Since the above exercise was a complete waste of time to understand what moves ADSWAP2s10 minus CDSW2s10 box, I will try looking at the AUD steepness versus CAD bottom-up by breaking down the chart into trends and looking into a broader set of instruments in the same period. Visually I would break up the chart into seven periods: 05/01/2000 – 12/02/2004, 12/02/2004 – 23/11/2005, 23/11/2005 – 29/02/2008, 29/02/2008 – 11/03/2009, 11/03/2009 – 22/10/2009, 22/10/2009 – 14/12/2012, 14/12/2012 – 23/02/2017.
05/01/2000 – 12/02/2004.
During this period the box was on a down-trend from 17.5 to -193. Most of the move came between 27/06/2001- 11/01/2002 (-131 bps) and 19/03/2003 – 12/02/2004 (-145 bps). The box rallied big on two occasions: 11/01/2002 – 22/03/2002 (+77 bps) and 07/01/2003 – 19/03/2003 (+95 bps).
RBA were active during the period:
- - 2000H1 hiked multiple times from 5% to 6.25%: +50 bps on 02/02/2000, +25 on 05/04/2000, +25 on 03/05/2000, +25 on 02/08/2000.
- - All 2001 cut to 4.25%: -50 bps on 07/02/2001, -25 on 07/03/2001, -50 on 04/04/2001, -25 on 05/09/2001, -25 on 03/10/2001, -25 on 05/12/2001.
- - Mid-2002 a few hikes to 4.75%: +25 on 08/05/2002, +25 on 05/06/2002
- - 2003Q4 a few more hikes to 5.25%: +25 on 05/11/2003, +25 on 03/12/2003
BoC were also active:
- - 2000H1 a few hikes from 4.75% to 5.75%: +25 on 03/02/2000, +25 on 22/03/2000, +50 on 17/05/2000
- - All 2001 deep cutting cycle from 5.75% to 2%: -25 on 23/01/2001, -50 on 05/03/2001, -25 on 17/04/2001, -25 on 29/05/2001, -25 on 17/07/2001, -25 on 28/08/2001, -50 on 17/09/2001, -75 on 23/10/2001, -50 on 27/11/2001, -25 on 15/01/2002.
- - 2002Q2-Q3 a few hikes from 2% to 2.5%: +25 on 16/04/2002, +25 on 04/06/2002, +25 on 16/07/2002
- - 2003 a failed hiking cycle: +25 on 04/03/2003, +25 on 15/04/2003, -25 on 15/07/2003, -25 on 03/09/2003
- - Early 2004 another -25 bps cut on 20/01/2004 to 2.5%
For the reference let’s look at the Fed too:
- - 2000H1 a few hikes from 5.5% to 6.5%: +25 on 02/02/2000, +25 on 21/03/2000, +50 on 16/05/2000.
- - All 2001 deep cutting from 6.5% to 1.75%: -50 on 03/01/2001, -50 on 31/01/2001, -50 on 20/03/2001, -50 on 18/04/2001, -50 on 15/05/2001, -25 on 27/06/2001, -25 on 21/08/2001, -50 on 17/09/2001, -50 on 02/10/2001, -50 on 06/11/2001, -25 on 11/12/2001
- - Nov-2012 50 bps cut to 1.25% on 06/11/2002.
- - Mid-2003: -25 to 1% on 25/06/2003. This is right after hikes but before the BoC hikes in the failing hiking cycle.
What about inflation? In Canada CPI was running above target in 2000, so it’s understandable the BoC hiked. As the BoC started cutting the base rate in 2001, headline CPI overshot in May-2001 hitting but collapsed by late 2001. The failed hiking cycle occurred as CPI started picking up year-on-year from June-2002, yet this returned to targ despite rate cut. In the end CPI started undershooting. Australia had GST tax introduced in 2001, hence that huge jump in headline and core CPIs. Inflation was quite stable and almost within the 2-3% policy target (not sure they had this target back then though).
Let’s now look at front STIR contracts and their differential: relatively stable until 2001Q1 with temporary widening in 2000Q3 as markets were expecting that RBA would deliver more, but BoC would stop, but narrowed as that didn’t materialize. In the 2001 cutting cycle BoC were a lot more aggressive, so the differential widened significantly. There is some narrowing from early-June 2002, which coincides with an RBA meeting, so probably RBA signaled they would pause hiking, and more narrowing as BoC tried to hike. This widened toward the end of the period as policy diverged.
