Fixed Income: Weekly Strategy

Transcription

1 12 June 2012 Staying bullish as Spain s bailout already looking like old news Spanish package seems to be fading already. ESM involvement implies subordination of existing bond holders. We have lowered our bond forecasts because we believe the forward-looking indicators argue for lower yields. The Aust-US 10Y spread has been volatile during recent days, but the long-term suggests more tightening. The Futures roll is this Friday. Current pricing shows the 3Y slightly cheap, but the 10Y close to fair. Australia s 3Y bond yield is up 37bp since last Monday driven mainly by disappointment with the RBA s 25bp rate cut on Tuesday and the stronger than expected Q1 GDP and May employment data. The 10Y yield is 23bp higher, leaving the curve 14bp flatter. Other global safe sovereign yields have also lifted from record lows, reflecting some settling of markets ahead of the weekend agreement in Europe to provide a 100bn bailout to Spain s banks. The US 10Y yield is 7bp higher and the AUS-US 10Y spread is 10bp wider at 139bp. Last week s events don t change our bullish view for Australian bonds. The RBA provided few direct hints on their next policy move, but clearly sees greater downside risks to their forecasts due to the slowdown in global growth and the risks confronting the outlook. So while they are reluctant to cut rates too aggressively, the question of how much easing the RBA will have to do remains wide open. We think the widening in the AUS-US spread provides an attractive entry point to re-enter the compression trade (see Page 9). The positive impetus from the 100bn support package for Spanish banks announced by EU Finance Ministers over the weekend has already begun to fade. Unlike previous bailouts, there is less onus on Spain s Government to meet austerity conditions, making it easier to implement and sell the support package to the Spanish electorate. But other bailout recipients have had to meet tougher fiscal conditions, which arguably increases the risk of fiscal slippage elsewhere. It is not yet clear whether the deal will be funded through the EFSF or ESM (or both). Both should provide a cheap source of funds for Spain. The problem is that the sum involved is almost twice what the EFSF has borrowed to date. Alternatively, it is a large number to put ahead of other creditors to Spain, who would be subordinated if the ESM lends the funds. The deal also still adds to Spain s stock of Government debt in a deteriorating economic environment. As a result, the deal has done little to ease concerns over Spain s fiscal stability and potential contagion elsewhere. Spanish 10Y yields are 40bp higher than before the bailout measure, while Italian 10Y are up 40bp over the past week. The intractable nature of these problems underpins our view that quality bond markets including Australia s will remain well bid this year. We discuss our updated forecasts on page 3. Focus in Europe will remain on Spain, but will also be on this weekend s election in Greece. The ongoing uncertainty should ensure Aussie bonds will be well supported this week. The risk to that view is positive comments from RBA Governor Glenn Stevens in his talk at the PM s Economic forum tomorrow. Last week, Stevens described the Australian economy as glass half-full. On Friday, the June bond futures contract rolls. Philip Brown provides a preview on Page 11. Contents: Key Positions... 2 Key Trades... 2 Lowering our bond forecasts to match the future, not the past (First Published 6 June)... 3 Re-entering the Aust-US 10Y spread contraction trade (First Published 7 June)... 9 Roll Update 3Y roll subject to significant variability Key Views CBA Forecasts: Calendar June Figure 1: Changes in forecasts Current Jun-12 Dec-12 Dec-13 Official Cash (%) day BBSW (%) Aus 3yr bond (%) Aus 10yr bond (%) Aus 3-10yr Curve (bp) Change Official Cash (%) Aus 3yr bond (%) Aus 10yr bond (%) Aus 3-10yr Curve (bp) US 2Y US 10Y Change US 2Y US 10Y 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 Philip Brown Quantitative Strategist T E. philip.brown@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 Most of our trades remain profitable. Although our trades generally express a long bias, we have no outright long positions and so haven t been hit too hard by the sell-off. The spread between the Australian and US 10Y bonds has widened a little and we were stopped out of our original 10Y spread trade for a substantial profit. (We were using a tight trailing stop.) We still believe the spread should slowly contract over time, since the fundamentals point in that direction. We re-initiated the trade at a spread of 145bp on Thursday. Our June bills to OIS trade has also expired with the bill future. The trade resulted in a small profit. Key Trades Trade Entry Current Profit Target Stop Comment Buy the TCV Jun-20 vs NSWTC May-20 Buy the ACGB Apr-23 versus the Apr-20. Buy a 6M put on the Oct-14 bond at a strike of 4.10% Buy a 20bp OTM conditional bull steepener. (2.9 times 3.31% call on Apr-15 and 1.0 times 3.89% call on Jul-22. Implicit slope 58bp). Buy the ACGB Jul-22 vs the UST Feb bp (16-Nov-11) 31bp (12-Jan-12) 5bp premium (9-Feb-12) 6bp premium (9-Feb-12) 217bp (15-Feb-12) Buy the ACGB Aug-15 linker vs the 250bp Oct-15 (BEI to widen). Receive fixed (30-Mar-12) in ZCS at 2.65%, creating Sell the June IR futures against OIS 30bp (11-Apr-12) NZD 2Y/5Y Flattener Receive 5Y AUD Bills/LIBOR EFP Box Trade (3Y to widen) Re-enter 10Y Aust-US spread trade. Buy ACGB Jul-22 vs UST May-22 58bp (21-May-12) 28bp (23-May-12) 8bp (31-May-12) 145bp (7-Jun-12) +2bp 1.5bp 10bp -5bp Hold: TCV s AAA is safe and the funding task is modest. NSW is subject to some rating risk. 30bp +1bp 20bp 37bp Hold: RV analysis reveals the Apr-23 is cheap against the Apr % Hold: It looked good for a while, but the bearish side of the trades seems redundant now. Current yields: 2.29 and 2.99, for 70bp slope 140bp (6 June) 34bp (8-Jun-12) Slope +12, premium -6 =+6bp total +72bp (incl carry of -5bp, FX adjusted) Hold: The bullish side of a pair of trades to protect against tail risks. 110bp 140bp Profit Taken: Australian bonds continue to outperform. We have tightened the stop on this trade again. Hold: We transformed the original trade by receiving ZCS against it. The trade is now (close to) a 14bp per annum annuity. +4bp 20bp Trade Expired: A pre-emptory defence against an all-out credit contagion. 49bp +9bp 43bp 65bp Hold: Flattening trend in NZ can continue. 28bp 0bp 18bp 33bp Hold: Remains above the average despite growing concern. 11bp -3bp -20bp +15bp Hold: If contagion spreads to banks this spread could easily invert. 140bp +5bp 115bp 153bp New Trade: We have re-entered this trade because we believe the overall trend favours more tightening 2

