Australian and U.S dollar banknotes of various denominations are arranged for a photograph in Sydney, Australia. (Photographer: Brendon Thorne/Bloomberg)

Treasuries Premium to Aussie Rates Peaked, Bank of America Says

(Bloomberg) -- The spread between Australian and U.S. bond yields has reached its most extreme and will narrow again as Aussie wages and inflation spur an earlier start to monetary tightening Down Under than most anticipate, according to Bank of America Merrill Lynch.

Australian 10-year yields have sunk to the lowest in more than four decades relative to their U.S. counterparts as the Federal Reserve continues its tightening path, while the Reserve Bank of Australia remains firmly on hold. That gap will now hold steady before potentially vanishing, according to Tony Morriss, head of economies and rates strategy for Australia and New Zealand at Bank of America Merrill Lynch.

“The Aussie-U.S. spread will remain low or negative for an extended period of time -- into next year -- but we don’t see a case for it to widen further,” said Morriss, who’s been monitoring markets for almost a quarter century, in an interview in Sydney. “At some point if the domestic dynamics change, then that Aussie-U.S. spread could reverse relatively quickly.”

Treasuries Premium to Aussie Rates Peaked, Bank of America Says

Morriss’s expectation for Australia’s official cash rate to be increased in the final quarter of this year and twice next year is a more aggressive path than what the swaps market is anticipating. Traders are pricing in just a 31 percent chance of a rate hike by December.

He discounted the potential impact of a recent run-up in bank funding costs on the outlook for the RBA to raise rates.

“If banks pass this on more than five to 10 basis points that might be material,” he said. But “if wages rise and inflation rises in Australia, they’re going to have to react to that regardless of what happens to funding markets,” he predicted. By waiting to act only after pay packets and consumer prices accelerate, "there’s a risk that they might have to do more later” with monetary tightening, he said of the RBA.

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