JP Trade balance - BOP basis, Apr, bn, (24.3) JP GDP, QI, q%ch, (-.9) UK PPI Input/Output/core, May, y%ch, (17.6/5.3/3.4) CA Ivey purchasing manager index, May, (57.7) US Consumer credit, Apr, $bn, (6.) EU GDP, QI, q/y%ch, (.8/2.5) EU ECB Monthly report UK NIESR GDP estimate, May, m%ch, (.3) GE Trade bal, Apr, bn, (18.9) EU ECB announces int. rate, %, 1.25, (1.25) US Import price index, May, m/y%ch, (2.2/11.1) GE Industrial production, Apr, y/y%ch, (.112) UK BoE announces rates, %,.5, (.5) CA Net change in employment, May, ', (58.3) GE Industrial production, Apr, m/y%ch, (.7/11.2) US Trade balance, Apr, $bn, (-48.2) CA Unemployment rate, May, %, (7.6) US Federal Reserve Beige Book US Wholesale inventories, Apr, m%ch, (1.1) CA Housing starts, May, ', (179.) CA Trade balance Apr, C$bn, (.6) AU Queens Birthday Public Holiday NZ Food prices, May, m%ch, (.1) AU Dwelling commence, QI, q%ch, 6., (-5.3) AU MI Consumer Inflation Expectat, Jun, %, (3.3) EU New car registrations May, y%ch, (-4.1) JP Machine orders, Apr, m/y%ch, (2.9/6.8) CH PPI/CPI, May, y%ch, (6.8/5.3) AU RBA Gov Glenn Stevens speaks in Brisbane AU MI Unemp. Expt., June, Index, (16.) EU Construction output, Apr, m/y%ch, (-.3/-4.9) CH Industrial production, May, y%ch, (13.4) NZ Retail sales ex inflation, QI, q%ch, (-.4) AU New motor veh. sales, May, m/y%ch, (-3.5/-8.4) EU Trade balance Apr, bn, (-.9) CH Retail sales, May, y%ch, (17.1) JP Machine tool orders, May, AU RBA Bulletin - June quarter 211 EU ECB Monthly report JP Capacity utilisation, Apr, m%ch, (-21.5) EU Industrial production Apr, m/y%ch, (-.2/5.3) NZ Business PMI, May, Index, (51.5) US Uni. Of Michigan confidence, Jun, Index JP Industrial production, Apr, UK ILO unemployment rate (3mths), Apr, %, (7.7) NZ Manufacturing activity QI, q%ch, (3.1) US Leading indicators, May, m%ch, (-.3) JP BoJ target rate, %, -.1, (-.1) US CPI, May, m/y%ch, (.4/3.2); core, (.2/1.3) EU CPI, May, m/y%ch, (.6/2.8); core, y%ch, (1.6) CA Wholesale sales, Apr, m%ch, (.1) UK RICS house price balance, May, %, (-21) US Empire manufacturing, Jun, Index, (11.88) UK Retail sales, May, m/y%ch, (1.1/2.8) UK CPI, May, m/y%ch, (1./4.5); core, y%ch, (3.7) US Capacity utilisation, May, %, (76.9) US Building permits, May, ', (551) US Producer price index May, m/y%ch, (.8/6.8) US Industrial production, May, m%ch, (.) US Housing starts, May, ', (523) US Retail sales, May, m%ch, (.5) US NAHB housing market index, Jun, (16) US Current account balance, QI, US$bn, (-113.3) US Business inventories, Apr, m%ch, (1.) US Philadelphia Fed, Jun, Index, (3.9) NZ PSI, Jun, Index, (52.6) AU RBA Board Minutes, June NZ Current account, QI, % of GDP, (-2.3) AU Population growth, QIV, q/y%ch, (.3/1.7) AU RBA Ass Gov Lowe speaks in Adelaide NZ Credit card spending, May, m/y%ch, (1.6/6.) EU/GE ZEW survey (econ. sentiment), Jun, (13.6/3.1) EU Industrial new orders, Apr, AU Financial Accounts, QI GE IFO - Business climate, Jun, Index JP Trade bal total/adj, May, US Existing home sales, May, mn/m%ch, (5.5/-.8) UK Bank of England minutes EU/GE PMI manufacturing, Jun, Index GE Retail sales, May, JP Leading / Coincident index CI, Apr, CA Leading indicators, May, m%ch, (.8) US FOMC rate decision, %, -¼, (-¼) EU PMI services/composite, Jun, Index US Durable goodes orders, May, EU Current account, Apr, bn, (-4.7) CA Retail sales, Apr, m%ch, (.) GE PMI services, Jun, Index US GDP, QI, GE Producer prices, May, m/y%ch, (1./6.4) US New home sales, May, Early July US Personal income/spending, May, m%ch RBA Ass Gov Debelle speaks in Sydney AU DEWR skilled vacancies, Jun, m%ch, (-.4) AU ABS Job vacancies, May, (-1.7) AU Job vacancies, May (1 July) US PCE deflator/core, May, y%ch JP Retail sales, May, AU HIA new home sales May, AU RP Data house prices, May, AU Retail trade, May (1 July) US Dallas Fed, Jun, Index GE CPI, Jun, JP Industrial production, May, AU Private sector credit, May, AU Building approvals, May (1 July) UK Total bus investment, QI, UK Net consumer credit, May, NZ Building permits/trade balance, May, AU Engineering Construction Activity, QI (1 July) UK Current account balance QI, (-1.5) US Pending home sales, May, NZ NBNZ Business confidence, Jun, Index AU Trade in Goods & Services, May (6 July) UK GDP, QI, CA CPI, May, m/y%ch, (.3/3.3) JP Vehicle production/housing starts, May, AU Labour Force, June, (8 July) US S&P/Case-Shiller home price ind., Apr, CA Teranet House Prices, Apr, JP Construction orders, May, AU Housing Finance, May (12 July) US Richmond Fed, Jun, Index UK GfK consumer confidence survey, Jun, Index Note: Figures in brackets represent previous result (if available). All information is preliminary and subject to revision. Chief Economist: Michael Blythe ph: Economist: James McIntyre:

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