Fixed Income: Weekly Strategy - CommBank€¦ · Fixed Income: Weekly Strategy 2 Key Positions We...

Fixed Income: Weekly Strategy 3 August 2011

Adam Donaldson Head of Debt Research T. +612 9118 1095 E. [email protected] Philip Brown Quantitative Strategist T. +612 9118 1090 E. [email protected] Alex Stanley Associate Analyst, Fixed Income T. +612 9118 1125 E. [email protected]

Important Disclosures and analyst certifications regarding subject companies are in the Disclosure and Disclaimer Appendix of this document and atwww.research.commbank.com.au. This report is published, approved and distributed by Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945.

The Debt Ceiling rises. The Cash Rate doesn’t. Bond yields fall, a lot.

Australian bonds have rallied sharply in the last two days. Poor domestic data compounded offshore moves.

We recommend a credit (near) arbitrage trade to take advantage of the difference between credit ASW and FRNs.

We also enter an IADB trade versus WATC on the view that foreign demand will narrow the spread.

The rally in Australian rates has been relentless and the last two days have been exceptional. Although most of the impetus is offshore, the market also took the RBA statement as being slightly dovish and the June Retail Sales report was on the weaker side this morning at -0.1%. The Australian 3Y bond has rallied 38bp since last Monday (25 July) and 47bp in the last two days. The 10Y has rallied 27bp since last Monday and 25bp in the last two days. The shift in the bill curve is even more dramatic. The IBs are currently pricing a cash rate of about 4% (there’s some volatility) by March 2012. Jun-12 bill futures have rallied 30bp since last Monday, but 57bp in the last two days.

The US political system has, finally, managed to raise the debt ceiling. This was not the cause of the major rally though – US bonds have underperformed Aussie bonds since the announcement. The default has been avoided, but questions remain over the US AAA rating. As discussed on p3, we still think an S&P downgrade is quite possible. US Treasuries had been remarkably stable for most of the last week, but a very strong rally began on Friday and has continued. The 10Y US yield has fallen from 2.98% last Monday to 2.59% now, a 39bp rally. The 2Y has fallen from 0.39% to 0.31%, an 8bp rally.

Most of the US rally was not because of the debt ceiling. The US economic data has been poor over the past few days and concerns in Europe intensified after the US deal to raise the debt ceiling. Friday’s GDP data showed only a 1.5% annualised growth rate and Q1 was revised down from 1.9% to 0.4% annualised. On Monday night the ISM data also fell much further than expected. QE 3 has been touted in some circles and is not inconceivable if conditions don’t improve.

Italian and Spanish bond spreads have continued to underperform bund. Once markets were convinced that the debt ceiling would be raised, attention returned to Europe and the market didn’t like what it saw.

This week, we try to find trades that are not related to the outright level of rates in the US or Europe. Philip Brown suggests a credit bond (near) arbitrage in his article on page 7. Adam Donaldson discusses the impact of offshore demand for AUD assets on page 3. He concludes that kangaroos are well placed to benefit from any ‘buy-the-dip’.

Although there is quite a lot of important data in the next week, the offshore sentiment is likely to be the main driver of Australian rates. Business and consumer confidence indices are scheduled for next Monday, but next Thursday’s employment data is more important.

In the US, this is payrolls week and we start the run with ADP this evening, before Initial Jobless Claims tomorrow and the big one on Friday. Current expectations are for only an +85 increase in total jobs. The FOMC meets on the morning of August 10 (Syd time) and the US retail sales is scheduled for next Friday.

Contents:

Key Positions......................................................................... 2 Key Trades ............................................................................ 2

European and US Supras – a safe-haven from the European and US storm? ...................................................... 3

Near-arbitrage opportunities in bank bonds: FRNs and asset-swapped fixed rate ............................................... 7

Key Views............................................................................ 10

CBA Forecasts: .................................................................... 12

Calendar – August 2011 ...................................................... 13

Foreign ownership of AUD bonds

Source: ABS, Bloomberg, CBA

0.40

0.60

0.80

1.00

1.20

20%

30%

40%

50%

60%

88 91 94 97 00 03 06 09 12

CGS & Semi-govts (lhs)

Kangaroos (lhs)

AUD/USD (rhs)

CBA (f)

AUD/USDShare of total

Global Markets Research

Fixed Income: Weekly Strategy

2

Key Positions

We have been stopped out of some of our trades – but the receiver swaption position is insuring us nicely, as we had hoped.

In an attempt to recommend a trade that isn’t gonig to be affected too much but the US or European markets, we recommend an Australian credit bond near arbitrage. The domestic bank Fixed rate bonds are much too cheap compared to the FRNs. The fixed rate bond can be asset swapped to achieve a spread 11bp more than the traded margin on the FRN. We also enter an IADB-WATC 2019 compression trade to take advantage of likely foreign appetite for AUD bonds.

Key Trades

Trade Entry Curent Profit Target Stop Comment Buy an NSWTC Nov-20 Linker vs UST 1.25% Jul-20 linker

213bp (14-Mar-11)

235bp -22bp 150bp 235bp Stopped Out: The real yield pickup is large. The US linkers are likely to underperform once QE ends. Has performed OK despite the rally in nominal bonds.

Buy a 6M*1Y receiver 20bp below spot yields (4.85%)

7.5bp premium (11-Apr-11)

Current forward is 4.40%

+37.5bp (if exercised today, so more)

n/a n/a Hold: Insurance trade is paying off.

Sell the KfW Dec-19 against the IBRD Oct-19

22bp (30-May-11)

24bp +2bp 40bp 15bp Hold: Despite the growing concern in Europe, there has not been any movement in the basis or in the credit spread.

