ANZ RESEARCH

AUSTRALIAN RATES STRATEGY UPDATE

30 MARCH 2012 VIEWS
Core Views & Ideas Duration Semis Trade Bank Forecasts 1 2 3 4 5

CORE VIEWS & IDEAS POSITIVE NEWS FOR QTC, FRONT END SUPPORT FROM POSSIBLE RBA SURPRISE Duration: We see scope for a RBA surprise rate cut in April. As such, we favour taking profit on our short position in April IB. The 10-year ACGB-UST spread also has room to compress and the 3y-10y curve could steepen further. Semis: The electoral mandate supporting the Liberal-National party should be a long-term positive for QTC spreads. In the short-term there still remain challenges on the policy front.

CONTRIBUTORS
Tony Morriss Head of Interest Rate Research +61 2 9226 6757 Tony.Morriss@anz.com Shane Lee Senior Interest Rate Strategist +61 2 9226 4632 Shane.Lee@anz.com Carl Ang Interest Rate Strategist +61 2 9227 1479 Carl.Ang@anz.com

FIGURE 1. AUD INFLATION SWAPS

3.20 3.10 3.00 2.90 % 2.80 2.70 2.60 2.50 Jun 2011 2y Sep 2011 5y Dec 2011 7y Mar 2012 10y

Sources: ANZ, Bloomberg KEY VIEWS Duration: Mild long, but within ranges so we would look for any back up in yield towards 3.803.90% on 3 year bonds and 4.30% on 10-year bonds as offering some value. We continue to see better value in longer-dated bonds, but as we see a good chance that policy will be eased in coming months the whole curve should find support. Curve: The bias towards easier policy should keep the curve relatively steep, although the underlying value in longer-dated bonds should limit how far the curve can steepen. The curve is now around 58bp, but an RBA easing or more dovish comments from the central bank could push this towards 70bp. Semis: While ACGBs are likely to continue to be sought for their relative yield and intrinsic credit value, not to mention a scarcity premium in current conditions, we continue to view current spreads are misaligned for the underlying fundamental strength of the States and would expect further spread compression over time. The Queensland election is a medium to longer-term positive for QTC spreads. Swaps: Swap spreads are likely to remain wide with a range now set for Spreads: We retain a bias for the AUS-US spread to compress over time, but remain in a 170-215 range in the absence of a more extended domestic easing cycle as US policy-makers are still a considerable way off the start of any normalisation of US policy. Supply and currency factors also favour the AUS.

Australian Rates Strategy Update / 30 March 2012 / 2 of 7

DURATION
DURATION TAKE PROFIT ON SHORT APR-12 IB The direction from overseas has, on balance, favoured bonds after the extended correction seen over the past 12 weeks. the AUS-US spread remains in a 170-215bp range unless it looks likely the RBA will have to make policy substantially more accomodative.

Three-year bond yields have found support in the There has been some loss in momentum in US data and, technically significant area around 3.90% and could move towards 3.50% if the RBA does surprise in April. rising anxiety over the economic outlook in China. The curve should retain a steepening bias considering Risks have emerged around how the authorities will markets still expect to RBA to ease policy. We see transition the economy to slower growth and this has some scope for the curve to head towards +60bps in helped to reinforce an important level of support for the near-term as the market shifts to expect an early three-year bonds around 3.90%. move on rates.
FIGURE 2. CUMULATIVE MOVE IN THE CASH RATE
0

FIGURE 3. INFLATION EXPECTATIONS TO FALL

155 4.50 145

-11 -25 -24

4.00

135

3.50

-40
%

Bps

-58 -75

115

-62

-67

-70

-74 -74 -75 -77 -79 -78 -77 -76

-71

105 95 85

2.50

2.00

-100 04- 05- 06- 07- 08- 09- 10- 11- 12- 01- 02- 03- 04- 05- 06- 07- 0812 12 12 12 12 12 12 12 12 13 13 13 13 13 13 13 13 Spot 1m ago 3m ago

1.50 1999 2001 2003 2005 2007 2009 2011

1997

Sources: Bloomberg, ANZ

Long-term BEI [RHS] 3 per. Mov. Avg. (AIG Manufacturing Inflation Indicator (LHS)) 3 per. Mov. Avg. (AIG Services Inflation Indicator (LHS)) 3 per. Mov. Avg. (AIG Construction Inflation Indicator (LHS))

