In my piece last week, I argued that this year would likely be a better year than 2011. 2011 was characterised by a number of natural disasters (floods in Australia, earthquakes in Japan and NZ) and we were smashed around by politics on both side of the Atlantic. Not to mention the constant fear of a US double dip.
The political shenanigans I’m sure will continue and Europe will remain a cause of angst for the market – as we’ve just seen with S&P’s downgrade of nine European nations and renewed market turmoil over Greece (see SCOREBOARD: Year of the bond sell-off, January 11).
But otherwise, for 2012 to be like 2011 you need to think that we will be hit by a similar number of events and events of a similar magnitude. Europe would actually need to implode, and I think the market’s comparatively muted reaction to S&P’s downgrade shows this. Talking about it is no longer good enough to illicit market carnage it seems. While I’m sure it could happen – it’s not improbable – on the balance of probability it is unlikely, and we’ve seen significant steps toward a stabilisation in Europe following the ECB’s first 3-year LTRO and moves to cheapen US dollar through forex swap lines. Similarly, fears of a US double dip have receded markedly given the recent data flow. Consequently we’ve seen an easing in some leading market stress indicators (see chart below).
It’s difficult in this environment to formulate a strong market view – and moves were certainly punishing last year. But I do think, given the above, that some of the anomalies that developed through the year may unwind to some extent. Not completely, and there are very good reasons why they will remain. But, on balance, I’m not looking for them to extend on a sustained basis, given some of the unique characteristics of 2011 and the policy steps mentioned above.
Aussie semis, for instance, look attractive in this space. Through much of 2011, spreads to ACGB and swap blew out – part of the generalised ‘risk off’ trade and also a function of the market’s liquidity preference. Semis have been viewed through the credit prism rather than the sovereign, so foreign real money accounts have shown less interest than you would otherwise expect.
Domestic balance sheets in contrast have been stronger buyers, taking up nearly all new issuance over the last year, fuelled by tier 1 capital requirements and the fact they are comparatively cheap to ACGB.
Demand from domestic balance sheets will likely remain strong given said capital requirements and the fact they are still cheap to ACGB and swap. I think the spread compression will be driven more by a switch out of ACGB to semis by foreign real money accounts, as the preference for liquidity that we saw in 2011 gives way to a preference for yield – solid demand at recent European debt auctions highlights this. Obviously ACGB will themselves still benefit enormously from this flow, in comparison to other sovereigns, and are set to be a key outperformer through 2012 on a relative basis.
The key issue will be Europe and whether the tentative stabilisation that we have seen thus far remains in train. Key signposts remain ‘club med’ spreads to bunds, euro/US dollar basis and the usual spread of volatility indicators.
More broadly I’m looking for the Aussie yield curve to flatten though the first half of 2012. Predominantly this is based on my RBA view – which I will go into next week. For now, it’s sufficient to note that I’m not looking for the RBA to cut as much as priced by the OIS curve. OIS has a cash rate of 3.25 per cent by mid-year which I think is inconsistent with the current dataflow and a reflection of only one, lower probability outcome – Europe imploding. So I suspect the curve will bear-flatten for the first half of year, then steepen as it becomes clear the RBA are on hold, even as inflation and global growth surprise on the upside.
If I’m right on this front, we should see EFP continue to come in somewhat – with especially good value mid-curve. My expected backdrop for 2012 and view that the search for yield will pick up this year, should mean lower volatility vis-a-vis 2011. I’m not saying no volatility and I reasonably expect it to be higher relative to history – Europe isn’t going away. But investors look to have become a little desensitised to some of the news flow. Thought of another way, there is a lot of pessimism priced in; it’s been priced in for a long time. Now it is time to deliver, otherwise we’ll see some of this pessimism unwind.
For real money managers it probably won’t do to lose money this year. 2012 has to be about making money. Certainly some of the volatility indicators have dropped off of late – the VIX index has more than halved since its peaks in August and October. Similarly, we’ve been seeing some decent selling pressure in the Aussie swaptions market over the last week which is another indicator that risk has subsided somewhat.
A key head-wind to this spread compression is commercial bank bond issuance and what looks to be increased mortgage fixing interest. At this stage though, and given the already elevated spread, I don’t think these will be sufficient to provide more than just a partial offset. The most marked impact of this will likely be a continued bid for Aussie basis, from 5-years out.
Lots of ifs and buts for this view I can appreciate, and I’ll update it as time goes on – paying particular attention to some of those stress indicators to see how the view is tracking.
Adam Carr is senior economist at ICAP Australia. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.
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