Buy the Jan-18 vs the Apr-15 28bp (21-Jun-11)

35bp -7bp 15bp 35bp Stopped Out: Massive steepening overwhelmed the RV

Sell the September Bill Future against receiving the 3M*3M OIS

19bp (21-Jun-11)

31bp +12bp 40bp (?) 10bp Hold: An insurance trade.

Sell the EFP box trade (3Y to widen, 10Y to tighten)

25bp (5-jul-11)

26bp -1bp 15bp 30bp Hold: The 3Y EFP may widen on flattening of the curve. The 10Y looks too wide.

Buy a 3M ATM option on the ACGB Jun-14 against selling a 3M ATMF receiver on the 3Y AUD swap. (Conditional bull spread widener)

Entry cost 2.5bp Effective spread: 47bp: 4.28 and 4.75 (19-Jul-11)

Bond: 4.01 Swap: 4.47

-1bp Hold: An insurance trade in case the rally continues. The bonds have rallied, but the 3Y swap spread has not massively widened – yet.

Pay fixed in 5Y ZCS vs 4Y -3bp (20-7-11)

0bp 3bp +5bp -8bp Hold: Trade established in Monthly Inflation Report. (We apologise for overlooking it in the trade table last week)

Buy an AUD bear flattener. 3M*3Y vs 3M*10Y Entry cost 3bp. Entry slope 82bp

Option Strikes: 5.075 and 5.895. (23-Jul-11)

Current slope 90bp –but well OTM

0bp Hold: If the curve sells off it is likely to flatten. No sign of a sell-off – options OTM.

Receive the AUD versus NZD 2/10Y swap box (AUD 2/10Y flattener versus NZD 2/10Y steepener)

-75bp (26-Jul-11)

-60bp -15bp -110bp -60bp Stopped out: The Aussie curve continues to rally and steepen.

Buy the NAB Apr-13 as an ASW against selling the NAB Apr-13 FRN

+11bp (3-Aug-11)

0bp 17bp New Trade: There is little reason for the ASW fixed rate to be different to the FRN price.

Buy the IBRD Aug-19 vs the WATC Oct-19

39bp 93-Aug-11)

25bp 45bp New Trade: The IBRD is likely to attract foreign demand while the WATC looks dear.



3

European and US Supras – a safe-haven from the European and US storm?

Adam Donaldson – Head of Debt Research – 61 2 9118 1095 – [email protected]

The US Debt deal is closer to S&P’s weak scenario than a strong outcome. A downgrade remains possible.

We examine which sector is likely to benefit from the pick-up in foreign demand that Australia should enjoy.

Spreads for Kangaroos in Australia remain stable – reflecting demand from FX carry players we think.

We recommend buying the IBRD 2019 against the WATC to take advantage of likely strength in foreign appetite.

Revisiting the debt deal

We reviewed our thoughts on the US debt negotiations last week. We concluded that the political (rather than financial) nature of the crisis meant a deal to raise the debt ceiling was likely (or would continue to be considered likely even if it didn’t arrive in time to avoid default). But we also suggested that a poor outcome, in line with S&P’s scenario of an agreement to raise the Debt Ceiling but no credible plan to reduce debt, was the most likely option. We thought this would damage the credit standing of US Treasuries and that “we are now at the point where a downgrade should be considered the most likely outcome.”

As things stand, the deal that has been passed looks more like this ‘poor’ result than a ‘strong’ decision to reduce debt. Whether it’s weak enough to prompt S&P to downgrade the AAA rating remains to be seen. Moody’s have opted to keep the US on Outlook Negative while Fitch said the current debt profile is “not consistent with the United States retaining its ‘AAA’ sovereign rating.”

In our view, the deal doesn’t do enough to arrest the ongoing rise in debt to meet the criteria S&P set out in their analysis a few weeks ago. In short, the $2.4 trillion deficit reduction plan doesn’t go far enough to offset the $6.7 trillion rise in debt forecast by the Congressional Budget Office over the next 10 years (Figure 1). And much of it is back-loaded. But it would obviously be a controversial decision to downgrade the rating and we could see another Negative Outlook decision pending further progress after the 2012 election following this encouraging ‘first step’.

Given the central place that US Government bonds occupy within the world’s only reserve currency system, we have been of the view that the credit premium fall-out from a downgrade would be minimal and counter-balanced by the depressing impact on yields from risk aversion and a weaker growth outlook. Things seem to have panned out that way thus far. US Treasuries rallied strongly even before the debt deal was done, as risk aversion set in. More recently, this week, they have benefited from

Figure 1: US Federal debt/GDP

Source: CBO, CBA

Figure 2: Sovereign 5yr US CDS

Source: Bloomberg, CBA

60%

65%

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75%

80%

85%

90%

2010 2012 2014 2016 2018 2020

2011 Budget

Incorporating Budget Control Act

% of GDP

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80

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Jan-11 Mar-11 May-11 Jul-11 Sep-11

GermanyUSA

UKAustralia

bpbp

US result looks more like a “poor” than a “strong” result

Moody’s have put the US on negative watch, S&P may follow-suit, or downgrade



4

soft US data and on-going tension in US markets. They have of course also benefited over recent days from the lack of a default. Figure 2, for instance, shows that US CDS tightened 8bp this week, while key quality European spreads widened slightly.

