Stevens Inflation Forecast Seen too High by Bond Markets: Australia Credit

By Candice Zachariahs - Nov 6, 2011 8:00 PM GMT+0700

Australian inflation-linked bonds are signaling that gains in consumer prices may slow more than the central bank is expecting as an export boom peaks.

Yields on the securities show that traders reduced their forecast for annual inflation over the next five years by six basis points last week, the steepest decline since September, to 2.42 percent. At one point the debt implied a rate of 2.37 percent for inflation, the lowest in 14 months. That compares with the 1.83 percent indicated by similar bonds in the U.S.

The Reserve Bank of Australia, which cut interest rates last week for the first time in 2 1/2 years, may be too bullish in estimating that gross domestic product will expand 4 percent in the 12 months ending June 30, 2012, according to the bond market. Money-market securities show traders expect the RBA will lower what is still the highest benchmark rate among major developed economies by one percentage point within 12 months.

“Given what’s happening globally, the RBA rate cut and the fact that the economy hasn’t performed as well as some people thought, growth expectations are softer and that’s being reflected in real yields as well,” said Sally Auld, a Sydney- based interest-rate strategist at JPMorgan Chase & Co. “The RBA’s global growth forecasts look a little optimistic, and that translates through to the Australian growth figures as well.”

Linker Gains

Australian inflation-linked notes have generated 13.7 percent returns this year, outpacing the 10.5 percent offered by the rest of the nation’s government debt, Bank of America Merrill Lynch indexes show.

The RBA lowered its GDP forecast for the 12 months ending June 30, 2012, from a previous estimate of 4.5 percent made in August. It dropped inflation expectations to 2 percent for the same period and estimates consumer prices will climb 3.25 percent in the full year of 2012. The RBA previously forecast inflation of 2.5 percent through June next year and 3.5 percent for the whole of 2012.

The so-called breakeven rate on Australia’s five-year inflation debt remains the highest across eight developed markets tracked by Bloomberg, though the gap to the U.K.’s second-highest level has narrowed to seven basis points.

Central bank Governor Glenn Stevens said Nov. 1 after his first rate cut in 2 1/2 years that Europe’s debt crisis is spilling into Asia.

“The RBA is cutting because of the risks of what might happen, not because of what it thinks will happen,” said Sean Keane, an analyst in Auckland at financial advisory group Triple T Consulting and a former head of Asia-Pacific rates trading at Credit Suisse Group AG. “There’s no immediate trigger for further RBA rate cuts as the slowdown we are seeing in Australia is coming off reasonably strong levels.”

Bonds Rallying

Investors are seeking the safest securities, driving rallies in sovereign bonds from Australia, Germany and the U.S.

Euro-area finance ministers meet in Brussels today as more than one European Union government teeters on the brink. Greek Prime Minister George Papandreou, trying to preserve international aid before the nation runs out of money next month, has been striving to form a unity government.

His Italian counterpart Silvio Berlusconi also faces mounting pressure to step down as 10-year borrowing costs for the region’s third-biggest economy approach the 7 percent level that forced Greece, Ireland and Portugal to seek bailouts.

Australian Yields Drop

The yield on Australia’s benchmark 10-year government bond tumbled 23 basis points, or 0.23 percentage point, last week to 4.31 percent, the largest drop since Aug. 5. The longest- maturity bond, due April 2027, slid 24 basis points to 4.65 percent and is the nation’s only sovereign security to yield more than the RBA’s 4.5 percent benchmark.

Australia’s central bank cut its key rate after underlying inflation slowed to 0.3 percent in the three months ended Sept. 30, the weakest quarterly pace in 14 years. The overall consumer price index rose at a 3.5 percent annual rate, down from a 2 1/2-year high of 3.6 percent in the second quarter, a government report on Oct. 26 showed. Annual CPI gains have averaged 3.1 percent since 2000.

The implied yield on December interbank cash rate futures was 4.265 percent, indicating the market expects the central bank will cut rates again at its Dec. 6 meeting. The RBA will lower its benchmark by one percentage point within 12 months, the steepest reductions in the Group of 10 currencies, according to Credit Suisse Group AG indexes based on interest-rate swaps.

Real Yields

Australia’s target rate is still at least two percentage points higher than any other G-10 country. The RBA said last week its forecasts are based on an unchanged interest rate.

“There’s good demand for Australian inflation-linked debt as real yields here look quite high in a relative sense with negative rates on offer in some countries,” Auld said.

The yield on Australia’s inflation-linked note maturing in August 2015 was 1.34 percent last week, compared with negative 1.172 percent for the Treasury Inflation-Protected Security due in July 2015.

The Australian dollar fell 3 percent to $1.0375 in the five days ended Nov. 4, snapping four weeks of gains. The so-called Aussie, the world’s fifth-most traded currency, is down from $1.1081 on July 27, its strongest since exchange controls were scrapped in 1983.

Jobs Growth Slows

Australian employment weakened this year from record growth in 2010. Economists forecast the jobless rate climbed in October to match the highest level since a year earlier as the Aussie’s strength hurt tourism and manufacturing and concerns that Europe and the U.S. will fall back into recession undermined business confidence. The statistics bureau will say on Nov. 10 that the jobless rate rose to 5.3 percent, according to the median estimate in a Bloomberg News survey of strategists.

The chance of a significant acceleration in wage growth has lessened, the RBA said Nov. 4. Hiring has been fueled by a mining investment boom driven by China and India’s demand for iron ore, liquefied natural gas and coal, boosting prices for Australia’s resources, the central bank said.

‘Economic Uncertainty’

“The bank’s liaison suggests that the general increase in economic uncertainty has led some firms to wait for evidence of stronger demand before hiring additional workers,” the RBA said.

Australian government bonds returned 11 percent this year, trailing U.K., Swedish and New Zealand securities among 26 markets tracked by Bloomberg/EFFAS indexes. The debt gained from January through September in the longest monthly rally since 1997, a Bank of America Merrill Lynch index shows.

The cost of insuring Australian corporate debt climbed last week by the most since the five days ended Sept. 23 as Greek Prime Minister George Papandreou called for a referendum on accepting bailout terms and then stepped back from holding a vote after opposition from European counterparts.

The Markit iTraxx Australia index of credit-default swaps jumped 20 basis points to 176 basis points, according to data provider CMA, which is owned by CME Group Inc. and compiles prices in the privately negotiated market. The advance pared some of the index’s 51 basis-point drop in October to 166, the biggest monthly decline since July 2009.

Corporate Spreads

The extra yield investors demand to hold Australian corporate bonds instead of government debt widened 6 basis points last month to 247 basis points and reached 253 on Oct. 27, the highest since August 2009, Bank of America Merrill Lynch index data show.

The five-year Australian breakeven rate had reached a 4 1/2-year high of 3.14 percentage point in May as flooding in the nation’s northeast drove up food prices and surging revenue from a record mining boom spurred expectations that economic growth would accelerate.

“You’ve seen a re-pricing of the growth-inflation trade- off as investors start to focus on a subdued outlook globally and Australia is a part of that,” said Justin Tyler, a portfolio manager who helps manage A$4.3 billion in inflation- linked assets at Aberdeen Asset Management Ltd. in Sydney. “The RBA has acknowledged weakness in the non-mining sectors of the economy, perhaps more specifically than has been the case in the past statements.”

To contact the reporter on this story: Candice Zachariahs in Sydney at czachariahs2@bloomberg.net

To contact the editor responsible for this story: Rocky Swift at rswift5@bloomberg.net