On first sight the 2y differentials tracked the front contract differentials, but differences have been very been significant at times, from -75 to 20 bps. 2y swap differentials were initially roughly equal to front contract differentials, but went down to -20 on 15/09/2000 as odds of a near term hike decreased for BoC and increased for RBA. In 2001H1 this box was quite volatile with RBA and BOC racing to cut first, and it was perfect for front contracts to fall 10 bps a few times a week. As the cutting cycle was nearing its end, front contracts differential was 75 bps wider than 2-year differential as CAD curve got relatively steep with 2-year swap only falling 300 bps despite 475 bps of cuts. Once this excess was removed, the box returned to roughly zero. It visited -20 bps area again in Feb-2003 when it was uncertain if RBA were any likely to hike in the future and in end-2013 after RBA did hike and it wasn’t certain they would hike more.
Now let’s look at 2s10 curves and see if central bank policy changes and front contract trading has fed into this. Canadian 2s10 flattened very slightly as BoC did a few hikes but steepened from 20 bps to 250 bps as BoC delivered 3.75% of hikes, so roughly a third of cutting passed into the 10y yield decrease. This flattened from 250 to 150 as BoC hiked in 2002Q2-Q3 from 2% to 2.50% and CDSW2-BA1 implied more hikes, but further increases didn’t materialize, so 2s10 kept trading above 150bps. It tried to return below 150bps as BoC attempted a hiking cycle, but ended the year at 215 bps on more BoC cuts and a sell-off of 10y in summer 2003 without a corresponding move in the short end.
First half of the period was quite similar for the Australian curve. 2s10 flattened from 67 bps to 0 on hikes in 2000 and steepened to 145 on 2001 cutting 2%, so 75% pass-through from cuts to 10y. In 2001Q2 there was a retreat in 2s10 from 125 to 75 bps, which coincided with the 2y-front contract differential box increase that was mentioned in one of the paragraphs above, when for some reason 2y implied RBA hiking, but RBA went on cutting. 2s10 returned from 145 bps to below 50 bps in mid-2002 as RBA delivered 50 bps of hikes and further hike expectations wore off. Mid 2002- mid 2003 was extreme 2s10 whipsawing – we saw that manifested in 2y differential – front contract box visiting -20 area in paragraph above. Finally by period end 2s10 was at 25 bps as RBA delivered 100 bps of hikes in 2002-2003.
This should be enough to take a first stab at performance of the Australian 2s10 versus Canadian 2s10 box. Why did it go down 211 bps during the period from 18 to -193? The 2y differential moved 262 bps in Australian favour from 62 to 324 bps, but 10y differential only moved 51 bps from 80 to 131. Through the period RBA had net base rate increase of +25 bps, BoC -225 bps cut, so 250 bps divergence. At that point 2y rate was 579 bps and 10y rate at 600 bps in Australia, 256 bps for 2y and 469 bps for 10y in Canada.
-131 bps of down-move happened in the 27/06/2001 – 11/01/2002 period. This coincides with BoC accelerating rate cuts in 2011H2 versus RBA slowing down, 225 bps of cuts vs 75 bps. As discussed above, the 2y CAD rate lagged the cuts at first, so this roughly 200 bps of divergence didn’t pass to 2 years, 41 bps was lost on 2y-front contracts differential going down but 45 bps gained on BA pointing at relatively more cuts than IR. Finally, the 10y differential increased from 40 to 63. Thus, ~-150 + 41 - 45 + 23 = -131.
145 bps came in the 19/03/2003 – 12/02/2004 period, some policy divergence with BoC cutting by 50 bps and RBA hiking +50 bps, 100 bps divergence. The 10y differential increased by 83 bps. The 2y-front contract box was stable at -16, but change in policy rate implied from front contract was -90 bps for CAD and +40 bps for AUD. Thus we have, -100 + 83 + 0 - 90 - 40 = -147.
The +77 bps rally between 11/01/2002 and 22/03/2002 came as BoC made a 25 bps cut, 10y differential widened by 10 bps, 2y-front contract box was 28 bps down, and major short-term outlook changes for short-term policy with BoC expected to hike a lot more aggressively (front contracts changed relative to base rate by 160 in CAD and 95 bps in AUD):
-25 + 10 + 28 + 160 – 95 = 78 bps.
The +95 bps rally between 07/01/2003 and 19/03/2003 was with BoC delivering a 25 bps hike, +6 bps from 2y-front contract box, 10y differential widening from 23 to 48 bps (+25) and CAD front contract pointing at more hikes vs chance of a cut for AUD. Contribution:
25 + 25 - 6 + 44 + 9 = 97.
In this period out of four largest moves up and down not a single one was predominantly 10-year differential driven. 10y differential increased by 83 bps in the 19/03/2003 – 12/02/2004, but even there it didn’t offset the changes in very near-term expected monetary policy change.
It’s actually quite interesting what caused such a turn-around in the 11/01/2002 – 22/03/2002 period from cutting to hiking. Oil started climbing up past 20, relevant equity indices were stable during the period and in the run up to the period, copper was stable – but it started its rally in late 2003. Unemployment was increasing both in Canada and Australia, subsued GDP in Canada but good retail sales, solid retail sales in Australia.