US Treasuries have, however, under-performed other ‘true’ AAA nations like Germany and Australia over recent weeks (Figure 3). The AUS-US bond spread touched 186bp last week before the deal and the high Q2 CPI print in Australia. The spread continues to hover around 200bp notwithstanding the RBA’s declaration it considered tightening monetary policy at yesterday’s Board meeting (though the money market is obviously ignoring that). Figure 4 shows that such outperformance is unusual when Treasuries are rallying.

Over the long term, we see a weaker US credit rating (and the weak fiscal position) as likely to contribute to an under-performance of US Treasuries to quality markets such as Australia. The trend of reserve diversification to other currencies including the AUD should continue, if not accelerate (Figure 5). This supports our view that spreads will narrow over time and the AUD will remain well supported (with our currency strategists suggesting they will lower their USD forecasts if a downgrade does occur). Today, we examine which segments of the market will benefit from this trend.

Demand

The attraction of AUD bonds for foreign investors is well understood. It is clearly having a major impact on the CGS market given the entire curve is trading below the cash rate. The flight to quality is apparent in the widening of AUD swap spreads, with 10yrs having now moved from 50bp to 75bp over the past six weeks. That is obviously adding to widening pressure for other high-grade credits such as semi-governments. In fact, as discussed a few weeks ago, that sector has suffered even relative to swap given a decent chunk of the domestic investor base use semis for duration purposes and are currently very short.

So, with CGS under cash and semis unloved, what sector might benefit from this strong global demand? Figure 6 shows that more than half of the Kangaroo market is owned by foreign investors. We can’t break that down between SSAs and corporates (financials) that dominate this sector, but our sense is that both are held widely offshore because the investor base is seeking AUD risk in names they often already know and understand. Figure 7 shows that, like the rest of the high-grade market, the share of foreign ownership for Kangaroos is quite closely correlated to the fortunes of the AUD.

Figure 3: German and Australian spreads to US

Figure 4: AUS-US bond spreads has recently narrowed despite US rally

Figure 5: Central bank currency allocations

Source: IMF, Bloomberg, CBA

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Jan-10 Jun-10 Nov-10 Apr-11

bp

GER-US 10yr spread

(rhs)

AUS-US 10yr spread

(lhs)

bp

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US 10yr (inverted, rhs)

AUS-US 10yr spread

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% share

EUR

Other

USD (rhs)

GBP

* share of 55% of reserves that have been allocated

JPY

US underperforming “true” AAA like Germany and Australia

Medium term, the US credit is weaker and reserve diversification will continue

Demand for AUD bonds from foreign sources is affecting yields

Kangaroo names held by offshore investors



5

The AUD has dipped in the past two days as global risk aversion has set in. But we (and our currency strategists) think this is likely to be a short-term development and represents a buying opportunity for the AUD. They would downgrade their USD forecasts if a credit downgrade does occur. Recent experience has strongly supported the notion that investors should step in to ‘buy the dip’ when the AUD falls on global risk events. To us, this seems like one of those occasions.

What will they buy?

In this environment, we typically see that the AUD risk is reinforced with as much yield or carry as investors can access. We think this mindset likely explains the relative stability of foreign name spreads in Figures 8 and 9. SSAs have performed very well over recent days and weeks despite the European and US attachment of these names. Similarly, spreads of Kangaroo financials have generally held their own despite the risk aversion in the market that would normally take spreads wider.

The relative resilience of the AUD market is highlighted further in Figure 10, which plots the path of the major 4 Australian banks USD issues. The spread widening in foreign markets relative to the stability apparent in Figure 8 is readily apparent. This likely represents an attractive opportunity for those clients who can access Australian names in foreign currencies and swap them back. But our sense is that this market could remain quite volatile and the relative security of the AUD/Australian story won’t count for as much in this space (especially given offshore concerns over the state of the Australian housing market).

Figure 8: Kanga financials v domestic majors

Figure 6: Foreign ownership of AUD bonds*

Calculations assume all bonds issued offshore are owned offshore. Source: ABS, CBA

Figure 7: Foreign ownership of AUD bonds*

Figure 9: Kanga SSAs v domestic semi-govts

60

90

120

150

180

210

2-Feb-11 2-Apr-11 2-Jun-11 2-Aug-11

BNPAUS (18-Mar-15)JP MORGAN (11-Mar-15)NAB (05-Nov-15)JP MORGAN (16-Mar-16)WBC (09-Nov-15)BNPAUS (24-May-16)

bp

Goldman Nov 2016

Westpac Nov 2016

Rabo April 2015

Citi Mar 2016

Goldman April 2016

0%

20%

40%

60%

80%

100%

0.40

0.60

0.80

1.00

1.20

20%

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88 91 94 97 00 03 06 09 12

CGS & Semi-govts (lhs)

Kangaroos (lhs)

AUD/USD (rhs)

CBA (f)

AUD/USDShare of total

-40

-20

0

20

40

60

Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11

QTC GG (14-Jun-19) EIB (07-Aug-19)

KFW (04-Dec-19) IBRD (21-Oct-19)

QTC (21-Feb-20) EIB (06-Aug-20)

NSW GG April 2019

NSW May 2020

IADB Aug 2019

bp

AUD has dipped, but this is likely to reverse

Demand for yield has likely kept spreads in Aussie bonds stable



6

We are hesitant to enter risk trades at the current juncture given moves in equity markets and middle tier European sovereigns (Spain & Italy) over recent days. But we are taking great comfort from the resilience of AUD credit spreads and expect a lift in appetite for these names as currency-related buying comes through. With that in mind, we are moving to buy the IADB August 2019 (where we expect on-going US fiscal support to remain strongest) relative to the WATC October 2019 (which we think looks a little tight relative to the other semi-governments) at a spread of 39bp. We target 25bp, with a stop of 45bp. The added advantage is that issuance for SSAs has slowed dramatically following the strong start to the year (Figure 11).

