Originally published by Commonwealth Bank of Australia
The RBA are blatantly neutral, until wages and inflation pick up. In the post‑crisis world, the flattening of Phillips curves across the developed world suggest central banks can afford to let inflation surprise on the high side, not the low side. If anything, central banks should seek to raise inflation targets, not lower them. Reflation should steepen curves globally.
The Australian interest rate curve is still flat enough to play the “reflation” trade, and hedge. The shift in bias from the likes of the ECB, BoE and BoC, supports the thesis of reflationary risks over deflationary risks, and reinforces the confidence of the Fed. If global interest rates continue to grind higher, Australia’s curve should steepen as the RBA remains steadfast.
We recommend a 6m1y versus 6m5y swap curve steepener, at 50bps. The carry on the steepener is essentially zero (12bps of pickup on the 6m1y is offset by 12bps on the 6m5y). We target a move to 85bps and hold a stop of 35bps.
We also receive the 1y OIS again at 1.55%, as a hedge to all things nauseating, nasty and nuclear.
In yesterday’s wrap up of the RBA decision, we noted RBA officials are so neutral, they’re wearing beige cardigans. The RBA delivered a deliberately neutral tone, talking down both the positives and negatives. The RBA are growing more comfortable with the economic evolution, but risks remain either side. Until wages and inflation surprise, consistently, on the high side, a tightening bias would be premature. And the currency would likely strengthen in that scenario, tightening monetary conditions.
Australia’s Phillips curve, like most developed nations, has flattened post‑crisis (chart 1). The development is frustrating for central banks mandated to the Phillips curve. What’s the answer? Higher inflation targets. We have argued for higher inflation targets, but good things take time. A higher inflation target (3‑4% for example) would allow for looser policy near‑term, a swifter reflation medium term, and a greater distance for the zero bound long term. Whether formally adopted or not, we think central banks will allow inflation to surprise on the high side, for a change. Rising inflation is easy to deal with, there’s no need to stampede over green shoots.
We recommend a mid‑curve steeper
The RBA’s neutral bias leads itself to received positions in the short‑end of the Australian curve. The risks are two‑sided. We’d argue the risk of a rate cut exceed the risk of a rate hike in the next 12 months. We pick the 6m1y at 1.90% as the (positive) carry is enough to entice, and the 18 month duration offers some protection to downside (rate cutting risks). The 6m5y rate of 2.40% (compared to 2.30% spot 5y) is flat enough, and should benefit from a continued sell‑off in global rates, and/or a surprise move to a hawkish bias from the RBA. At 50bps, the 6m1y versus 6m5y should track higher towards our initial target of 85bps. We hold a stop at 35bps.
We like this position for three reasons. First, we expect short‑end rates to trade sideways into 2018. Second, if we’re wrong, and the RBA becomes as hawkish as John Edwards suggests (see Aces and Edwards eights, tell him he’s dreaming) then the 3‑to‑7 year sector of the Australian curve will rise at a faster clip than the 1‑to‑2 year sector. Third, our relative value analysis overleaf supports the curve points.
The risk to this trade is a slow grind towards RBA easing. The 3‑to‑5 year sector will fall and 1s5s will flatten.
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