The current Australian yield curve looks ominous:
The 3-month rate, which isn't displayed on the chart, is also up by 3.5%. According to the liquidity preference theory, the yield curve should almost always uptrending, as shorter-term lenders implicitly retain the option to not re-lend later, while longer-term lenders do not. Therefore, longer-term lenders are compensated more. Borrowing short-term and lending long-term is how banks make money, and how they get into trouble when they suddenly can't borrow short-term to keep funding the long-term debt. In this case, the expectations theory seems to be telling us that the market expects short-term rates to drop in the next couple of years.
Now why is that? It appears that the Australian housing market, which is widely written about as being overinflated on various fundamental bases, appears to be still in the early stages of a bust similar to what the US has just experienced. Australian government data shows the peak of the experimental all-dwelling price index occurred at the end of 2010, and has been downtrending since. http://www.abs.gov.au/ausstats/abs@.nsf/Latestproducts/6416.0Feature%20Article1Jun%202012?opendocument&tabname=Summary&prodno=6416.0&issue=Jun%202012&num=&view=. Since the government only has the incentive to show a continuing price uptrend, the fact that it isn't means that I trust the data is unmanipulated.
Interestingly, Australian banking and homebuilding equities have barely bounced since the US-led global financial crisis of '08, even though Australian housing prices still bounced strongly after '08, so it appears those markets have already anticipated a future housing bust. So the better trade that remains is the yield curve trade. The market is telling me in the yield curve that it expects the gov't to drop rates. However, the strip of 3-month bill futures going out 3 years is not telling me the same thing. This offers me a risk-free arbitrage, whereby I borrow Australian money for 3 years at 2.7% via a 3-year future (via YT futures traded on the Sydney exchange) and lend money for 3-months at a time at rates varying between 3.5% and 3.1% (via IR futures traded on the Sydney exchange), depending on the particular future expiring between Sept '12 and 3 years from then. I pick up positive carry, all while retaining the option not to re-lend, which the liquidity preference theory would say is backwards. This trade would be purely risk-free in terms of locking in a guaranteed profit as long as I hold to the 3-year maturity. Any marked-to-market losses caused from the arbitrage blowing out further would be perfectly matched by increased positive carry going forward. The problem is that my brokerage doesn't allow me to accept or supply physical delivery of bonds, so I'm forced to roll over any expiring futures. So I can't ever deliver a 3-year bond at a locked-in 2.7% and receive a consecutive series of 90-day bills locked in at higher rates. Instead, I have to count on this kink on the yield curve being unsustainable while rolling over the futures. The nice thing is that this means my upside isn't limited to the 0.4-0.8% yield difference. Instead, the yield curve can revert to a normal uptrend and give me the additional spread usually occurring between the 3-month and 3-year.
The 3-year rates are decided more strongly by the market, while the short-term 3-month rates are dictated by the Australian central bank. Also, the Australian inflation index is running close to 1%, giving the RBA plenty of scope to lower rates without sparking overinflation. Given this fact, along w/ the other indicators given above indicating the housing market is coming down, I'm guessing the RBA will have to stop fighting reality (http://globaleconomicanalysis.blogspot.com/2011/08/secretly-broke-in-australia.html and http://globaleconomicanalysis.blogspot.com/2012/06/laugh-of-day-no-risk-of-housing-bust.html) and short-end rates will have to come down soon. Rather than make an outright bet on dropping short-end rates, I will make the spread trade against the 3-year bond in order to:
1) reduce day-to-day and intermediate-term volatility, thereby allowing me to increase leverage on the idea, and
2) hedge against the risk that the market on the 3-year rates is wrong in anticipating a housing bust and/or lower future short-term rates.
Basically, I'm betting that this curve kink is unsustainable. Since, like I wrote earlier, the futures going out a couple years on the 3-mo bills don't even price in a rate drop, I will be placing my bet in that timeframe, and rolling over front-month 3-year futures until the curve appears normal. Some things to look for to ensure the trade should work (besides being green on the trade) is to continue monitoring home price data for continued drops, and to look at the long-end of the curve to see if the 10-year yields start to tip downward even more relative to the front-end, which would be the market anticipating that current conditions are causing long-term disinflation--a kind of market forecast that the CPI won't be spiking anytime soon in spite of whichever monetary or fiscal concoctions Australia formulates.
Another trade to monitor is the spread between interbank rates (IB futures on the Sydney exchange) and RBA bill rates, which is currently very low. This is similar to the TED spread, but unlike LIBOR, which has been under the microscope lately for being easily maniuplated, the interbank rates in Australia are based on actual market lending rates, rather than hypothetical rates volunteered by the banks. The interbank (IB) rate futures are standardized at 30-day timeframes, so the durations on those don't line up directly with the 3-month RBA bills, but they're close enough in my opinion. I will be getting long the spread down the road if home prices continue falling and bank stocks drop more, causing large losses in the banks and spreading fear among them to loan to each other. To the extent the spread widens contemporaneously with the downslide, I will be riding the trend. However, as a trader, I have no problem arriving late to the party to mop up when it's the most fun! Most smart guys chronically arrive early, and that's why I make money much faster than them.