Figure 10: Australian majors in USD

Figure 11: Primary issuance

0

25

50

75

100

125

150

175

200

29-Apr 29-Jul 28-Oct 27-Jan 28-Apr 28-Jul

ANZ 4.875 01/12/21

NAB 4.375 12/10/20

CBAAU 5 03/19/20

ANZ 5.1 01/13/20

CBA 5 10/15/19

WSTP 4.875 11/19/19

NAB 2.75 09/28/15

WSTP 3 08/04/15

CBAAU 3.5 03/19/15

NAB 3.75 03/02/15

WSTP 4.2 02/27/15

ANZ 3.7 01/13/15

CBA 3.75 10/15/14

ANZ 2.125 09/19/14

CBAAU 3 09/20/13

NAB 5.35 06/12/13

ANZ 2.4 01/11/13

NAB 2.5 01/08/13

WSTP 2.25 11/19/12

WSTP 2.25 11/19/12

CBAAU 5 11/06/12

CBAAU 5 11/06/12

Spread to swap bp

Source: CBA



7

Near-arbitrage opportunities in bank bonds: FRNs and asset-swapped fixed rate

Philip Brown – Fixed Income Quantitative Strategist – 61 3 9675 7522 – [email protected]

There are significant discrepancies between the yields on Floaters and asset-swapped Fixed-rate bonds.

For domestic bank issuers, the fixed rate bonds are generally much cheaper than the floaters.

For foreign bank issuers, the results are more mixed, though the fixed bonds tend to be dearer.

Recently, an anomaly in the pricing of credit bonds was brought to my attention. Simply put, an asset swapped fixed-rate bond is the equivalent of a floating rate note. Yet the two prices are often quite different. They shouldn’t be.

To analyse this phenomenon we first isolated the 54 matching pairs of bonds in the Australian market. Then, we subtracted the FRN margin from the fixed-rate ASW margin. Figure 1 shows the resultant spreads set out against maturity date.

We recommend buying the NAB Apr-13 as an ASW against the NAB FRN at 11bp. We like this trade because it should revert to zero, but also, it shouldn’t be too strongly correlated with offshore moves.

Theory: Asset-swap is (nearly) an FRN

In theory, a fixed rate bond which has been asset-swapped is equivalent to an FRN. In broad terms, they are equivalent. There are some differences, of course, and these differences do justify a slight difference in pricing between an ASW and an FRN. However, the current differences in pricing seem excessive.

The similarities between an ASW and an FRN are quite obvious. Both pay the floating 3M BBSW rate plus a spread to represent credit risk.

The main differences between an ASW and an FRN are that an ASW requires a counterparty and an FRN can have an “out-of-market” next coupon.

The need to include a swap counterparty in an ASW means that, on some levels, a fixed rate bond with an ASW overlay has more risk than an FRN. Also, with the current uncertainty about the direction of swap Central Clearing, there may be some suspicion of using swaps. However, we don’t believe Asset Swaps will be in the first set of swaps put on to Central clearing. Interest rate swaps and OIS are much more likely to be among the first products centrally cleared.

Figure 1: Matched pairs of bonds, ASW less FRN traded margin

Source: CBA Spectrum, CBA

Figure 2: BBSW has been moving, but not enough to justify price moves


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<-FR

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che

ap

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xed

is c

heap

->

2-Aug-11

4.50

4.75

5.00

5.25

May-11 Jun-11 Jul-11 Aug-11

3M BBSW

The market is not pricing FRNs and ASWs the same way

Some theoretical differences between ASW and FRN, but don’t justify the differences in price

ASW need a swap counterparty



8

Secondly, the pricing of the first coupon in an FRN and an asset swap are, subtly, different. In between coupon days, the asset-swap will use a current market rate to price the underlying bill rate for the first coupon. In contrast, an FRN has the coupon set on the previous coupon day. If the current bill rate for the partial coupon period is very different to the coupon rate actually set on the previous coupon day, then an FRN suffers a capital gain (or loss).

Either of these differences could, in theory, affect the relative prices of an FRN and an ASW, even for the same credit.

Although there has been some movement in BBSW recently, the changes aren’t enough to justify the large discrepancies seen between fixed and floating (see figure 2). There has only been about 20bp of movement in 3M BBSW within the last coupon period. That equates to only about 5bp of actual coupon payment, which must be further reduced by the DV01 of the maturity of the bond. The BBSW difference can matter a lot, but is not the explanation for the current discrepancies.

Domestic banks have dear FRNs

At the front of the curve, there are many Australian banks whose floating rate bonds are much dearer than their fixed rate. The Westpac April-13 FRN is 10bp dearer than the equivalent bond, and the NAB is 11bp dearer. Figure 3 shows the spreads for only the major Australian banks. The results are remarkably uniform. In shorter maturities the Fixed bonds are cheap, but for 2015 and 2016 the fixed bonds are dearer than the FRNs.

This could, in part, reflect a desire by domestic fund managers to be short duration. Before you consider hedging, a manager trying to be short duration will prefer a credit FRN to a credit Bond. Conversely, many offshore investors are attracted by Australia’s high fixed yields and tend to prefer long-dated paper. However, after the fixed rate bond has been swapped, the rates exposure is essentially nil in both cases (first coupons are the exception).

