Yield Curve

As I mentioned on the 13th of September future rate hikes hadn’t been fully priced into the curve and the suggestion was that there would be better opportunities in the three-year part of the curve at a later date. Since then Glenn Stevens has spoken and lifted the possibility of an October rate rise. As such the curve has steepened in the short end and flattened in the long end. For instance, 30 day bills have gone up 9 points, 180 day bills up 13 points, 3 year government bonds have moved up 15 points yet the 10 year government bond was at 5.07% and while it has moved up and down in the interim is still at 5.07%. The margin between 3-yr and 10-yr bonds has moved from 35 bps in to 20 bps.

The reason the long end of the curve has stayed in the same area is two fold. The market is taking the view that while rates will need to rise in the future it’s impact in the long run will be to keep inflation under control (the main determinant of long rates). The other reason is one of supply and demand. We have a limited supply of government bonds in Australia and one trader I speak with informs me that there is an insatiable demand, from Central Banks around the world, for our AAA bonds. This is a shift in the way they operate and their focus in the past has almost exclusively been on the USA.

Despite the fact the short end has moved up I still believe there is further to go. IF the RBA tightens next week the market will start to factor in a tightening in November and possibly one in December or February. The RBA rarely moves rates in isolation.

Such a scenario could result in Australia having a humped yield curve or possibly even an inverse one. A humped curve would result in rates in the short and longer parts of the curve being lower than the middle (3 – 5 years) part of the curve.

If the cash rate ends up higher than 10-year rates, a distinct possibility, we’ll have an inverse curve. In this case the market will be telling us that cash has moved to a restrictive setting and that growth and inflation are likely to be subdued in the long run.

For this reason there could be some better opportunities from the 90-day to 3-year part of the curve in the next few weeks.

The caveat to the above however is a further deterioration in Europe, which could delay the RBA’s rate hike plans.