australia rates strategy

8/2/2019 Australia Rates Strategy

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Macro Commodities Forex Rates Equity Credit Derivatives

Please see disclaimer and disclosures at the end of this document

30 March 2012

Fixed IncomeSpecial comment

Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independentinvestment research as referred to in MiFID and that it should be treated as a marketing communication even if it contains a research recommendation.This publication is also not subject to any prohibition on dealing ahead of the dissemination of investment research. However, SG is required to havepolicies to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.

AUD Rates Strategy [email protected]

Key points:Policymaker statements highlighting the need of a

budget surplus by FY2012-13 are very questionable

from an economic perspective and are akin to

believing in the existence of a confidence fairy.

If the surplus goal is pursued at all costs expect lower

than forecast growth and inflation, lower RBA cash

rates, low ACGB yields and wide EFPs as result.

Australia: A Surplus Fetish Swanny, what are you doing??!!

Australias Deputy Prime Minister and Treasurer Hon.Wayne Swan (aka@SwannyDPMon Twitter) has reaffirmedhis commitment to return the Federal budget to a surplusof AUD1.5bn in the 2012-13 financial year. In a speech toAustralia Business Economists (ABE) Mr. Swan called

accusations that the budget surplus was a political strategyrubbish. This is on reflection that flexibility provided bythe previous budget surpluses allowed for a swift fiscal

response in the aftermath of the 2008 financial crisis (GFC).

In Mr Swans own words you can't be a Keynesian on theway down, but not on the way back up.By this he means

that given the governments expectation of a capex boom

towards 2012-13 it is appropriate for government to step

out of the way. However, various elements of his speech

are a contradiction to his own thesis that the Federal

surplus makes so much sense. In our view, from amacroeconomic perspective a return surplus quicklydoesnt make that much sense and could prove a self-inflicted wound to Australias economic performance.Graph 1: GDP and tax receipt estimates comparison of2008-09 Budget to 2011-12 MYEFO

Source: Australia Treasury

Graph1 borrows from Mr. Swans presentation to ABE

comparing projections of GDP and tax receipts projections

from the 2008-09 FY budget and the most recent 2011-12

Mid-Year Economic and Fiscal Outlook (MYEFO.) As the

graph shows, Treasury has been very accurate in its GDP

projections but their tax receipts forecasts have been

widely off the mark for prolonged periods of time.

A basic lesson is that macroeconomic forecasting is a

difficult exercise. A second observation is that a reason

why GDP forecasts have been so much better than tax

receipts projections is that the latter are a control variable

which can be changed so that GDP growth targets can be

more easily achieved. Assuming the expected capex boomwill fill Federal coffers with enough revenue to offsetspending cuts could be a case of counting your chickensbefore they are hatched.We have been worried at the degree of slippage onAustralian Federal budget given persistent claims of areturn to surplus in FY 2012-13. As of the latest monthlybudgetfigures, there has been some progress towards thesurplus goal driven by some gains in tax revenues but amid

what looks like sharp reductions in government spending

after seasonality is taken into account. Our observation isthat, as the cumulative headline deficit has already reachedAUD 32.6bn by January 2012, it seems difficult that the2011-12 MYEFOtargetsare achievable.Graph 2: Government Budget monthly statistics indicate aslow move towards Federal surplus

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Bal ance (3M SAAR) T otal Ex penditur e ( SA) To tal Rev enue (SA)

Source: RBA and SG Cross Asset Research calculations

The slippage observed on monthly budget statistics seems

consistent with the apparent degree of over-issuance of

Australian Commonwealth Government Bonds (ACGBs) by

the Australian Office of Financial Management (AOFM).

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Fixed Income Special report

30 March 20122

As of the latest AOFMupdateon the issuance program on

20 March gross issuance of ACGBs in FY2011-12 is

expected to be around $53 billion. After accounting for

maturities of $14 billion this represents net issuance of $39billion. This is already an AUD6bn upward revision from

the AUD 33bn original net issuance target.

Our seasonality analysis suggests there could be anotherrevision higher in net ACGB issuances. At the current paceof gross issuances the net amount offered could be about

AUD45bn by end FY2011-12. If the most recent AUD39bn

target is to be achieved monthly gross issuances need to

be more than halved to about AUD2bn from a monthly

average of AUD5.1bn so far in FY2011-12. A fundingrequirement of the magnitude observed in FY2011-12signals that Mr. Swans budget surplus target is a hugemountain to climb in FY2012-13.Graph 3: Gross and net issuance of ACGBs (AUD Bn)

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ACGB Issuance (AUD bn, SA) Net issuance (AUD Bn, 12M roll ing rhs)

Source: AOFM and SG Cross Asset Research calculations

Surplus as make-up brand: Because I am worth itA natural question given the current position of theAustralian budget is whether a return to a surplus inFY2012-13 is worth the effort. Australian PM Julia Gillardseems to believe so and said in a recentinterviewthat the

economic imperative is to bring the budget to surplus, thatwill lock in the confidence we need for the future. Suchtalk suggests she subscribes to some version of what is

commonly known as the confidence fairy theory.