Not all fund managers can transact in swaps, though, and swaps are not actually free. Not only does a swap have a bid-offer spread, the uncertainty about swap clearing is probably contributing to this. Our traders suggest bid-offer on the asset swap is unlikely to be anything like the size of the 10bp discrepancies we have seen, though. The possibility of swaps requiring central clearing decreases the practical return from an ASW. To maintain the swap the investor must deposit collateral. If that collateral is not readily available, it must be purchased and will, normally, have a negative

Figure 3: Australian banks have consistent patterns


Figure 4: Fixed spreads less floating have been widening in the rally


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ANZ CBA NAB WBC

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Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

WBC (19-Apr-13)NAB (01-Apr-13)CBA (10-Sep-13)

BBSW has been volatile, but not enough to cause the current discrepancy

The treatment of an FRN first coupon is slightly different

Domestic issues tend to have dear FRNs

A rate view?



9

running yield to the investor. (See our article in the Strategy Weekly on Central Clearing from 11 July.)

Either an inability to trade swap or a disinclination to face the uncertainty of central clearing could suggest that fund managers would prefer to simply buy the FRN than the fixed rate. As figure 4 shows, the fixed rates have been getting cheaper relative to the FRNs as the market has rallied over the past few weeks.

Foreign banks have dearer Fixed rate bonds

Although not quite as consistent as the domestic banks, foreign banks are, generally, much more likely to have dear fixed rate bonds. The FRNs are cheaper. We think this shows a difference in the target markets of the two deals. Offshore investors are more likely to be buying bonds in the offshore names. We have also commented recently that we think the offshore investors are more bullish Australian bonds than domestic players.

As such, the offshore investors will be happier taking the fixed rate exposure.

Buy the 2013 area domestic fixed vs FRN

We think the best opportunities are to buy the domestic fixed rate bonds vs FRNs. Figures 3 and 4 show that the 2013 Aussie bonds are quite cheap compared to the FRNs and that this is at a reasonably extreme level. There also appears to be some mean reversion activity, but it does appear that we should be prepared to hold the position for a while.

We recommend buying the NAB Apr-13 on an ASW basis against selling the FRN at a spread of 11bp.

This trade is particularly attractive because it is not strongly correlated with the level of rates offshore.

Figure 5: Foreign banks have dearer fixed bonds


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FRN

is c

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>

Foreign Banks

Foreign banks have more mixed results



10

Key Views

United States

Tactical (<1 mth)

Strategic (>3 mths)

US politicians agreed to a last minute solution to raise the debt ceiling by $2.1tn and cut deficits by a similar amount over the next decade. The bill has passed the House of Representatives and should clear the senate. The deal averts a default because of a failure to raise the borrowing limit, but it may not be enough to prevent a downgrade to the AAA sovereign credit rating.

The Q2 GDP figures and revisions to prior quarters confirmed information from the ISM and payrolls reports that US growth is running at a slower pace than the market and Fed had anticipated earlier in the year. Recent Labour market data has also been weak. The FOMC officially ended QE2 in June, but continues to invest coupons and US policy remains highly stimulatory. Market speculation for QE3 could step up a notch if the data remains this soft.

We expect a stronger economic recovery to take hold later in 2011 and for bond yields to head higher as the situation becomes clearer. The Fed remains concerned about the slow recovery in the labour market and the low level of (underlying) inflation. We expect the Fed to first stop investing coupons March 2012. Later, once the Fed starts raising the Fed Funds rate, we see room for the curve to flatten markedly as US 10yrs push toward 3.5% this year and 4.0% in 2012.

Policy rate 0.1% 0.1%

10yr bond 3.00% 3.50%

2/10 curve 260bp 250bp

USD/JPY 80.00 82.00

EUR/USD 1.39 1.47

Now that the ECB has delivered its telegraphed interest rate hike, markets are likely to focus on burgeoning public debt in Europe and the US. Market concern has shifted from the smaller economies to Italy. Given Italy’s size – it is the third largest economy in the Eurozone – we see potential for EUR to retreat below 1.40. But we think that the fundamentals will eventually win out. Based on our prediction that volatility will eventually settle down and the ECB will lift its policy interest rate further this year to 1.75%, we still expect EUR to recover, though the odds of EUR reaching our end-September forecast of 1.50 is lengthening slightly.

Australia

Tactical (<1 mth)

Strategic (>3 mths)

Australia’s economy remains in robust health on a medium term outlook. The most recent Employment data was better, but Retail Sales remain mediocre (non-discretionary spending is better) and sentiment has weakened considerably. RBA officials have reiterated the ‘rates move higher’ since the May forecasts, but this week’s statement acknowledged downside risks. Our Economists have pushed out the time of the first forecast rate hike to November. The Government’s Carbon Plan is marginally stimulatory as there is overcompensation. The RBA will likely look though the initial CPI effect, but might react if it sees any second round CPI effects. There will be some impact on ZCS and inflation markets, but little economic effect.

We see the fundamental strength exerted by high commodity prices and booming investment as dominating over the year and pushing the RBA to eventually tighten policy over the course of 2011-13. Our bias is toward a flatter curve over time. Australian spreads to US should narrow slowly in 2011 before tightening quickly when the Fed starts to raise rates in 2012.

The AUD has recently shown a degree of resilience to the ongoing public debt issues in Europe. But the spread of concern about European public debt to Italy raises the odds for a period of softness in the AUD in the near term as risk aversion dominates markets. However, the soft US economy, relatively contained volatility, and Australia’s economic out-performance should continue to support the AUD. When coupled with a return to broad USD weakness, we expect the AUD to head above 1.08 in coming months.


