The delivery of rate cuts would see rates fall further, particularly in the belly of the curve. ANZ Research sees a risk of lower long-end rates and a flatter curve at the fully priced front end is unlikely to see yields drop significantly more than current pricing.
We see the curve continuing to flatten in the sub 5-year sector. Over the next few months, we can see yields falling further in the 3 to 5-year area, while the sub 3-year sector will be driven by policy rate expectations, the level of the $A and the economic data.
For borrowers, we see little likelihood of a significant rise in short term yields notwithstanding the likelihood of tighter US monetary policy.
The Australian long end wrong-footed market expectations during 2014. Instead of a significant sell-off as quantitative easing (QE) was unwound, monetary policy came closer to normalisation, US gross domestic product rebounded and employment grew, yields fell sharply and hit record lows.
The factors that drove yields lower across the year were varied. On the economic front, wages remain soft despite better US growth and employment, EM concerns pushed the investor market back to the core rates markets, the Bank of Japan increased its QE program and a soft European underbelly has dragged the European Central Bank closer to implementing a QE in 2015.
Inflation globally is well contained and the sharp fall in commodity prices, oil, iron ore, coal and metals as supply hit the market have anchored or lowered inflation expectations. Borrowers were able to issue a significant amount of debt, with no ill effects felt on the supply front as investors scrambled for fixed income assets.
Most importantly, some of these factors persist as we commence 2015. The ECB is yet to deliver QE, but yields continue to fall in Europe. The global inflation pulse has remained benign, with some concerns that the commodity price falls will drive inflation expectations to fall. Demand for fixed income assets from investors is competing with the needs for regulatory or liability hedging, which at worst as capping yields and potentially could drive them lower.
An interesting development of late has been the widening in the domestic basis, which was quite pronounced over the last quarter and is likely to remain elevated in the early part of 2015.
This is a by-product of the introduction of new liquidity rules in Australia as well as the issuance of short term debt. The higher cost of issuing short-term debt for banks has pushed issuance out the curve to the 6 and 12-month maturities, steepening the bank bill curve.
This has pushed the spread of bank bill swap rates to overnight index swaps wider, and the spread steeper as shown in the chart below. Normally, such a move has been driven by credit events, but as global credit spreads have remained at the tighter end of ranges it has been the regulatory aspects that have driven the move.
Martin Whetton is a senior AUD Rates Strategist at ANZ.