Thursday, July 2, 2015

Move Over Greece: The Down-Under Version

Since the surprise start of the week, and large rally in rates, rates are almost back to the levels it lost, with steeper curve, especially in Euro. Break-evens are little budged (except a sort of swing in sterling) and dollar marginally stronger and Euro marginally weaker. Only equities still nursing the wounds so far.

I think my optimism about UK turned out to be justified so far. Data-wise US, UK continue on strong data flow. At the same time, I think we are focused on Greece more than it deserves and missing other big thing in the bargain - the unraveling of the Chinese stock markets. This will definitely have a strong influence on the Australian rates markets. I have argued before that the AUD curve is to steep and has to flatten. Since then it flattened from 100+ to 70bps level and now back to 105 (in 5s30s).

We can propose a simple model of the factors that drive the slope in line with similar models for Euro and USD. The explanatory variables are the terms of trade (CTOTAUD Index on Bloomberg), RBA policy rate, and the China current account balance (GDP is also somewhat significant, but not included, inflation not much significant). The estimates are as below.

The model fits as below (click to enlarge)

Post-crisis there is a change in unconditional expected level of slope, which is higher that what it used to be before 2008. But also a couple of changes interesting: a higher sensitivity to China current account balance (as percentage of GDP) and RBA policy measure. The RBA part is as expected. On the China sensitivity, one conjecture can be that current account balance shrunk in China primarily as exports reduced, along with a reduction in imports. That directly impact Australia, and builds in pressure for bull flattening.

This, along with the current directionality of rates with slopes means a very asymmetric positioning for a AUD flattener. If we see a strong return of job growth and commodities inflations, we will see a more hawkish RBA, leading to a flattening. If we see a further worsening in sentiments from China, but no deterioration in inflations, the correlation should lead to a bullish move. A separate estimates shows for each 1 percentage point reduction in China current account balance (% of GDP) leads to a 30bps rally in 5y and 17bps in 30y in AUD.

Given this, and the recent steepening and sell-off in AUD rates, it is a good opportunity to enter a trade. It can be either a flattener (probably balanced by a 5y point to take care of the directionality) or it can be a 5y or 5y5y outright receiver. And all of this will have a positive carry. Which can be used to pay for a sell-off protection in either EUR, GBP or USD long end.

All good, then there is this one possibility of course.

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