3 Lowering our bond forecasts to match the future, not the past (First Published 6 June) Adam Donaldson Head of Debt Research adam.donaldson@cba.com.au Philip Brown Quantitative Strategist philip.brown@cba.com.au European situation is worsening and the outlook for Australia isn t as strong as it used to be as China and US slow. Uncertainty in Europe is likely to drive an ongoing bid for Australian bonds, even if RBA rates little changed. Swap spreads are likely to widen driven by demand for bonds rather than a direct credit effect. The back-up in yields presents a buying opportunity Bonds are likely to remain strongly bid for the rest of the year After a massive rally in recent weeks, Australian bonds have sold-off sharply over the past two days. After touching a record low 1.89% on Monday, 3Y Commonwealth bond yields have traded up to 2.34% today following stronger than expected Q1 GDP data and disappointment with the size of the RBA s 25bp rate cut yesterday. We think this back-up in yields presents a good buying opportunity in the Aussie market, subject to some risk that tomorrow s labour force report also surprises on the strong side. We see the broader rally continuing as the world slowly adjusts to a new bleak reality and questions Australia s growth outlook. We have lowered our forecasts to account for the rally in global bonds and changes in our RBA profile. Not only is the European problem emphatically not fixed, it seems to be getting worse. More insidiously, however, the market s faith in the Chinese and US economies is starting to weaken too. By extension, Australia s status as one of the few countries with a strong growth outlook is looking a little shaky. Australia s rates have reached record lows while the economic outlook here was still about trend. If the market s faith in our growth outlook weakens, then our rates can drop still further. We expect Australian bonds to remain very well bid until at least the end of the year. The 3Y bond yield can fall below the record levels it set a couple of days ago. We forecast the yield to bottom-out at around 1.8% by year end and for the 10Y to approach to 2.5% (Figure 1). The curve should remain reasonably steady in this environment, before perhaps flattening when yields start to back-up next year. We expect US bonds will rally down to around 1.4% as growth concerns persist and the Fed considers QE3 ahead of the fiscal cliff However, we judge the expansion remains on track and it will be tough to rally further. The AUS-US bond spread should narrow. Figure 1: Changes in forecasts Current Jun-12 Dec-12 Dec-13 Official Cash (%) day BBSW (%) Aus 3yr bond (%) Aus 10yr bond (%) Aus 3-10yr Curve (bp) Change Official Cash (%) Aus 3yr bond (%) Aus 10yr bond (%) Aus 3-10yr Curve (bp) US 2Y US 10Y Change US 2Y US 10Y Figure 2: Australian rates history and forecasts % Cash 10-yr 3-yr CBA (f) 3