10yr bond 5.20% 5.30%

3/10 curve 60bp 40bp

10yr EFP 60bp 60bp

10yr v US 200 200

AUD/USD 1.0500 1.0800

New Zealand

Tactical (<1 mth)

Strategic (>3 mths)

The NZ economy is starting to recover after the Christchurch earthquake. The Q1 GDP figures were surprisingly strong and the Q2 CPI figures higher than expected. We believe the RBNZ will commence raising rates in December 2011. Nonetheless, the destruction in Christchurch is considerable and the recovery will be a very long, slow one.

The NZD continues to set post-float records vis-à-vis the USD. With Eurozone debt issues not severely undermining the outlook for global growth, we expect the NZD to stay around 0.85 over coming months assisted by insurance repatriation flows, firm agricultural prices and expected RBNZ rate hikes. The significant rebuild of Christchurch and the upcoming Rugby World Cup should compound current economic momentum. New Zealand’s economic recovery, firm commodity prices and continued export growth should maintain the recent NZD strength. By contrast, we expect AUD/NZD to lift more in line with the 2-year bond spread to reflect the risks of an increase by the RBA, but then decline again into year-end as the RBNZ tightening cycle begins.


10yr bond 5.50% 5.80%

2/10 swap curve

210bp 200bp

10yr v US 210 200

10yr v AUS -10bp 0bp

NZD/USD 0.3200 0.8800

AUD/NZD 1.2800 1.2100



11

\\\

Cash Rate Pricing

Source: All data sourced from Bloomberg. Rates displayed are calculated using IB Futures (Australia), FF Futures (US) and OIS in all other currencies.

Australian Cash Rate Pricing New Zealand OCR Pricing US Fed Funds PricingCum. % chance Cum. % chance Cum. % chance

Rate of +25bp Rate of +25bp Rate of +25bpCurrent 4.75 0 Current 2.50 0 Current 0.15 06-Sep-11 4.62 -54 15-Sep-11 2.76 106 9-Aug-11 0.11 -174-Oct-11 4.42 -133 27-Oct-11 2.83 133 20-Sep-11 0.13 -101-Nov-11 4.27 -192 8-Dec-11 2.94 174 2-Nov-11 0.13 -86-Dec-11 4.22 -210 26-Jan-12 2.91 163 13-Dec-11 0.14 -57-Feb-12 4.11 -257 8-Mar-12 3.07 227 25-Jan-12 0.16 46-Mar-12 4.07 -272 26-Apr-12 3.20 278 13-Mar-12 0.17 73-Apr-12 4.04 -285 14-Jun-12 3.19 275 25-Apr-12 0.18 121-May-12 4.03 -288 3-Aug-12 3.22 288 20-Jun-12 0.19 175-Jun-12 4.01 -295 15-Sep-12 3.22 288 31-Jul-12 0.20 22

Candian Rate Pricing EUR EONIA Pricing UK SONIA PricingCum. % chance Cum. % chance Cum. % chance

Rate of +25bp Rate of +25bp Rate of +25bpCurrent 0.99 0 Current Target 1.50 Current 0.52 07-Sep-11 1.03 18 4-Aug-11 1.17 -133 4-Aug-11 0.52 025-Oct-11 1.04 20 8-Sep-11 1.16 -138 8-Sep-11 0.53 16-Dec-11 1.07 35 6-Oct-11 1.16 -136 6-Oct-11 0.52 -118-Jan-12 1.06 31 3-Nov-11 1.17 -132 10-Nov-11 0.62 3929-Feb-12 1.15 65 8-Dec-11 1.21 -115 8-Dec-11 0.45 -3011-Apr-12 1.13 59 12-Jan-12 1.20 -121 5-Jan-12 0.52 -1

9-Feb-12 1.20 -122 8-Mar-12 0.55 117-Feb-13 1.22 -111 5-Apr-12 0.59 26

7-Mar-13 1.22 -111 10-May-12 0.57 19

3.60

3.80

4.00

4.20

4.40

4.60

4.80

5.00

Aug Oct Dec Feb Apr Jun Aug

AUD Implied Cash Rate

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50


NZD Implied Cash Rate

0.00

0.05

0.10

0.15

0.20

0.25


USD Implied Cash Rate

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40


CAD Implied Cash Rate

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70


GBP Implied Cash Rate

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40


EUR Implied Cash Rate



12

CBA Forecasts:

Cash rate 3-Aug Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 0.25 0.25 0.25 0.25 0.50 1.00 1.50Australia 4.75 4.75 5.00 5.25 5.25 5.50 5.50New Zealand 2.50 3.00 3.00 3.50 4.00 4.50 4.50United Kingdom 0.50 0.50 0.50 0.50 0.75 1.00 1.25Eurozone 1.50 1.50 1.75 2.00 2.00 2.25 2.25China 6.31 6.56 6.56 6.56 6.81 6.81 7.06Japan 0.10 0.10 0.10 0.10 0.10 0.10 0.102-yr bond yield 3-Aug Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 0.32 0.60 1.10 1.40 1.70 2.00 2.30Australia 4.09 4.50 4.90 5.40 5.55 5.70 5.80New Zealand 3.39 3.40 3.70 4.00 4.20 4.40 4.60United Kingdom 0.61 1.00 1.20 1.40 1.70 2.00 2.20Eurozone 1.02 1.90 2.20 2.40 2.60 2.80 2.80Japan 0.15 0.25 0.25 0.30 0.35 0.40 0.4010-yr bond yield 3-Aug Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12US 2.58 3.20 3.50 3.60 3.70 3.80 3.90Australia 4.63 5.20 5.50 5.55 5.60 5.60 5.65New Zealand 4.75 5.20 5.30 5.40 5.50 5.60 5.60United Kingdom 2.73 3.40 3.50 3.60 3.80 4.00 4.20Eurozone 2.36 3.30 3.60 3.80 3.90 4.00 4.00Japan 1.02 1.25 1.30 1.40 1.40 1.50 1.50