The reason for this name goes back to Alfred Marshalls

belief that confidence (in this case presumably coming

from the Australian government cutting spending) would

touch all industries with her magic wand. Practical

experience of this theory of sharply cutting government

spending in a downturn proved disastrous in Europe as

the IMF nowacknowledgesand is a significant reason for

economic growth underperformance in the UK according

to BoE board member Adam Posen.

A more reasonable understanding of the purpose of abudget surplus comes from the definition of agovernments intertemporal budget constraint:

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ii

ttit

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ierB

Equation (1) states that the stock of current public debt Bminus the present value of future primary budgetsurpluses1 between now some (infinite) time in the future

should be equal to zero for that government debt to be

credibly sustainable (no Ponzi scheme constraint).

Graph 4 shows that the Australian Federal budget

accumulated headline and primary surpluses through most

of the previous decade. These turned into deficits in the

aftermath of the GFC. At the current pace of improvementthe primary balance seems on a trajectory to naturally goback to surplus perhaps sometime in FY 2013-14.Graph 4: Headline and primary budget balances (AUD Bn)

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Headline Balance Primary Balance


Recent statements by Ms. Gillard and Mr. Swan imply thatthe next budget will contain sharp spending reductions toachieve a surplus in FY2012-13. We think this is overkill.What matters for fiscal credibility is equation (1). To

achieve this fiscal equilibrium a headline deficit in the

region of AUD 10-15bn would be more sufficient. Aheadline budget surplus would just cut the outstandinglevel of government debt and not make it more credible inany meaningful way. However, the stubbornness onmoving to a surplus will have an impact on aggregate

demand by reducing spending power depending on the

measures implemented on the budget.

A follow-up question is if there is any economic rationaleto reducing the stock of government debt. Many analystsseem to believe that government debt is an inherent evil

that constrains the growth of a virtuous private sector.

We disagree with that point of view: there is a role for

government debt in a modern, well-functioning economy.

The RBA and APRA seems to believe as much given the

privileged role they give to ACGBs on the path to

Implementing Basel III Liquidity Reforms in Australia.

1 A primary budget surplus is defined as equal to revenue r minusexpenditures e excluding interest payments on public debt i. These

surpluses are discounted to today using the rate paid on public debt y.

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30 March 2012 3

There is also sense that government debt should be lowin economies that have highly leveraged private sectors.The problem with applying this observation to Australia in

2012 is that its private sector is already undergoing adeleveraging process and does not need government

fiscal tightening to accelerate it further.

One way of seeing this was highlighted in the RBAs

Financial Stability Review. This shows that Australian

debt-to income ratios are falling as a result of a

persistently high household savings rate. The

consequence of this has been that bank deposit liability

growth is fast outstripping bank lending growth. This

caused Australian bank balance sheets to deleverage too

(loan/depo ratio is at a its lowest level since 1997).

Graph 5: Balance sheets already deleveraging, do notneed help from a Federal budget surplus

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Loan Growth Deposit Growth Loan/Depo Ratio (right)


A headline budget surplus will reduce the outstandingstock of ACGBs without any obvious economic benefitand could even hurt financial stability. Mr. Swan highlightsthe decline in household consumption growth as one

reason for lower than expected tax revenues. However,

additional government spending cuts could depress tax

revenue growth further as households could (optimally)

respond to fiscal tightening by saving even more. Even if

Mr. Swan is successful and the surplus is achieved this

could imply that in the absence of ACGBs to buy banksmay be forced to issue riskier loans just to match their fastdeposit liability growth. What market impact of the Australian surplus fetish?We believe that a forced return to a budget surplus

(regardless of economic conditions) could be a serious

policy error given the evolution of the Australian economy

post-GFC. One consequence of the surplus fetish couldbe that the RBA is forced to ease interest rates inresponse to weaker domestic demand as it signalled in itsmost recentpolicy statement.

After the last RBA meeting the AUD OIS curve is pricing inhigher probabilities of a rate cut at the April RBA meeting.We do not think this is because of weaker-than-expectedemployment data on 8 March but is likely the result of

increased concerns about Chinese growth and more

recently the insistence that a budget surplus is a goal that

should be achieved at all costs.

Graph 6: AUD OIS forwards price higher chances, largermagnitude of RBA Cash rate cuts since 21 March

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30-Mar-12 21-Mar-12 29-Feb-12

Source: Bloomberg and SG Cross Asset Research calculations

Such policy mix would also result in ACGB yieldsremaining low and swap spreads wide. This could be onereason why our macro models of the ACGB curve

persistently see 3y ACGB yields as too low (Graph 7)

relative to fundamentals. Our models could be failing to

capture fears of ACGB shortages if Mr. Swan decides to

go for surplus in FY2012-13. At the same time this means

that swaps spreads could remain wide reflecting a decline

in ACGB supply amid abundant liquidity result of high

domestic savings. As result we close our current short 5yEFPpositionat +80bpGraph 7: ACGB yields remain too low but this couldreflect expectations of a return to surplus at all costs.