And there appears to be a subtle shift in the debate over the scope for domestic policy to support the structural transition of the domestic economy. Some sectors of the domestic economy are labouring under the sustained appreciation of the AUD and the current phase of the resources boom is capital rather than labour intensive. Weak credit growth data later this week could add weight to the argument for a cut. However, labour market readings are also important and we do not get another update until April 12th. We have been holding a short in the April IBs, but we now look to close this out considering the shift in the risk/reward of a policy move in April. The risk of a surprise move cannot be ruled out so we will lock in profit of +5bps on the trade and wait to reassess the outlook. We still have a bias for the US-AUS 10-year spread to compress over time despite recent underperformance. In our view, a move back towards +215bps would be an attractive entry level to put on a flattener, particularly as there is still scope for lower rates in Australia in coming months. Comments from Bernanke this week are a reminder that US policy-makers still appear determined to ensure the recovery gains momentum. This means they will err on the side of trying to cap any sharp rise in US bond yields. Furhtermore, this should also mean that

Sources: Bloomberg, ANZ.

We recommend receiving fixed on 5-year inflation swaps. We constructed inflation indicators based on the AIG surveys of manufacturing, services and construction. Indicators across these sectors have peaked, with the construction sector experiencing the heaviest decline. Although global oil prices still remain high, our indicators suggest capacity pressures have waned, although this may be a consequence of improvements in productivity. We like receiving short and mid-curve tenors like the 5-year, which have begun to range trade compared to the longer end.
FIGURE 4. RECEIVE FIXED ON 5Y INFLATION SWAP Current: 2.79% Initiate: 2.79% Target: 2.51% Stop: 2.93%

Tony Morriss

-50

125

-49

3.00

Australian Rates Strategy Update / 30 March 2012 / 3 of 7

SEMIS
SEMIS - WHAT WE DO AND DONT KNOW ABOUT THE FISCAL OUTLOOK ON QUEENSLAND The clear mandate on fiscal discipline from the Queensland election result and the priority of the commitment to return the State to AAA status are positives for QTC spreads. However, the scope for significant outperformance in the near-term looks limited. There is some uncertainty surrounding the likely restatement of the fiscal position of the State from the Audit commission report. Qld will to have a relatively large call on markets next fiscal year and policy statements by the new government will only have a marginal impact on the underlying cash position. News that the government will sell down its holding in QR National will help the bottom line and should be taken as a sign of the commitment to positively change the fiscal dynamics of the state.
FIGURE 5. AUD BOND MARKET EXPECTATIONS CUMULATIVE POLICY MOVE IN THE RBA CASH RATE
Per cent of Non-Financial Public Sector Operating Revenue 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 2013 2014 2015

There are clearly some large challenges that lie ahead before we can see a path to a ratings upgrade, particularly as further asset sales have been taken off the table. It does seem likely that infrastructure funding will need to rely on the private sector. However, we will need to see how the state plans to do this. We now wait for the Budget to get more insight.
FIGURE 6. AUD SEMIS ON ASSET SWAP
50 40 30 20 Bps 10 0 -10 -20 -30 2011 NSWTC 2013 QTC 2015 SAFA 2017 TCV 2019 WATC 2021 NSWTC-AUGG 2023 2025 QTC-AUGG

Sources: Yieldbroker, ANZ.

And while the ACGB curve remains expensive, mean reversion of Semi spreads is unlikely. But we would see spreads compressing further in the near-term and would re-enter spreads should they widen 10 bps from here. We still think 2014-2015 sector offers best asset swap pickup such as the WATC 14, TCV 14 and NSWTC 15.
LNP - Optimistic LNP - Baseline LNP - Pessimistic

Sources: QLD Treasury, LNP, ANZ.

Tony Morriss

We examined the costings of LNPs policies to assess the impact on the fiscal position. In the chart above we plot the estimated change to the debt burden position of QLD based on 3 scenarios: 1) Optimistic, which includes only positive policy effects on on revenues (relative to the mid-year review), 2) Baseline, which spans policy adjustments to both revenue and expenses, and 3) Pessimistic, which accounts for policies that only lead to higher costs. Assuming all additional expenses are paid for in cash, the policy impact on the overall debt burden appears relatively minimal. At best the net financial liabilities decrease by 0.9% of operating revenues, which is relatively small compared to the 23% margin needed to reach the upper bound of the AAA ratings trigger.