4 European story not done yet Spain is a much larger problem than Greece The lack of political consensus in Europe bodes ill We wrote recently that the Grexit wasn t our major worry. It is the Spanish banking system that keeps us up at night. (See EFP box trade could easily invert if no package is launched for Spain, published 31 May.) Spain s Government has essentially admitted it needs a bailout because it can t afford to bailout its banking system alone. If they do receive a bailout, Spain will be the second-last of the famous porcine acronym to get one. However, they will also be far and away the largest. (See Figure 3.) Greece (2.4% of European 2011 GDP), Portugal (1.8%) and Ireland (1.65%) pale in comparison with the size of Spain (11.5%). The EFSF is, theoretically, large enough to handle a bailout of Spain. But only if the EFSF itself can borrow the huge amount of funds required. We recently analysed the performance of Multilateral Banks and found the quality of their underlying banking businesses was a significant determinant in spread performance for European names. (See SSA pricing shows bank risk, capital risk and anti-europe bias published 28 May.) We do not expect the market would lend the EFSF the volumes required to bailout Spain since the only assets of the EFSF would be peripheral European bonds. In any major European default scenario, the EFSF becomes a Eurobond by stealth, since the backing of the European sovereigns becomes necessary to ensure solvency. The lack of political consensus in Europe is deeply troubling. Spain requires significant assistance. But there is no agreement on how to provide it. Every day the problem grows slightly worse. We can certainly envisage scenarios where a temporary solution is found (such as a deposit guarantee and greater funding for the bail-out vehicles). That would likely prompt a large sell-off that could last a few months, as we saw in Q1. But the inherent problems in Europe are structural and we doubt Germany or the ECB will sign the blank cheque required to make sovereign and bank problems disappear (but create new inflationary ones). We suspect any solution would only delay the problem for a few months, at most, and should no longer form the basis of our forecasts. It is also possible that the solution in Europe could actually lead to lower bond yields in Australia. For example, should the solution involve more QE, the excess funds given to banks in Europe have had a habit of finding their way into ACGBs recently. The foreign ownership of ACGBs is hovering just under 80%. Further printing of money in Europe (or the US) might lower Australian bond yields. Figure 3: Percentage of 2011 European GDP Italy 16.87% Malta 0.07% Slovenia 0.39% Lux. 0% Slovak Republic 0.74% Finland 2.01% Figure 4: Foreign ownership of ACGBs is pushing higher and higher % 80% 60% 40% 20% Belgium 3.86% Spain 11.48% Cyprus 0.19% Austria 3.14% Semi-government bonds (incl. foreign issuance) Commonwealth bonds Semi-government (ex foreign issuance) Greece 2.40% Portugal 1.83% Ireland 1.65% 0% Germany 27.20% France 21.27% Neth'lands 6% % 80% 60% 40% 20% 0% 4

5 Revisions to US payrolls change the tone of US recovery China is also slowing, causing falls in commodity prices US and China weakening too The recovery in the US appears to be losing momentum and the landing in China is starting to look a little harder. The US payrolls data was substantially revised and now looks to have been overestimating the strength of the recovery. We still think the US recovery can splutter along. But with so much fear in Europe, US rates are not likely to sell-off as quickly as we first f thought. We have revised our US forecasts to include a rally from here until about December, when the 10Y yield is i likely to be around 1.4%. Europe s crisis should keep safe-haveis clearly becoming a greater risk, though the bond rally lessens the impact (and therefore likelihood) of Treasury purchases by the Fed. We then look for US yields to rise, but on a more sedate trajectory than previously anticipated. The lack of a powerful self- treasuries well bid and QE3 sustaining recovery means thee fiscal cliff and possibility of political gridlock around the election could have a greater impact than previously thought. We think the 10Y bond can rise to 2.2% by the end of 2013 and 2.8% by the end of As with Europe, the combination of quantitative easing but limited policy firepower from here presents substantial tail risks on both sides s of the central case. The Chinese situation is hard to read, but the data seems to suggest that economic growth is slowing more quickly than originally expected. The Chinese PMIss have been weaker and there is mounting pressure on steel and commodity price forecasts. While we anticipate further monetary and fiscal stimulus inn China, our commodities team have revised key price forecasts lower (including 4% for iron ore and 19% for thermal coal in ). Figure 5: Labourr Force data weakening in US US U/E EZ U/E Figure 6: Australian terms of trade Source: Commonwealth Budget Paper 1 Figure 7: Australian front-end rally is crushing the term premiumm Commodity price forecasts and Australia s terms of trade remain high in absolute terms. But the far side off the commodity boom may be approaching. Our team expects prices to fall for most of our major exports over the next five years. Certainly, as the RBA noted yesterday, Australia s terms of trade seemm to have peaked and are now heading down. (See Figure 6) ). The risk is that China slowing only adds to expectations for a lower cash rate in Australia and the foreign bid for bonds Y Nominal 3Y ZCS Space for Australian ratess to rally We expect Australian bonds too outperform the US for two reasons. First, the market has more room to change its view of thee Australian economic outlook. Secondly, Australian bond yields are higher, allowing a larger rally in a global move. We have written previously that the collapsing

6 Domestic market looks for strength still Current data is strong, but forward looking series show weakness term premium explains most of the rally in Australian bonds (see Strategy Weekly from 23 April). The weakening in China has since added a little to the rally, but the move still seems to reflect offshore influences rather than a fundamental change in view on the Australian economy. (See Figure 7.) So far, most of the domestic market seems to believe that the strength in the Australian economy will continue. Consensus expectations are for only a slight cut in the cash rate. Aggressive pricing for cash rate cuts obviously presents a risk that bond yields will back up, as we ve seen over the past two days. But our suspicion is that we will see further evolution of forecasts toward market pricing (Figure 8). There has been some strong data recently. The unemployment rate fell to 4.9% in April and Q1 GDP data this morning printed well above expectations (at +1.3% in the quarter and +4.3% for the year). However, nominal GDP has begun to slow sharply as the terms of trade falls (Figure 9). The price deflators in the report were very weak. There are a few worrying signs the global economic malaise is finally starting to be felt in Australia. Last week s ABS capex survey showed solid growth is still likely in , implying an increase of over 30%. However, the process of upgrades to the estimate looks to have run its course. Both BHP and RIO have recently announced that they are slowing down their CAPEX pipeline. BHP now regrets publically estimating an $80bn five-year program and will not take any new projects to the board for approval until The miners have blamed falling prices, rising costs and the weaker global macroeconomic backdrop. Figure 10 suggests that a hole is developing in the capex story 2-4 years ahead. House prices in Australia have continued to fall despite the cuts in the cash rate starting last November (Figure 11). While risks attached to this are minimal in our view, it strongly suggests the bias will be toward further stimulus in an environment where the mining story is faltering. At this stage, federal and state governments are focussed on returning budget positions to surplus. That looks necessary given the widening current account deficit means fiscal performance needs to be strong to retain the AAA rating. Deterioration would impact both the states and broader financial system. Figure 8: Economists RBA cash rate forecasts % Figure 9: Australian GDP y/y Source: ABS, CBA Figure 10: 4 June 27 April 30 March 2½%2¾% 3% 3¼%3½%3¾% 4% 4¼%4½% Nominal GDP Real GDP % of GDP CAPEX & PROJECT STATUS Business capex (lhs) Under consideration* (adv 2-years, rhs) Index Nor is the high AUD providing any real relief at this point. None of these factors appear particularly damaging on their own. The problem is that the Australian economy is softening against some fairly major headwinds. Markets will perceive that the burden to ease *Source: ACCESS Economics 8 Mar-02 Mar-05 Mar-08 Mar-11 Source: Access Economics, CBA 0 6