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+1 Std Dev - 1 Std. Dev 3y ACGB Model

Source: SG Cross Asset Research calculations

If the purpose is protecting Australias AAA sovereignrating a return to surplus could be seen as the right goal.The UK seems to be following that very same strategy at

great cost to its population and not yet making its AAA

rating safe, according to recent agency statements. Wecaution on pursuing a budget surplus strategy withoutconsidering its broader impact to the Australian economy.

[email protected]

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AUD/USD: further decline expected AUD/USD - The lower end ofthe ST declining channel, whichcomes at 1.0255 today, and theJanuary rebound level of 1.0145should be the first major stepson the way to the 0.9390/0.9405region.Given the break below the1.0380/1.0400 support area, theAUD/USD is likely to extend thedecline initiated at 1.0855 in lateFebruary.

It should break below last weekslow of 1.0335, which is currentlybeing tested, and head towardsthe 0.9390/0.9405 region (*).

The lower end of the ST decliningchannel, which comes at 1.0255today, and the January reboundlevel of 1.0145 should be the firstmajor steps on the way.

(*) October 2011 low andpullback level.

Written at 12:30 GMT on 29March.

3rd support 2nd support 1st support Last 1st resistance 2nd resistance 3rd resistance1.0145 1.0230/55 1.0335 1.0345 1.0405 1.0460 1.0530

SFE 3yr bond to gain further ground SFE 3yr bond should rise to atleast the 96.740/820 resistancezone, with a step at 96.620.Following the upside breakout ofthe declining channel in whichthe SFE 3yr bond had beenmoving since mid-December, thebreach of the 96.500 resistancelevel (*) has strengthened the riseinitiated at 96.130 last week.

The SFE 3yr bond should rise toat least the 96.740/820resistance zone (**), with a stepat 96.620.

(*) Early March high andFibonacci retracement.(**) Gap opened on earlyFebruary.

Written at 14:00 GMT on 29March.

3rd support 2nd support 1st support Last 1st resistance 2nd resistance 3rd resistance96.240 96.340 96.410/440 96.510 96.620 96.740/820 96.900

[email protected]

1.0380/1.0400

DAILY CHART

0.9390/0.9405

1.0855

0.9665

0.9860

1.0670

WEEKLY CHART

97.090/180

96.500

96.740/820

96.130

ST declining channel

ST declining channel

1.0335

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30 March 2012

CROSS ASSET RESEARCH FIXED INCOME & FOREX GROUPSGlobal Head of ResearchPatrick Legland(33) 1 42 13 97 [email protected]

Head of Fixed Income StrategyVincent Chaigneau(33) 1 42 13 30 [email protected]

Alberto Brondolo Christian Carrillo Jean-David Cirotteau Wee-Khoon Chong(44) 20 7676 7510 (81) 3 5549 5626 (33) 1 42 13 72 52 (852) 2166 [email protected] [email protected] [email protected] [email protected]

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Takuma Sugawara Fidelio Tata Julian Wiseman81-3-5549-5432 (1) 212 278 6213 (44) 20 7676 7342

[email protected] [email protected] [email protected]

Head of Foreign ExchangeKit Juckes(44) 20 7676 [email protected]

David Deddouche Sbastien Galy Olivier Korber (Derivatives) Lauren Rosborough(33) 1 42 13 56 22 (1) 212 278 7644 (33) 1 42 13 32 88 (44) 20 7676 [email protected] [email protected] [email protected] [email protected]

Head of Emerging Markets StrategyBenot Anne(44) 20 7676 [email protected]

Galle Blanchard Esther Law Guillaume Salomon(44) 20 7676 7439 (44) 20 7676 7396 (44) 20 7676 [email protected] [email protected] [email protected]

Technical analysisHugues Naka Fabien Manach(33) 1 42 13 51 10 (33) 1 42 13 88 [email protected] [email protected]

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on disclosure of certain interests in securities.Notice to Hong Kong Investors: This report is distributed in Hong Kong by Socit Gnrale, Hong Kong Branch which is licensed by the Securities andFutures Commission of Hong Kong under the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) ("SFO"). This publication does notconstitute a solicitation or an offer of securities or an invitation to the public within the meaning of the SFO. This report is to be circulated only to"professional investors" as defined in the SFO.Notice to Japanese Investors: This publication is distributed in Japan by Societe Generale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated bythe Financial Services Agency of Japan. This publication is intended only for the Specified Investors, as defined by the Financial Instruments and Exchange

Law in Japan and only for those people to whom it is sent directly by Societe Generale Securities (North Pacific) Ltd., Tokyo Branch, and under nocircumstances should it be forwarded to any third party. The products mentioned in this report may not be eligible for sale in Japan and they may not besuitable for all types of investors.Notice to Australian Investors: This publication is issued in Australia by Socit Gnrale (ABN 71 092 516 286) ("SG"). SG is regulated by APRA and ASICand holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this publication is only directed torecipients who are wholesale clients as defined under the Act.

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