UBS has slashed its forecast for 10-year Australian government bond yields

But not that kind of Slash… Photo: Scott Gries/Getty Images

The Reserve Bank of Australia’s decision to cut rates, along with the sharp downward revisions the bank made to its inflation forecasts in its quarterly statement on monetary policy released last Friday, has certainly created a stir across markets.

The RBA’s cut to a record-low level of 1.75% in May, leaving the cash rate some 3% below the level when the current easing cycle began in late 2011.

Interest rates futures now put the odds of a further 25 basis point rate cut in August at 86%, mirroring the view of economists who, collectively, also expect the cash rate to fall to 1.5% on August 2.

Looking further ahead, rates markets put the probability of the cash rate falling to just 1.25% by November — indicating two further 25 basis point cuts from the RBA — at 25%.

It’s been a remarkable turnaround, particularly from economists who were largely predicting that the next move in interest rate would be higher, not lower, just two weeks ago.

Given the shift in expectations, many are now asking whether the RBA could potentially be drawn into easing policy even more aggressively in the years ahead, taking interest rates below 1% to levels more accustomed by investors in other major monetary jurisdictions.

Based on the chart below, supplied by UBS, the gap between Australia’s main policy rate and those in the US, eurozone, UK and Japan is narrowing fast.

While he disagrees with the view that the RBA is about to join the ‘race to the bottom’ when it comes to interest rates, George Tharenou, a UBS economist, believes that latest inflation forecasts offered by the RBA raises the risk that the bank may cut interest rates beyond 1.5% in the months ahead.

“They (the RBA) now see underlying CPI below, or at the bottom of, their 2-3% target for an unprecedented 3 years,” Tharenou wrote in a research note released on Monday.

He is forecasting a further rate cut in August, adding that beyond that there’s a “risk of further easing”, implying that more than one rate cut could be delivered.

As a consequence of this view, UBS has cut its forecasts for benchmark 10-year Australian government bond yields this year and next, with risks to its targets “skewed to the downside”.

“For 10 years, we now see end-16 at 2.30% (was 2.50%) and target a spread compression to US Treasuries to 30bp. For end-2017, despite Fed rate hikes & rising US yields, Australian 10’s could stay lower for longer at 2.40%, as the spread tightens further to 10bp,” says Tharenou.

“Although further budget slippage will drive another year of record bond issuance, we still consider the risks to our yield and spread forecasts to be skewed to the downside.”

As a result of the expected yield compression between Australian and US rates (the 2-year spread between Australian and US rates is still more than 140 basis points), UBS retain the view that the AUD/USD will end 2016 buying US68 cents.

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