7 Our new forecasts are substantially lower Scarcity value can drive spreads wider this pressure will fall to the RBA. We expect pricing of rate cuts to remain aggressive for some time. A substantial reduction in rate forecasts Our new forecasts represent a substantial reduction on our previous bond forecasts. We have cut the December 2012 estimate for Australian bond yields by 100bp for 3Y and 130bp for 10Y. Pressure will remain on cash rate pricing and fears over the creditworthiness of European borrowers (and possibly even the US) are likely to drive more investors into the Australian market. A similar dynamic is at play in Switzerland, where rates are now clearly negative out to the 4Y point. This does not suggest Switzerland s 4Y GDP outlook is negative just that a lot of people are scared and want to buy Swiss bonds. A worsening world outlook (with a little help from a weaker Australian economic outlook) should see the bid side for Australian bonds remain very strong for the remainder of the year. This is particularly true if a weakening in the Australian economic outlook convince more domestic fund managers to end their shortduration positions. From what we hear, few domestic players have been long through this rally, suggesting there remain potential buyers for Australian bonds from domestic sources too. Swap Spreads The strong bid side for Australian bonds should see swap spreads in Australia remain wide. Doubly so if the drive for bonds in the 2Y-3Y section doesn t necessarily lead to a fall in the cash and BBSW rates. The fixed supply of ACGBs on issue can cause a scarcity value. The Australian government is intending to run a surplus and so the supply of new bonds is forecast to drop significantly. (Figure 12.) We expect Australian swap spreads can remain at, or above, current levels for a while as the scarcity of bonds lowers bond yields. Obviously, any credit contagion scare would widen spreads too, but this isn t our core view. We expect 3Y swap spreads to widen to 110bp in September, before slowly contracting as markets recover in (See Figure 13.) Figure 11: Australian House Prices House Prices Figure 12: Supply of new ACGBs falling $bn New Issuance 70 Refunding of Existing Debt Stock 60 Supply will fall /07 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 Figure 13: Supply of new ACGBs falling Current Jun-12 Dec-12 Jun-13 3Y Swap Spread Swap Spread

8 Figure 14: Full rates forecasts Cash rate 6-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada yr bond yield 6-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada yr bond yield 6-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada

9 Re-entering the Aust-US 10Y spread contraction trade (First Published 7 June) Philip Brown Quantitative Strategist philip.brown@cba.com.au The Aust-US 10Y spread has been tightening for months driven by medium-term factors. But the spread has backed up this week following the RBA rate cut and strong GDP and employment data. The recent volatility seems short-term to us. We expect the underlying move to reassert. We re-establish the 10Y Aust-US spread trade at 145bp, with a target of 115bp and a stop at 153bp. 10Y spread has tightened significantly since February On 15 February we recommended buying the ACGB Jul-22 against the UST Feb-22 at a spread of 217bp. The trade has performed very well overall (see Figure 1). We frequently extended the target and lowered the stop. However, we were eventually stopped out of the trade on Wednesday after the GDP data at a spread of 140bp. (See Daily Wrap of 6 June). At the time, we noted we intended to re-enter the trade soon. We choose to re-enter the trade now at the current spread of 145bp, though we switch to the new on-the-run US 10Y: the May-22. We target 115bp with a stop at 153bp. A significant tightening from February to June The Aust-US 10Y spread has tightened significantly since February. This tightening has continued both against the backdrop of a sharp sell-off (in March) and a big rally (essentially everything since March). The tightening was so consistent because the medium-term factors all point in the same direction. The US economy is slowly recovering while the Australian economy appears to be slowly weakening. Australia has a sound fiscal position, safe AAA rating, and limited new borrowing requirement. This obviously stands in stark contrast to most of the world s large, safe borrowers. Australia also offers a comparatively high yield structure, diversification benefits and reasonable liquidity that are known to be attracting reserve managers and other global fund managers. On 6 June we published new bond forecasts detailing why we expected the Australian bond curve to keep rallying. As well as a weaker outlook for Australia domestically (driven by falling commodity prices, moderating capex and weakness in China), there has also been a strong bid for Australian bonds driven by concerns over the European situation. We believe the European situation remains fundamentally unsolved and will trigger new rallies at some point. Figure 1: Long-term Aust-US 10Y spread % Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Figure 2: Spread tightened against both a selloff and a rally % Aust-US 10Y Aust 10Y US 10Y (rhs) % 2.50 Jan-12 Mar-12 May

