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Best AAA Debt Set for Longest Drop Since 2010: Australia Credit

November 21, 2012

Australian government bonds, the biggest gainers among AAA sovereigns for most of the year, are set for the first two-month slide since 2010 as inflation inhibits the central bank’s ability to cut interest rates.

The securities delivered a 0.5 percent loss since Sept. 30, poised for the biggest drop since the final three months of 2010, according to Bank of America Merrill Lynch data. The debt rose 6.1 percent in the first three quarters. The yield on benchmark 10-year debt has risen 20 basis points in October and November, while the U.S. rate climbed by 3.

Inflation pressures, fueled by the carbon tax brought in July 1 and a slowing in currency gains, prompted Reserve Bank of Australia Governor Glenn Stevens to say on Nov. 21 that it would be prudent to leave borrowing costs on hold. Steps to avert the U.S.’s so-called fiscal cliff and a financial crisis in Europe, combined with signs of stabilization in China have also led investors to shift from the safety of government debt.

“What’s priced into the short end of the bond market is now a lot more modest in terms of where rates are expected to gravitate to over the cycle,” said Steven Mansell, Sydney-based head of G-10 rates strategy for the Asia Pacific region at Citigroup Inc. Mansell said the U.S. will probably avoid an “Armageddon” scenario and that Australian yields will rise.

The extra premium investors demand to hold 10-year Australian notes instead of three-year debt widened to 56 basis points yesterday, the most since Nov. 1.

Stevens’s ‘Prudence’

The RBA’s Stevens said it was prudent to keep the nation’s benchmark unchanged “for the moment” as policy makers monitor the impact of 1.5 percentage points of reductions since November 2011 that took the key rate to 3.25 percent.

Overnight index swaps data compiled by Bloomberg indicate a 53 percent chance that the RBA will lower its benchmark to a record low 2.75 percent by April, down from an 82 percent probability seen at the end of September.

The odds of a quarter-point cut at the next meeting on Dec. 4 are 70 percent, the data show. Minutes of the November policy meeting indicated that board members considered more easing “may be appropriate in the period ahead.”

“They said further easing is possible, but they weren’t aggressive enough,” said Chungkeun Oh, who invests in Australian bonds for Industrial Bank of Korea (024110), South Korea’s largest lender to small- and medium-sized companies. “Yields will have a hard time going lower.”

Fiscal Cliff

Further rate reductions may become necessary should U.S. lawmakers fail to agree on a solution to avoid more than $600 billion in automatic spending cuts and tax increases that threaten to tip the world’s largest economy back into recession.

Fallout from Europe’s debt crisis also poses a risk, with disagreement over how to rescue the region’s most-indebted nations continuing even after the European Central Bank announced a plan for potentially unlimited bond purchases.

China’s situation appears to have stabilized. While annual gross domestic product growth dropped to 7.4 percent in the third quarter, the slowest pace since 2009, October data on exports, factory production and retail sales improved.

Inflation Pressures

In Australia, third-quarter consumer-price gains reached the most in six years, staying the RBA’s hand at its last meeting. Data released Oct. 24 showed the consumer price index climbed by 2 percent from a year earlier, while the trimmed mean measure of core inflation rose 2.4 percent and the weighted median gained 2.6 percent. The RBA aims to keep core inflation in a range of 2 percent to 3 percent.

Investors expect that consumer prices will climb at a rate of 2.65 percent over the next 10 years, according to yields on bonds linked to inflation.

The rate on 10-year bonds that aren’t indexed to inflation rose to 3.19 percent yesterday, its highest close since Oct. 26. The yield was 2.99 percent at the end of September.

The so-called real yield, or the return when adjusted for inflation, has declined to 1.19 percent, from a 2012 peak of 2.53 percent. The real rate on 10-year Treasuries is minus 0.52 percent, down from a positive 0.43 percent in August.

The gap between Australian 10-year yields and equivalent U.S. rates yesterday increased to 155 basis points, the highest since Sept. 19. The widening spread indicates domestic factors are influencing Australian yields not just the global environment, according to Su-Lin Ong, an economist and fixed- income strategist at Royal Bank of Canada in Sydney.

Gains to Losses

Australian government debt has handed investors a 0.1 percent loss this month and 0.4 percent in October, according to Bank of America data. In the first nine months, the debt beat that issued by Finland, which returned 5.5 percent.

Corporate debt in Australia has been a better bet for investors this quarter, with an index compiled by Bank of America showing a 1 percent return since Sept. 30. State government bonds, known as semi-governments, lost 0.3 percent.

“Within the Australian market, we see much more value away from Commonwealth government bonds in the short term,” said Robert Mead, Sydney-based head of portfolio management at Pacific Investment Management Co., which runs the world’s biggest bond fund. “Various parts of the Commonwealth curve are less attractive than interest-rate swaps, semi-government bonds and high-quality credit.”

Even so, Mead said sovereign yields are “essentially capped,” because of a rebalancing of China’s economy, an elevated Australian currency, tighter fiscal policy and the dwindling in the number of AAA sovereign markets.

“There’s a very balanced opinion in the market about the prospects for the RBA to ease rates further in the near term,” said Citigroup’s Mansell “The domestic economy’s doing quite well and the tail risk events globally, certainly in Europe and China, are now lower.”

To contact the reporter on this story: Benjamin Purvis in Sydney at

To contact the editor responsible for this story: Garfield Reynolds at

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