Currencies 3-Aug Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12AUD/USD 1.07 1.08 1.04 1.02 0.97 0.95 0.95AUD/JPY 82.84 86.40 85.28 84.66 82.45 83.60 85.50AUD/EUR 0.76 0.72 0.71 0.71 0.70 0.70 0.68AUD/GBP 0.66 0.65 0.64 0.62 0.61 0.60 0.59

AUD/CAD 1.03 1.03 1.02 1.02 1.02 1.01 1.01AUD/NZD 1.25 1.27 1.27 1.28 1.28 1.27 1.27USD/JPY 77.11 80.00 82.00 83.00 85.00 88.00 90.00EUR/USD 1.42 1.50 1.47 1.43 1.38 1.35 1.40

GBP/USD 1.63 1.67 1.63 1.64 1.60 1.58 1.62USD/CAD 0.96 0.95 0.98 1.00 1.05 1.06 1.06NZD/USD 0.86 0.85 0.82 0.80 0.76 0.75 0.75



13

Calendar – August 2011

Note: Figures in brackets represent previous result (if available). All information is preliminary and subject to revision. Chief Economist: Michael Blythe ph: 9118-1101 Economist: James McIntyre: 9118-1100

Monday Tuesday Wednesday Thursday Friday1 2 3 4 5

AU NSW & ACT Bank holiday AU ABS House price indexes, QII, AU CBA/Ai-Group Perf of Serv Index, Jul, (48.5) NZ Emp Growth/Unemp Rate, QII, AU Ai-Group PCI, Jul, Index, (35.8)AU AI-Group PMI, Jul, Index, (52.9) AU Trade balance Jun, $bn, 2.6, (2.3) AU Retail trade, Jun, m%ch, 0.5, (-0.6) EU ECB announces int. rate, %, 1.50, (1.50) AU RBA Statement on Monetary Policy AU HIA new home sales Jun, m%ch, (-0.2) AU Build approv, Jun, m%ch, 4, (-7.9) AU Retail sales ex inflation, QII, q%ch, 0.4 (0.0) GE Factory orders, Jun, m/y%ch, (1.8/12.2) JP Leading / Coincident index CI, Jun, (99.6/106.3)CH PMI Manufacturing, Jul, Index, (50.9) AU RBA cash rate, %, 4.75, (4.75) CH Non-Manuf PMI Jul, Index, (57) UK BoE announces rates, %, 0.50, (0.50) JP BoJ target rate, %, 0-0.10, (0-0.10)JP Vehicle sales, Jul, y%ch, (-0.233) NZ Avg Hourly Earnings, QII, EU PMI services/composite, Jul, Index, (51.4/50.8) UK New car registrations, Jul, y%ch, (-6.2) UK PPI Input/Output/core, Jul, y%ch, (17.0/5.7/3.2)EU/GE/UK PMI manufacturing, Jul, Index, (50.4/52.1/51.3) EU PPI, Jun, m/y%ch, (-0.2/6.2) EU Retail sales, Jun, m/y%ch, (-1.1/-1.9) US Non-farm payrolls, Jul, '000, (18)US Construction spending, Jun, m%ch, (-0.6) UK PMI construction, Jul, Index, (53.6) GE/UK PMI services, Jul, Index, (52.9/53.9) US Unemployment rate, Jul, %, (9.2)US ISM manufacturing, Jul, Index, (55.3) US Personal income/spending, Jun, m%ch, (0.3/0.0) US ISM non-manufacturing, Jul, Index, (53.3) US Avg hrly earnings, Jul, m/y%ch, (0.0/1.9)

US PCE deflator/core, Jun, y%ch, (2.5/1.2) US Factory orders, Jun, m%ch, (0.8) US Consumer credit, Jun, $bn, (5.1)US Total vehicle sales, Jul, mn, (11.41) CA Net change in employment, Jul, '000, (28.4)

8 9 10 11 12AU TD inflat gauge Jul, m/y%ch, (0.0/2.9) AU Housing finance, Jun AU MI/WBC Consumer Sent, Aug, Index, (92.8) AU MI Consumer Inflation Exp., Aug, %, (3.4) NZ Retail sales ex inflation, QII, q%ch, (0.9)AU ANZ Job ads, Jul, m%ch, (3.7) No. of own-occupiers, %, 2.0, (4.4) AU Lending finance, Jul, AU MI Unemp. Exp., Aug, Index, (132.4) JP Industrial production, Jun, y/y%chJP Curr a/c total/adjusted, Jun, ¥bn, (590.7/391.0) Value of all loans, %, 2.0, (2.2) CH Trade balance Jul, US$bn, (22.3) AU Labour force, July JP Capacity utilisation, Jun, m%ch, (12.8)JP Trade balance - BOP basis, Jun, ¥bn, (-772.7) AU NAB Bus conf/cond, Jul, Index, (0/2) JP Housing loans, QII, y%ch, (2.7) employment, '000, 15, (23.4) EU Industrial production Jun, m/y%ch, (0.1/4.0)

