Trade Ideas: The Curious Case of Down Under

See the left hand side chart below for all large developed economies in interest rates swaps space, 2 year rates differential to US vs the 5s30s slope. Returns of FX carry trades have strong correlation to curve slope. Researches (see this and this, open PDFs) show buying currencies with flatter curve slope against steeper slope pair produces returns which are often better than the traditional carry trades based on short end rates differentials.

My general conjecture is that in this connected global economies, the long end of the yield curve is driven by the state of the global economy (flow of goods, services, money and inflation drives nominal rates). Where as the short end is up to the central bankers. Now to the extent that US drives the global, or at least the developed, economies, the relationship between this differential to slope is a straight line. Higher the differential, lower the slope, driven by the shorter end. And all points should lie on the trend line.

And to the extent they are off from it, that signifies the presence of other possible drivers. In this case, the Aussie and the Loonie are the obvious picks, possibly China driven. But AUD is simply way off. Assuming China does not influence, the AUD curve needs to flatten a lot. Assuming China does influence, and is forcing Australia to a possible recession, then there is a good chance it will keep rallying pressure on the long end further, which will lead to flattening if US rates hikes drive the carry trades out. 

The only case against it is a sharp central bank response. Australia has not seen much recessions in recent years and it is not clear how the response will be. On the flow side, we have seen recent international outflows (dominated by equities, but also in bonds), while stepped up bonds allocation from domestic investors. The assumption is internal flows will be concentrated more in the shorter end of the curve than domestic

Wait out for the possible rate cut next meeting and then go for a significant AUD flattening in the medium to long term. A good cross market version is against EUR, the spread is near historical lows