Westpac: What Is Driving The AU-US 10yr Bond Spread?

Westpac note that "in recent weeks the AU-US 10yr bond spread has both widened and narrowed within a relatively tight range. The tight range is perhaps not unexpected given the fact that both countries have lowered their respective cash rates to their effective lower bound and there is not change to the current policy settings likely for the foreseeable future. While the cash rates are the same it is definitely correct to price the AU bond yield above its US counterpart as Australia is a small open economy with a savings deficit that needs to attract capital. Thus far this extra margin has not risen above the 30-35bp region despite a significant AOFM issuance programme. We think that will remain the upper end of the range for now, with the 20bp level likely to be near the lower end. The effective cash differential will help with assessing timing within the range. There has been a major shift in the relative components since the pandemic struck. Noticeably, the real yield spread has widened while the inflation differential has narrowed. We would not expect this to shift much near term. The major influence is the ongoing rise in the AUD/USD since its lows at the beginning of the year. Our economics team now expect AUD/USD to be at $0.75 by the end of 2020 and $0.80 by end 2021. This would historically be associated with a wider bond spread. However, with no shift in monetary policy likely, the relationship is not likely to be as strong near term."