10 Recent volatility pushed the trade past our stop In our view, these longer-term factors remain the dominant medium-term force and we expect the tightening trend to continue. The European problem is unlikely to be totally solved and the general direction of the Australian and US economies remains unchanged. But recent volatility widened spread Despite the medium-term trend, the Australian market has sold-off significantly in the last few days. The market was spurred by a series of strong data prints and a general improvement in tone in Europe. The improvement in European tone comes, in part, from media reports of a coming grand plan to solve current problems with a new fiscal arrangement and growth plans. We have our doubts that this grand bargain is financially or politically possible. The Germans remain strongly opposed to becoming burdened with the debt of the peripheral countries. The peripheral countries themselves are in absolutely no position to embark on a borrowand-spend growth program unaided. Nonetheless, the improvement in tone has affected market pricing significantly. The Australian 3Y has sold-off nearly 50bp since the lows on Monday (yes, only three days ago). The sell-off in the 10Y has also been sharp, but is slightly smaller at only 36bp. The spread between the Australian 10 and US 10Y has been quite volatile in recent days (See Figure 3). After reaching as low as 127bp, the spread widened to 148bp, passing our 140bp stop on the way. Figure 3: Recent Aust-US 10Y spread Aust-US 10Y spread May 1-Jun 3-Jun 5-Jun 7-Jun Figure 4: Australian GDP y/y Source: ABS, CBA Nominal GDP Real GDP Data calendar now quietens, allowing long-term trend to reassert We favour the back end of the curve The recent Australian data has been quite strong on the surface, but a little weaker underneath. The real GDP figure grew 1.3% in Q1, but the nominal GDP figure grew only 0.3%. The terms of trade is declining as global risks mount. Similarly, today s unemployment data was good at +38.9K jobs created. However, our enthusiasm is slightly dimmed by the 0.2% rise in the unemployment rate. Last month s employment data wasn t as bad as it seemed, but nor is this month s quite as good as it seems. The recent volatility widened the spread out past our 140bp stop. But the data calendar now quietens down and we think the longer-term trends that favour tightening - will be able to reassert. We like the long-end of the curve, which is impacted less by the will they, wont they RBA backdrop. Aussie 10 year bonds benefit from good liquidity, higher yields and confidence in the credit. It is more likely to benefit from strategic position taking. We re-establish our Aust-US 10Y spread trade today at 145bp, looking for a target of 115bp with a stop at 153bp. We use the physical Jul-22 in Australia and the physical May-22 in the US. 10

11 Roll Update 3Y roll subject to significant variability Philip Brown Quantitative Strategist philip.brown@cba.com.au The 3Y bond futures roll is trading slightly cheap. Market price is -6bp, compared to fair value of -5bp. The 10Y roll is close to fair value. Market price is +5bp, compared to fair value of +4.4bp. The front of the curve is highly inverted, causing the 3Y roll to be negative. The positive value of the 10Y roll is mostly due to a switch in the bond basket (dropping the Apr-20). 3Y slightly cheap. 10Y fair. 3Y basket lengthening adds 1.5bp. 10Y basket lengthening adds 5bp The Australian Futures roll will occur on Friday 15 June. Both the 3Y and 10Y bond futures baskets are changing, with both baskets being slightly lengthened. Both rolls are currently trading relatively close to their respective fair values, though the 3Y is slightly on the cheap side. The fair value of the 3Y bond is highly negative at -5bp, while the trading is at around -6bp so far. The fair value of the 10Y bond is strongly positive at +4.5bp, with the market price closer to +5bp. (See Figure 1.) Changes in baskets affect the 3Y and 10Y rolls differently The 3Y futures basket is being extended. Compared to the June basket, the September basket has had the Oct-14 removed and the Feb-17 added. Currently, the difference between the Oct-14 and the Feb-17 is about 6bp (positively sloped). Since there are four bonds in the basket, the change of bonds would, all else equal, cause a positive roll of about +1.5bp. The 10Y bond basket is also being effectively extended. The June basket comprises four bonds and includes the Apr-20. However, the Apr-20 has been dropped from the September basket, effectively increasing the average length of the bonds. The Apr-20 currently has a yield of 2.78%, which is much lower than the other 10Y bonds. The average spot yield of the June basket is 2.92%, 5bp lower than the average of the spot yields of the September basket. The change in the bond basket is the dominant reason for the 10Y roll being +4.5bp. The shape of the front-end of the curve drives the negative 3Y roll The change in bonds for the 3Y actually adds 1.5bp to the 3Y roll. However the total roll is -4.5bp. The difference is caused by the major inversion at the front of the bond curve. (See Figure 2.) The repo rate used in calculating the September Figure 1: Bond Futures Roll details 3Y Roll Near Bond Basket (June) Far Bond Basket (September) 4.50 Oct-14, 6.25 Apr-15, 4.75 Oct-15, 4.75 Jun Apr-15, 4.75 Oct-15, 4.75 Jun-16, 6.00 Feb-17 Implied Price Market Price -6.0 Roll Convexity (bp per bp sell-off) 10Y Roll Near Bond Basket (June) Far Bond Basket (September) 4.50 Apr-20, 5.75 May-21, 5.75 Jul-22, 5.50 Apr May-21, 5.75 Jul-22, 5.50 Apr-23 Implied Price 4.42 Market Price 5.0 Roll Convexity (bp per bp sell-off) Figure 2: Shape of the bond curve Yield Repo Yields 11

