Westpac: Can AU Rates Sustain Last Week’s Outperformance?

Westpac note that the “benchmark AU/U.S. 10-Year bond spread has exhibited remarkable volatility over the past fortnight, widening by 40bp then narrowing by around 30bp last week. Clearly a position squeeze was at work initially, although there is certainly a case to be made that the uncertainty around RBA messaging might have played its part. Also, with so much geopolitical and economic uncertainty at play, these are not the conditions that AU rates would tend to outperform in. Therefore, a greater risk premium needs to apply to make them attractive. However, what are the medium-term prospects? Clearly there is an opportunity if we are confident in our medium-term forecasts. What is behind the forecast? Historically, most of the risks to the longer maturity spreads have been captured by the AU/U.S. cash spread, and, while the post-pandemic world has a lot of contrasts to the prior years of the “great moderation”, the starting point for assessing cross-market value does still remain the expected evolution in the cash rates in each country. Our expectation that the RBA cash target will settle around 75bp below fed funds in 1 years’ time is very different to market pricing, which has AU pushing rates 25bp above the U.S. If we are right, then AU/U.S. spreads across the curve are currently way too wide. However, a word of caution is that the relationship between the cash and 10-Year spreads is not as linear as it used to be. That suggests the longer spread can remain wider than expected for some time, given the global risk environment and its implications for flows into the market near term.”