Australian Rates Strategy Update / 30 March 2012 / 4 of 7

TRADE BANK
OPEN TRADES Open Close 17-Feb-12 17-Feb-12 23-Feb-12 23-Feb-12 02-Mar-12 02-Mar-12 09-Mar-12 09-Mar-12 -

Description AUD 10y EFP and AUDUSD 10y Basis Swap TCV 22-TCV 16 asset swap switch AUD Apr-12 IB Futures TCV 18-NSWTC 18 spread on asset swap WATC 14 on asset swap WATC 14-QTC 14 asset swap switch NZD 1y1y swap QTC 18-SAFA 17 asset swap switch

Position Receive EFP and Basis Buy TCV 22 on asset swap Short Sell TCV 18s on asset swap Long Sell QTC 14 on asset swap Pay Buy QTC 18 on asset swap Total TOTAL

USD Delta $10,000 $0 $10,000 $10,000 $10,000 $0 $0 $10,000 $50,000 $955,000

Bp P&L 6.9 0.0 4.5 -2.1 3.2 3.5 2.5 -2.2 16.2 236.7

USD P&L $68,750 $0 $45,000 -$20,600 $31,600 $0 $0 -$22,400 $102,350 $2,987,203

Current 101.1 13.4 95.86 -2.1 4.8 13.5 3.27 16.2

Initiate 108.0 19.0 95.90 0.0 8.0 10.0 3.24 14.0

Target 72.0 5.0 95.76 21.0 -16.0 20.0 3.62 -7.0

Stop 124.0 26.0 95.97 -7.0 20.0 5.0 3.04 21.0

Australian Rates Strategy Update / 30 March 2012 / 5 of 7

FORECASTS

AUSTRALIAN ECONOMIC INDICATORS Economic activity (annual % change) Private final demand Household consumption Dwelling investment Business investment Public demand Domestic final demand Inventories (contribution to GDP) Gross National Expenditure (GNE) Exports Imports Net Exports (contribution to GDP) Gross Domestic Product (GDP) Prices and wages (annual % change) Inflation: Headline CPI Underlying (RBA core) Wages: Labour market Employment (annual % change) Unemployment rate (annual average %) External sector Terms of trade (annual % change) Current account balance: AUDbn % of GDP AUSTRALIAN INTEREST RATES RBA cash rate 90 day bill 3 year bond 10 year bond 3s10s yield curve 10 year spread to the US 3 year swap 10 year swap NEW ZEALAND INTEREST RATES Overnight cash rate NZ 90 day bill 3 year bond 10 year bond 3s10s yield curve 10 year spread to US 10 year spread to AU

2010 2.0 2.9 4.1 -1.3 8.7 3.6 0.4 4.1 5.8 14.1 -1.5 2.5 2.8 2.8 3.4 2.7 5.2 16.4 -38.5 -2.8 CURRENT 4.25 4.36 3.47 3.97 0.50 1.87 4.04 4.75 CURRENT 2.50 2.75 3.04 4.09 1.06 1.93 0.11 MAR 12F 4.25 4.20 3.60 4.00 0.40 2.10 4.20 4.80 MAR 12F 2.50 2.73 2.93 3.80 0.87 1.90 -0.20

2011F 5.6 3.4 1.1 16.9 -0.6 4.1 0.4 4.4 -1.6 11.6 -2.7 2.0 3.4 2.6 3.7 1.7 5.1 13.2 -32.0 -2.2 JUN 12F 4.00 4.15 3.20 3.80 0.60 1.90 3.80 4.60 JUN 12F 2.50 2.75 3.37 3.90 0.53 2.00 0.10

2012F 6.2 3.1 -5.5 20.7 -0.3 4.7 -0.2 4.5 9.6 13.5 -1.3 3.2 2.0 2.8 3.6 1.1 5.4 -6.9 -70.0 -4.7 SEP 12F 4.00 4.15 3.40 4.00 0.60 2.00 3.90 4.70 SEP 12F 2.50 2.75 3.51 4.00 0.49 2.00 0.00

2013F 6.3 3.3 6.1 15.3 0.1 5.0 0.0 5.0 9.9 14.8 -1.7 3.1 3.3 3.4 3.9 2.4 5.1 -1.5 -95.6 -6.1 DEC 12F 4.00 4.15 3.40 3.90 0.50 1.90 3.85 4.50 DEC 12F 2.75 3.17 3.72 4.00 0.28 2.00 0.10 MAR 13F 4.00 4.15 3.30 3.80 0.50 1.70 3.75 4.35 MAR 13F 2.75 3.67 3.93 4.10 0.17 2.00 0.30

* Includes carbon tax. ^ Average of RBA trimmed mean and weighted statistical measures

Australian Rates Strategy Update / 30 March 2012 / 6 of 7

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Australian Rates Strategy Update / 30 March 2012 / 7 of 7

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