30 March 2012

Fixed Income
Special comment
Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independent investment 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 have policies to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.

AUD Rates Strategy Update

christian.carrillo@sgcib.com

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.

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 boom will fill Federal coffers with enough revenue to offset spending cuts could be a case of counting your chickens before they are hatched. We have been worried at the degree of slippage on Australian Federal budget given persistent claims of a return to surplus in FY 2012-13. As of the latest monthly budget figures, there has been some progress towards the surplus 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 is that, as the cumulative headline deficit has already reached AUD 32.6bn by January 2012, it seems difficult that the 2011-12 MYEFO targets are achievable. Graph 2: Government Budget monthly statistics indicate a slow move towards Federal surplus
60 40 30 20 35

Australia: A Surplus Fetish

Swanny, what are you doing??!! Australias Deputy Prime Minister and Treasurer Hon. Wayne Swan (aka @SwannyDPM on Twitter) has reaffirmed his commitment to return the Federal budget to a surplus of AUD1.5bn in the 2012-13 financial year. In a speech to Australia Business Economists (ABE) Mr. Swan called accusations that the budget surplus was a political strategy rubbish. This is on reflection that flexibility provided by the 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 the way 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 a macroeconomic perspective a return surplus quickly doesnt make that much sense and could prove a selfinflicted wound to Australias economic performance. Graph 1: GDP and tax receipt estimates comparison of 2008-09 Budget to 2011-12 MYEFO

0
-20 -40 -60

25

20

15
-80 -100 Jan-00 10 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10 Jan-12 Balance (3M SAAR) Total Expenditure (SA) Total Revenue (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).
Source: Australia Treasury

Macro

Commodities

Forex

Rates

Equity

Credit
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Please see disclaimer and disclosures at the end of this document

Fixed Income Special report

As of the latest AOFM update on 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 $39 billion. This is already an AUD6bn upward revision from the AUD 33bn original net issuance target. Our seasonality analysis suggests there could be another revision higher in net ACGB issuances. At the current pace of 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 funding requirement of the magnitude observed in FY2011-12 signals that Mr. Swans budget surplus target is a huge mountain to climb in FY2012-13. Graph 3: Gross and net issuance of ACGBs (AUD Bn)
9 8 7 6 5 4 3 2 1 Jun-08 60 55 50 45 40 35 30 25 20 15 10 5 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 0 Jun-12

Bt

rt i et 1 it 1 0 1 y i i 1

Equation (1) states that the stock of current public debt B minus the present value of future primary budget surpluses1 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 improvement the primary balance seems on a trajectory to naturally go back to surplus perhaps sometime in FY 2013-14. Graph 4: Headline and primary budget balances (AUD Bn)
50 40 50 40

30 20 10 0 -10 -20 -30 -40

-50 -60 -70

30 20 10 0 -10 -20 -30 -40

-50 -60 -70

-80 -80 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Headline Balance Primary Balance

ACGB Issuance (AUD bn, SA)

Net issuance (AUD Bn, 12M rolling rhs)

Source: RBA and SG Cross Asset Research calculations

Source: AOFM and SG Cross Asset Research calculations

Surplus as make-up brand: Because I am worth it A natural question given the current position of the Australian budget is whether a return to a surplus in FY2012-13 is worth the effort. Australian PM Julia Gillard seems to believe so and said in a recent interview that the economic imperative is to bring the budget to surplus, that will lock in the confidence we need for the future. Such talk 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 now acknowledges and 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 a budget surplus comes from the definition of a governments intertemporal budget constraint:

Recent statements by Ms. Gillard and Mr. Swan imply that the next budget will contain sharp spending reductions to achieve 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. A headline budget surplus would just cut the outstanding level of government debt and not make it more credible in any meaningful way. However, the stubbornness on moving 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 rationale to reducing the stock of government debt. Many analysts seem 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 minus expenditures 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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There is also sense that government debt should be low in 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 a deleveraging 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 not need help from a Federal budget surplus
35% 30% 1.30 25% 1.35

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, larger magnitude of RBA Cash rate cuts since 21 March
4.250 4.125 4.000

3.875
3.750 3.625 3.500 3.375 3.250 1 2 3 30-Mar-12 4 5 6 7 8 9 10 29-Feb-12 11 21-Mar-12

Source: Bloomberg and SG Cross Asset Research calculations

20%
15% 10% 5%

1.25

1.20

1.15
0% -5% Mar-02 1.10 Mar-12

Jun-03

Sep-04

Dec-05

Mar-07

Jun-08

Sep-09

Dec-10

Loan Growth

Deposit Growth

Loan/Depo Ratio (right)

Source: RBA and SG Cross Asset Research calculations

Such policy mix would also result in ACGB yields remaining low and swap spreads wide. This could be one reason 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 5y EFP position at +80bp Graph 7: ACGB yields remain too low but this could reflect expectations of a return to surplus at all costs.
7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5

