The Australian bond market has got ahead of itself in anticipation of RBA rate hikes next year, according to Credit Suisse.
As a result, the bank’s analysts are forecasting a flattening of the yield curve — in other words, a narrowing of the spread between the yields on long-term and short-term debt.
And they expect that to occur via a material fall in Australian 10-year government bond yields, as the RBA refrains from raising rates in the near future.
“This could possibly drag the AUD/USD lower as well, as real yield differentials (with respect to the US) narrow,” the bank’s analysts said.
Australian 10-year bond yields dipped below their recent range above 2.8%, in the wake of yesterday’s weak inflation report. However, the 10-year bond yield remains elevated from its June lows beneath 2.4%.
Credit Suisse said the Australian real yield curve is currently showing a difference of around 100 basis points.
The bank’s preferred measure of the yield curve is to take the spread between 10-year bond yields and 90-day bank bill yields, both adjusted for inflation.
“The focus on real, rather than nominal, spreads helps us to focus on growth expectations,” the bank said.
The analysts then composed a model based on four factors, which indicates the yield spread should be more like 15 basis points.
Given that Credit Suisse expects the spread to narrow from a fall in longer-term bond yields, then if the 90-day bank bill yield holds constant it would suggest a 10-year bond yield close to 2% — a level it hasn’t fallen below since September last year.
A 10-year government bond yield at closer to 2% would most likely add to downward pressure on the Aussie dollar, particularly with recent signs indicating that US bond yields may be poised to rise.
The Australian dollar has already dipped by more than 3% since the start of September, with a large fall yesterday driven by the weak inflation report for Q3.
The bank’s four-factor model is comprised of the following elements:
- Home-buying sentiment in the monthly Westpac consumer confidence survey
- Business confidence from the monthly NAB business survey
- Reduced availability of US dollars in offshore markets
- A fall in the “neutral” interest rate stemming from lower measure of GDP and rising household leverage
The bank said in recent surveys, home-buying sentiment has fallen well below average in NSW and Victoria, amid reduced affordability and lower expectations for capital gains.
They added that while the NAB business survey shows trading conditions are near all-time highs, confidence has started to waiver which suggests skepticism around the sustainability of current activity.
The availability of US dollars in the financial system has been driven by the US maintaining a wide trade deficit due to weakness in the US dollar, but that may change as the USD strengthens off its recent lows.
And Credit Suisse’s modelling of a neutral interest rate has also been “drifting lower”, which has the effect of reducing upwards pressure on actual interest rates.
The neutral rate is the theoretical rate at which GDP growth would be at trend levels and inflation would be stable, without any additional monetary stimulus.
The bank’s calculation of the neutral rate is derived from nominal GDP growth on a historical 10-year basis, and household debt.
While nominal-GDP growth has been slowing, household leverage has increased — both of which have the effect of lowering the neutral rate of interest.