12 futures contract is 3.10%, well below the bond yields, which are closer to 2.35%. Inversion at the front end drives 3Y roll negative This difference matters because the bond futures roll looks in part like a forward rate. The September contract is like a 3M*3Y bond rate. Roughly speaking, the -75bp (per year) difference in running yield between the repo and the bonds is worth -18bp over the threemonth period between June and September (75/4 = 18). Divide that 18bp by the DV01 of the three-year bond futures (near enough 3) for an impact on the roll of -6bp. (For a more detailed explanation of this phenomenon see our Education Resource on the roll, available from the CBA research website.) The 3Y roll is -4.5bp, with the approximately -6bp of front-end inversion offset by approximately +1.5bp of roll gained from the change in bonds in an upward sloping curve. The 10Y bond yields are much closer to the current repo rates, so this feature does not impact the 10Y roll very much. Figure 3: Recent volatility has been high Aust 3M OIS 3Y Bond 10Y Bond Apr-12 May-12 Jun-12 Roll convexity is a major consideration, given the recent volatility of the 3Y. The major risk to the roll is the possibility of a change in yields The current 3Y roll is sitting a little cheap to the fair value. We think the 3Y roll should move closer to the fair value as trading volumes increase. However, there is a significant risk to the roll in the form of roll convexity. The 3Y bond yields have been exceptionally volatile in recent weeks and the volatility seems likely to continue. There are still many questions about the details of the Spanish bailout, for example. The 3Y bond futures roll shifts by about 0.8bp for each 10bp sell-off (known as roll convexity). There is a risk that there could be a substantial shift in the 3Y bond futures roll should there be a significant change in bond yields. The 10Y rates have been volatile too, but the 10Y roll is less affected by roll convexity. The 10Y roll should increase only 0.3bp per 10bp of sell-off (all else equal). 12

13 \\\ Key Views United States US data has noticeably softened. The unemployment rate has ticked up to 8.3% in May. US inflation remains stronger than Fed forecasts, limiting room for breakevens to fall and putting a floor under yields. The Fiscal Cliff will be a growing issue towards the end of 2012 even if the European situation is corrected soon. The FOMC has slightly lowered their unemployment forecasts, raised 2012 GDP forecasts and increased CPI forecasts, but hasn t changed the forward guidance on rates. The Fed does not expect to tighten rates until the end of 2014 and stands ready to ease further if required that latter risk is obviously becoming more likely as Europe re-enters a crisis period. In the nearterm the risk of a Greece exit, concerns about possible contagion, and/or participants questioning the willingness and ability for the rest of Europe to put in place an appropriate and timely policy response means the chance of disruptions that take quality sovereign yields to even lower levels are significant. Tactical (<1 mth) Strategic (>3 mths) Policy rate 0.1% 0.1% 10yr bond 1.50% 1.40% 2/10 curve 125bp 115bp USD/JPY EUR/USD We expect the USD and JPY to remain firm in the near-term, reflecting the concerns in the global economy and uncertainty from the Eurozone. The US economy continues to relatively out-perform most of the G6, and US-G6 interest rate differentials have widened. Both developments support a firm USD. The current risks and global growth concerns suggest JPY will remain firm. However, over the longer-term we expect USD/JPY to resume its drift higher, as the JPY adjusts to various structural factors. Australia Tactical (<1 mth) Strategic (>3 mths) The RBA cut rates by 50bp in May and 25bp in June - citing a lower inflation outlook and downside risks to growth from offshore. There are relatively positive trends in some recent domestic economic data. However, that is offset by weakness in other parts of the economy. That weakness, combined with continued uncertainty over the future of the Eurozone and signs of slower growth in US and China, mean that further RBA policy easing is likely. The potential for further rate cuts later in 2012 and capital flight from Europe will keep Australian bonds well bid. Bonds look expensive versus the cash-rate outlook, but seem unlikely to sell-off until the European situation settles. We look for the 10Y AUS-US spread to narrow and for the slope of the curve to steepen slightly. AUD/USD is likely to remain below parity while concerns about the global economy dominate market sentiment. In addition to the concerns in Europe, recent Chinese economic data has been softer than expected, and has led to targeted easing by the PBoC. Uncertainty regarding global growth is a negative for AUD/USD. However, beyond the near-term weakness, we expect the AUD to be supported over H by stabilising global growth, a re-acceleration in China; and subsequently firmer commodity prices, and sustained robust demand for Australian AAA-rated bonds. Policy rate 3.25% 3.00% 10yr bond 2.80% 2.60% 3/10 curve 70bp 70bp 10yr EFP 120bp 100bp 10yr v US 110bp 130bp AUD/USD New Zealand Tactical (<1 mth) Strategic (>3 mths) The relatively high NZD and delays to the Christchurch rebuild mean that previous expectations for RBNZ rate hikes have been pushed well into Recent indications of slower growth, lower inflation and higher unemployment reinforce that conclusion. CBA expects the RBNZ to eventually lift rates, but no hike is likely until next year. For the time being, we expect the market to continue pricing RBNZ rate cuts. The RBNZ s key concern at the March and April OCR meetings was the strength in the NZD. The RBNZ highlighted that should the exchange rate remain strong without anything else changing, the RBNZ would need to reassess the outlook for monetary policy settings. The NZD has eased significantly over May, reflecting softer than expected Q1 data, softening global dairy prices, as well as global growth concerns. We expect NZD softness to continue in the short-term. However, over the year ahead, we think an improving global economic outlook, driven by Asia, should support New Zealand-specific commodity prices. These developments, coupled with ongoing reinsurance inflows related to the Christchurch earthquake should support the NZD. Policy rate 2.50% 2.50% 10yr bond 3.30% 3.20% 2/10 curve 110bp 110bp 10yr v US 180bp 180bp 10yr v AU 50bp 60bp NZD/USD AUD/NZD