A headline budget surplus will reduce the outstanding stock of ACGBs without any obvious economic benefit and could even hurt financial stability. Mr. Swan highlights the 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 banks may be forced to issue riskier loans just to match their fast deposit 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 could be that the RBA is forced to ease interest rates in response to weaker domestic demand as it signalled in its most recent policy statement. After the last RBA meeting the AUD OIS curve is pricing in higher probabilities of a rate cut at the April RBA meeting. We do not think this is because of weaker-than-expected employment data on 8 March but is likely the result of increased concerns about Chinese growth and more

2.0 2.0 Mar-03 Mar-04Mar-05Mar-06Mar-07 Mar-08Mar-09Mar-10Mar-11 Mar-12 Mar-13

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

Source: SG Cross Asset Research calculations

If the purpose is protecting Australias AAA sovereign rating 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. We caution on pursuing a budget surplus strategy without considering its broader impact to the Australian economy. christian.carrillo@sgcib.com

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AUD/USD: further decline expected

AUD/USD - The lower end of the ST declining channel, which comes at 1.0255 today, and the January rebound level of 1.0145 should be the first major steps on the way to the 0.9390/0.9405 region. Given the break below the 1.0380/1.0400 support area, the AUD/USD is likely to extend the decline initiated at 1.0855 in late February. It should break below last weeks low of 1.0335, which is currently being tested, and head towards the 0.9390/0.9405 region (*). The lower end of the ST declining channel, which comes at 1.0255 today, and the January rebound level of 1.0145 should be the first major steps on the way. (*) October 2011 pullback level. low and 0.9390/0.9405 0.9860 0.9665 1.0855 1.0670

1.0380/1.0400 1.0335 ST declining channel

DAILY CHART

Written at 12:30 GMT on 29 March.

3rd support

2nd support

1st support

Last

1st resistance

2nd resistance

3rd resistance

1.0145

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 at least the 96.740/820 resistance zone, with a step at 96.620. Following the upside breakout of the declining channel in which the SFE 3yr bond had been moving since mid-December, the breach of the 96.500 resistance level (*) has strengthened the rise initiated at 96.130 last week. The SFE 3yr bond should rise to at least the 96.740/820 resistance zone (**), with a step at 96.620. (*) Early March high and Fibonacci retracement. (**) Gap opened on early February. Written at 14:00 GMT on 29 March. 97.090/180

96.740/820 WEEKLY CHART 96.500

96.130

ST declining channel

3rd support

2nd support

1st support

Last

1st resistance

2nd resistance

3rd resistance

96.240

96.340

96.410/440

96.510

96.620

96.740/820

96.900

hugues.naka@sgcib.com

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CROSS ASSET RESEARCH FIXED INCOME & FOREX GROUPS

Global Head of Research Patrick Legland (33) 1 42 13 97 79
patrick.legland@sgcib.com

Head of Fixed Income Strategy Vincent Chaigneau (33) 1 42 13 30 53

vincent.chaigneau@sgcib.com

Alberto Brondolo (44) 20 7676 7510

alberto.brondolo@sgcib.com

Christian Carrillo (81) 3 5549 5626

christian.carrillo@sgcib.com

Jean-David Cirotteau (33) 1 42 13 72 52

jean-david.cirotteau@sgcib.com

Wee-Khoon Chong (852) 2166 5462

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Patrick Gouraud (1) 212 278 7671

patrick.gouraud@sgcib.com

Ciaran O'Hagan (33) 1 42 13 58 60

ciaran.ohagan@sgcib.com

Adam Kurpiel (33) 1 42 13 63 42

adam.kurpiel@sgcib.com

Jose Sarafana (33) 1 42 13 56 59

jose.sarafana@sgcib.com

Takuma Sugawara 81-3-5549-5432

takuma.sugawara@sgcib.com

Fidelio Tata (1) 212 278 6213

fidelio.tata@sgcib.com

Julian Wiseman (44) 20 7676 7342

julian.wiseman@sgcib.com

Head of Foreign Exchange Kit Juckes (44) 20 7676 7972

kit.juckes@sgcib.com

David Deddouche (33) 1 42 13 56 22

david.deddouche@sgcib.com

Sbastien Galy (1) 212 278 7644

sebastien.galy@sgcib.com

Olivier Korber (Derivatives) (33) 1 42 13 32 88

olivier.korber@sgcib.com

Lauren Rosborough (44) 20 7676 7878

Lauren.rosborough@sgcib.com

Head of Emerging Markets Strategy Benot Anne (44) 20 7676 7622

benoit.anne@sgcib.com

Galle Blanchard (44) 20 7676 7439

gaelle.blanchard@sgcib.com

Esther Law (44) 20 7676 7396

esther.law@sgcib.com

Guillaume Salomon (44) 20 7676 7514

guillaume.salomon@sgcib.com

Technical analysis Hugues Naka (33) 1 42 13 51 10

hugues.naka@sgcib.com

Fabien Manach (33) 1 42 13 88 35

fabien.manach@sgcib.com

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