NZ Credit card spending, Jul, m%ch, (0.8) JP Domestic CGPI, Jul, m/y%ch, (-0.1/2.5) unemployment rate, %, 4.9, (4.9) US Retail sales, Jul, m%ch, (0.1)CH PPI/CPI, Jul, y%ch, (7.1/6.4) GE CPI, Jul, participation rate, %, 65.6, (65.6) US Uni. Of Michigan confidence, Aug, IndexCH Industrial production, Jul, y%ch, (15.1) UK Bank of England Inflation Report NZ Business PMI, Jul, Index, (54.3) US Business inventories, Jun, m%ch, (1.0)CH Retail sales, Jul, y%ch, (17.7) US Wholesale inventories, Jun, m%ch, (1.8) JP Machine orders, Jun, m/y%ch, (3.0/10.5)JP Machine tool orders, Jul, y%ch, (53.5) EU ECB Monthly report UK Industrial production, Jun, m/y%ch, (0.9/-0.8) US Trade balance, Jun, $bn, (-50.2)US FOMC rate decision, %, 0-¼, (0-¼) CA Housing price index, Jun, m/y%ch, (0.4/1.9)CA Housing starts, Jul, '000, (197.4) CA Trade balance Jun, C$, (-0.8)

15 16 17 18 19AU Motor veh. sales, Jul, m/y%ch, (1.3/-11.5) AU RBA Board Minutes, AU DEWR skilled vacancies, Jul, AU AWE May, q/y%ch, 0.9/3.9 (1.0/3.8) NZ Visitor arrivals, Jul,NZ PSI, Jul, Index, (54.7) EU GDP, QII, q/y%ch, (0.8/2.5) AU WPI QII, q/y%ch, 1.0/4.0 (0.8/3.8) JP Trade bal total/adj, Jul, ¥bn, (70.7/-191.2) NZ Credit card spending, Jul, m/y%ch, (0.4/4.5)JP GDP, QII, q%ch, (-0.9) EU Trade balance Jun, €bn, (-0.6) NZ Producer prices, in/outputs, QII, EU Construction output, Jun, m/y%ch, (-1.1/-1.9) GE Producer prices, Jul, m/y%ch, (0.1/5.6)US Empire manufacturing, Aug, Index, (-3.76) GE GDP, QII, q/y%ch, (1.5/3.1) EU Current account, Jun, €bn, (-5.2) UK Retail sales, Jul, m/y%ch, (0.7/0.4) CA CPI, Jul, m/y%ch, (-0.7/3.1)US NAHB housing market index, Aug, (15) UK CPI, Jul, m/y%ch, (-0.1/4.2); core, y%ch, (2.8) EU CPI, Jul, m/y%ch, (0.0/2.7); core, y%ch, (1.6) US CPI, Jul, m/y%ch, (-0.2/3.6); core, m/y%ch, (0.3/1.6)

US Import price index, Jul, m/y%ch, (-0.5/13.6) UK Bank of England minutes US Leading indicators, Jul, m%ch, (0.3)US Housing starts, Jul, '000, (629) UK ILO unemployment rate (3mths), Jun, %, (7.7) US Philadelphia Fed, Aug, Index, (3.2)US Building permits, Jul, '000, (624) US Producer price index Jul, m/y%ch, (-0.4/7.0) US Existing home sales, Jul, mn/m%ch, (4.77/-0.8)US Industrial production, Jul, m%ch, (0.2) CA Leading indicators, Jul, m%ch, (0.2)US Capacity utilisation, Jul, %, (76.7) CA Wholesale sales, Jun, m%ch, (1.9)

22 23 24 25 26AU Government Financial Estimates, 2011-12 AU Prelim. construction work done, QII, q%ch, AU HIA Housing Affordability Index, QII, (55.7) JP CPI, Jul, JP Machine tool orders, Jul, NZ Trade balance, Jul, NZ Food prices, Jul, m%ch, (1.4) GE Retail sales, Jul,EU/GE ZEW survey (econ. sentiment), Aug, (-7/-15.1) EU Industrial new orders, Jun, m/y%ch, (3.6/15.5) UK Total bus investment, QII, q/y%ch, (-3.2/2.7)US New home sales, Jul, GE IFO - Business climate, Aug, Index, (112.9) US GDP, QII, q%chsaar, (1.9)CA Retail sales, Jun, m%ch, (0.1) US Durable goodes orders, Jul, US Uni. Of Michigan confidence, Aug, Index

29 30 31 Early September Central Bank MeetingsAU HIA new home sales Jul, AU Build approvals, Jul AU RP Data house prices, Jul, AU Capex, QII (1 Sep) AU RBA (2 Aug)GE CPI, Aug, NZ Building permits, Jul, AU Private sector credit, Jul, AU Retail trade, July (1 Sep) UK BoE (4 Aug)US Personal income/spending, Jul, JP Retail sales, Jul, NZ NBNZ Business confidence, Aug, Index AU RBA cash rate decision (2 Sep) EU ECB (5 Aug)US PCE deflator/core, Jul, UK Net consumer credit, Jul, JP Industrial production/vehicle production, Jul, AU Business Indicators, QII, (5 Sep) JP BoJ (5 Aug)US Pending home sales, Jul, US S&P/Case-Shiller home price ind., Jun, JP Construction orders/housing starts, Jul, AU Balance of Payments, QII (6 Sep) US FOMC (10 Aug)US Dallas Fed, Aug, Index US FOMC Minutes UK GfK consumer confidence survey, Aug, Index AU Government Finance Statistics, QII (6 Sep) CA BoC (7 Sep)

CA Current account, QII, C$bn, (-8.9) US Factory orders, Jul, AU Housing finance, Jul (6 Sep) NZ RBNZ (15 Sep)CA GDP, QII, q%chsaar, (3.9) AU GDP, QII (7 Sep)CA Teranet House Prices, Jun, AU Labour force, Aug (8 Sep)



14

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