14 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 Current Current Jul Jun Jun Aug Jul Jul Sep Aug Sep Oct Nov Oct Nov Jan Dec Dec Jan Feb Mar Mar Apr Apr Aug 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 W repo 0.14 Current Jun Jul Jul Jul Aug Aug Sep Sep Sep Oct Oct Oct Dec Nov Nov Sep Dec Dec Jan Jan Feb Jan Mar May CAD Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun EUR Implied Cash Rate Jun Aug Oct Dec Feb Apr Jun GBP Implied Cash Rate 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. 14

15 CBA Forecasts: Cash rate 12-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada yr bond yield 12-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada yr bond yield 12-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 US Australia New Zealand United Kingdom Germany Japan Canada Currencies 12-Jun Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 AUD/USD AUD/JPY AUD/EUR AUD/GBP AUD/CAD AUD/NZD USD/JPY EUR/USD GBP/USD USD/CAD NZD/USD

16 Calendar June 2012 Monday Tuesday Wednesday Thursday Friday Early July Central Bank Meetings 1 AU Building Approvals (3 July) AU RBA (5 June) A U AI-Group PM I, M ay, Index, (43.9) AU RBA Board M eeting (3 July) CA Bank of Canada (5 June) A U RP Data house prices, Apr, m%ch, (-0.8) AU Retail Trade (4 July) EZ ECB (6 June) NZ Terms of Trade Index, QI, q%ch, (-1.4) AU Trade Balance (5 July) UK BOE (7 June) CH PM I M anufacturing/non-manufacturing, M ay, Index, (53.3/56.1) AU Housing Finance (11 July) NZ RBNZ (14 June) EU/GE/UK PMI manufacturing, May, Index, (45/45/50.5) AU Labour Force (12 July) JP BoJ (15 June) US Non-farm payrolls, M ay, '000, (115) US FOMC (20 June) US Unemployment rate, May, %, (8.1) US Personal income/spending, Apr, m%ch, (0.4/0.3) US PCE deflator/core, Apr, y%ch, (2.1/2.0) US ISM manufacturing, May, Index, (54.8) CA GDP, QI, q%chsaar, (1.8) AU TD inflat gauge M ay, m/y%ch, (0.3/1.9) A U CBA/Ai-Group Perf of Serv Index, May, Index, (39.6) A U GDP, QI, q/y%ch, 0.5/3.2, (0.4/2.3) A U Ai-Group P CI, M ay, Index, (34.9) A U RBA Gov. Stevens speaks in Adelaide AU Company profits, QI, q%ch, -3.0, (-6.5) A U Current acc deficit, QI, $bn, -15.1, (-8.4) EU GDP, QI, q/y%ch, (0/0) A U Labour Force, M ay A U Housing Finance, Apr AU Inventories, QI, q%ch, 1.0, (1.4) A U Net export contrib, QI, ppt, -0.8, (0.3) EU ECB anno unces int. rate, %, 1.00, (1.00) employment, '000, -5, (15.5) No. of own-occupiers, %, 0.0, (0.3) AU ANZ Job ads, M ay, m%ch, (-3.1) A U RBA cash rate, %, 3.75, (3.75) GE Industrial pro ductio n, A pr, m/y%ch, (2.8/1.6) unemployment rate, %, 5.1, (4.9) Value of all loans, %, 1.0, (-0.3) EU P P I, A pr, m/y%ch, (0.5/3.3) A U Gov. Finance Statistics, QI UK P M I constructio n, M ay, Index, (55.8) participation rate, %, 65.2, (65.2) A U Trade balance Apr, $bn, -1.0, (-1.6) US Factory orders, Apr, m%ch, (-1.9) EU PMI services/composite, May, Index, (46.5/45.9) US Federal Reserve Beige Book JP Coincident / Leading index, Apr, Index, (96.7/96.4) CH PPI/CPI, May, y%ch, (-0.7/3.4) US ISM non-manufacturing, May, Index, (53.5) EU Retail sales, Apr, m/y%ch, (0.5/0.3) UK PMI services, May, Index, (53.3) CH Industrial production/retail sales, May, y%ch, (9.3/14.1) GE PMI services, May, Index, (52.2) UK BoE announces rates, %, 0.50, (0.50) CH Trade balance May, US$bn, (18.4) GE Factory orders, Apr, m/y%ch, (2.2/-1.3) US Consumer credit, Apr, US$bn, (21.4) JP GDP, QI, q%ch, (1.0) CA Building permits, Apr, m%ch, (4.7) JP Curr a/c total/adjusted, Apr, bn, (1589.4/785.5) CA Bank of Canada, %, 1.00, (1.00) UK PPI Input/Output/core, May, y%ch, (1.2/3.3/2.3) US Trade balance, Apr, US$bn, (-51.8) CA Unemployment rate, M ay, %, (7.3) NZ M anufacturing activity QI, q%ch, (1.2) A U NAB Bus conf/cond, May, Index, (4/0) A U M I/WBC Consumer Sent, Jun, Index, (95.3) A U M I Unemploy. Expectat, Jun, Index, (146.4) NZ B usiness P M I, M ay, Index, (48) JP Consumer confidence, M ay, Index, (40) A U 2012/13 NSW State Budget JP M achine o rders, A pr, m/y%ch, (-2.8/-1.1) A U M I Consumer Inflation Expectat, Jun, %, (3.1) JP B o J target rate, %, , (0.1) JP Machine tool orders, May, y%ch, (0.4) NZ Credit card spending, May, m%ch, (0.6) EU Industrial production Apr, m/y%ch, (-0.3/-2.2) NZ RBNZ official cash rate, %, 2.50, (2.50) EU Trade balance Apr, bn, (4.3) JP Domestic CGPI, May, m/y%ch, (0.3/-0.2) GE CPI, May NZ Food prices, May, m%ch, (-0.1) GR Greek Election (17 June) UK Industrial production, Apr, m/y%ch, (-0.3/-2.6) US Producer price index M ay, m/y%ch, (-0.2/1.9) JP Industrial production, Apr US Empire manufacturing, Jun, Index, (17.1) UK Total trade balance, Apr, bn, (-2.8) US Retail sales, May, m%ch, (0.1) EU ECB Monthly report US Industrial production, May, m%ch, (1.1) US Impo rt price index, M ay, m/y%ch, (-0.5/3.6) US B usiness inventories, A pr, m%ch, (0.3) EU CPI, M ay, m%ch, (0.5); Co re, y%ch, (1.6) US Capacity utilisation, M ay, %, (79.2) US CPI, May, m/y%ch, (0/2.3); Core, (0.2/2.3) US Uni. Of Michigan confidence, Jun CA Bank of Canada Financial System Review AU M otor veh. sales, M ay, m/y%ch, (-0.7/7.3) A U RBA Board Minutes, June A U RBA Head of Payments Richards speaks in Sydney A U RBA Bulletin, QII 2012 NZ NBNZ Business confidence, Jun, Index NZ PSI, M ay, Index, (56.7) JP Coincident / Leading index, Apr A U DEWR skilled vacancies, M ay, m%ch, (-0.8) NZ GDP, QI, q/y%ch, (0.3/1.8) NZ Credit card spending, M ay, m/y%ch, (0.2/3.7) JP B o J M o nthly repo rt EU Constructio n o utput, A pr, m/y%ch, (12.4/-3.8) A U Dwelling commencements, QI, q%ch, -1.5, (-6.9) EU Current account, Apr, bn, (9.1) GE IFO - B usiness climate, Jun, Index, (106.9) US NAHB housing market index, Jun, Index, (29) EU/GE ZEW survey (econ. sentiment), Jun, (-2.4/10.8) NZ Current account, QI, % of GDP, (-4) EU/GE PMI manufacturing, Jun GE PMI services, Jun, Index G20 Leaders Summit UK CPI, May, m/y%ch, (0.6/3.0); Core, y%ch, (2.1) JP Trade bal total/adj, May, bn, (-520.3/-480.2) UK Retail sales, May, m/y%ch, (-1.1/-2.3) CA CPI, May, m/y%ch, (0.4/2.0) US Housing starts, May, '000, (717) GE Producer prices, May, m/y%ch, (0.2/2.4) US Philadelphia Federal Index, Jun, Index, (-5.8) US Building permits, May, '000, (723) UK Bank of England minutes US Existing home sales, May, mn, (4.62) CA Wholesale sales, Apr, m%ch, (0.4) UK ILO unemployment rate (3mths), Apr, %, (8.2) US/CA Leading indicators, May, m%ch, (-0.1/0.3) US FOMC rate decision, %, 0-¼, (0.25) CA Retail sales, Apr, m%ch, (0.4) US New ho me sales, M ay, '000, (343) A U RBA As.Gov Debelle speaks in Adelaide NZ Trade balance, M ay, $mn, (355) A U HIA new home sales, M ay A U Private sector credit, M ay US Dallas Fed, Jun US S&P/Case-Shiller home price index, Apr GE CPI, Jun A U ABS Job vacancies, M ay, m%ch, (0.7) NZ Building permits, M ay US Richmond Fed, Jun, Index, (4) US Durable goodes orders, May, m%ch, (0.2) JP Retail sales, May JP CPI, May, m%ch, (0.4) US Pending home sales, M ay EU Leaders Summit JP Industrial/Vehicle production, M ay CA Teranet House Prices, Apr UK GDP, QI, q/y%ch, (-0.3/-0.1) JP Construction orders/housing starts, M ay UK Current account balance QI, bn, (-8.5) US Personal income/spending, M ay UK Total bus investment, QI, q/y%ch, (3.6/14.2) US PCE deflator/core, May US GDP, QI US Uni. Of Michigan confidence, Jun 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: