Why the collapse in the Australia-US 10 year bond spread matters to the economy

Photo: Getty Images

In a small open economy like Australia, with an almost perfectly free-floating exchange rate, bond and interest rate spreads matter.

So with both the Australian-US 10 year and Australia-US front-end spreads contracting as markets price in lower RBA rates and higher US rates, the impact of this arcane movement will be felt all across the economy.

Let me explain.

Government bond rates, and how markets sets them, are an interesting concoction of ingredients. There’s the anchor-point the central bank cash rate rates establishes, the inflation outlook, length of the bond, size of the coupons, sovereign credit rating, level of issuance by the government, as well as demand for the bonds by the private sector – or in some case under quantitative easing the central bank, demand from offshore investors – the list goes on.

But when it comes to bond spreads (the rate of difference between rates of the same maturity) between two nations – or multiple nations, as global bond fund managers look at them – the drivers can rise by multiple factors.

But bond, and interest rate spreads are vitally important in driving long-term capital flows into or out of countries. When a spread contracts to, or below, a level that investors see as fair value for a nation, capital flight often ensues and the nation’s currency comes under pressure.

On the other hand when bond spreads are seen as reflecting a fair, or better, perception of relative interest rates and economic outlooks (among other things) capital inflows result and a currency appreciates.

In many ways it is via the movement of bond spreads that we can best see what international investors and traders are thinking about Australia and its prospects relative to the rest of the world.

So it’s no surprise as David Plank, Deutsche Bank’s Sydney-based macro strategist, says there has been a repricing of the AUD front-end since the weak Q1 CPI and the following RBA rate cut [which] has seen the 10Y ACGB outperform its US equivalent, with the spread between the two below 50bp as we write.

That’s back toward cycle lows.

The spread contraction is also a good thing because given the contraction closely mirrors the front end spread move it helps put downward pressure on the Australian dollar. That, in turn, means the Aussie dollar can – as RBA governor Stevens said yesterday – do “what it is expected to do” by acting as “shock absorber” for the economy and falling.

That’s important because for the stability of Australia’s economic growth in the quarters ahead.

But could the bond spread fall to zero?

Plank says such a move begs two questions, “what will it take for the spread to fall to zero or less and how likely is this”.

In addressing these questions he said:

On the first we think it will take the expectation that the RBA cash rate will fall at least 50bp below Fed funds. On the second we would argue that such an expectation will likely push the AUD below 60 cents. At this stage we don’t think the Australian economy needs the combination of an AUD below 60 cents and a cash rate approaching 1% to generate the economic outcomes that would have inflation returning to at least the bottom of the RBA’s target band.

This is where spreads, central bank policies and exchange rate movements all converge and become a little bit complicated.

But Plank says “in the event that the Fed tightens by more than is currently implicit in our bond forecast the RBA will likely be able to get away with less easing. Still, based on our revised RBA forecasts since the May rate cut we do think it likely the 10Y ACGB/UST spread will settle in a somewhat lower range than we previously expected”.

In the end, it all means that we can get used to lower rates in Australia and a lower Australian dollar, but we don’t need to worry about any sort of destabilising currency crash.

All of which is good news for the economy going forward.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.