Fixed Income: Inflation Market Update

23 January 2012

Internal data suggests a low Q4 CPI

Key Views on Linker Markets .............................................................................................. 2 Using CBA credit card data to forecast Q4 CPI: +0.45% ..................................................... 3 A Strategists perspective: .................................................................................................. 5 Tenders and Issuance ......................................................................................................... 5 Long-term Charts ................................................................................................................ 6 Economists Preview: the QIV 2011 CPI .............................................................................. 7 Appendix 1: Significant (courtesy xkcd) ............................................................................. 9

Figure 1: Current Bond Yields

ACGB Aug-15 Aug-20 Sep-25 Sep-30 Yield 0.93 1.11 1.31 1.49 Semi NSWTC NSWTC NSWTC QTC ACT Maturity Nov-20 Nov-25 Nov-35 Aug-30 Jun-30 Yield 2.07 2.37 2.70 2.88 2.74

Source: CBA (20 January)

Figure 2: Yields on Aussie Government linkers Australian Q4-2011 CPI data is scheduled to be released on Wednesday 25 January. Currently, the economic consensus is for a print of +0.2%, though a significant number of economists are looking for negative prints.
3.00 Aug-15 Sep-30 Aug-20 10Y BEI Sep-25

Last November we explained how substitution bias could lead to a distinct fall in CPI readings when the basket was rebalanced. This effect can be as large as 0.5% per year. The change is a measurement change only, there is no change in the real economy, but the new weightings change the result. At the time we suspected that the Q4-11 CPI would be very low because of the new methodology. This month, we delve into the CBA credit card data to try to build a simple model for quarterly headline CPI. Our supposition is that changes in prices in the economy should show up as higher average spending per transaction on credit cards. We found that the behaviour of some of larger sub-categories (like Apparel) have predictive power for the CPI. By testing the various subcategories of card spending, we created an implied forecast for Q4 CPI of +0.58%. However, this doesnt take into account the change in the new CPI weightings. If we subtract 0.125% (5% divided by four) from that estimate we get a Q4 CPI forecast closer to 0.45%. We must caveat that this is the first time we have tried this procedure and there isnt enough history to properly backtest it. However, we are heartened that our forecast is quite close to the economics team who expect an increase of +0.2%. (See Pages 3 and 7.) The economics team uses a completely different methodology. In general, linker yields have been falling steadily for the last two months. The 2015 bond yield fell below 0.90% for a time and is starting to show real signs of rally fatigue. (See Figure 2.). This is in line with our expectation (see 22 August 2011 Inflation Monthly), though it has taken a little longer for this dynamic to exert itself than we had anticipated. Because the 2015 linker is finding it difficult to rally, any further rally in the 3Y bond is likely to force BEI very tight very quickly. Also this month we include our Chief Economist Michael Blythes CPI preview on page 7. They highlight that the ABS new, concurrent seasonal adjustment process complicates the outlook for the commonly-watched underlying CPI measures.

2.50 2.00 1.50 1.00 0.50 0.00 Feb-11Apr-11 Jun-11 Aug-11 Oct-11 Dec-11

Source: CBA, Bloomberg

Figure 3: Current BEI and ZCS curves

% 3.00 ZCS Curve Bond BEI

2.75

2.50

2.25

2.00 2013 2017 2021 2025 2029 2033 2038

Source: CBA, Bloomberg

Philip Brown Quantitative Strategist T. +612 9118 1090 E. philip.brown@cba.com.au

Important Disclosures and analyst certifications regarding subject companies are in the Disclosure and Disclaimer Appendix of this document and at www.research.commbank.com.au. This report is published, approved and distributed by Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945.

Global Markets Research

Fixed Income: Inflation Market Update

Key Views on Linker Markets

Our two recommended trades are both doing well and both have continued upside in our core view. We do not wish to change our trades. The indications are that the Q4-11 CPI print (scheduled 25 Jan) should be very low, assisting our 1Y ZCS trade. The 5Y ZCS vs BEI trade also benefits from a continued rally. We expect the RBA to cut rates and for bonds to rally in the next few months. This should see the nominals outperform the linkers and the basis between ZCS and BEI should widen further.

Key Trades
Trade
Pay 5Y ZCS against receiving BEI on the Aug-15 bond Receive 1Y ZCS

Entry
+14bp (22 Aug 2011) 2.84% (10-Nov-2011)

Curent
+28bp

Profit
+14bp

Target
+70bp

Stop
-5bp

Comment
Hold: An insurance trade, if the market keeps rallying, the spread should widen. It is currently mid-range Hold: The combination of substitution bias and the falls in fruit prices should see ZCS fall.

2.66

+18bp

2.40

3.00

Global Markets Research

Fixed Income: Inflation Market Update

Using CBA credit card data to forecast Q4 CPI: +0.45%

We attempt to use the CBA credit card data to model changes in CPI Australian CPI for Q4 2011 is scheduled to be released on 25 January (Wednesday). We explained last November why we expected the technical features of the new CPI weighting system would cause a low print. There is a substitution bias worth up to 0.5% per year that comes from changing the weightings in the basket to more accurately reflect the current spending (previously, items rising in price had been over-represented because people would substitute away from the expensive items). In this article, we try to forecast Q1 CPI using a completely new method. We have delved into the CBA credit card data looking for relationships between credit card spending and the CPI. The data is broken down by merchant category. We have found some interesting relationships between some categories and the total CPI results. The relationships we can find suggest a CPI of about 0.58%. However, we then need to subtract the substitution bias, which leads to a quarterly CPI forecast more like 0.45%. Our economists, using a completely different approach, are also predicting a low headline CPI result of 0.2%, q/q, which is comforting. Modelling the CPI using credit card data We have seasonally adjusted and detrended the category data from the CBA credit cards CBA has average transaction size data for multiple types of purchases. We now have a full three years worth of data, January 2009 to December 2011. We have tried to find relationships between this average spending figure and CPI. Although not a perfect sample, CBA credit cards do cover a significant number of transactions. To begin with, we have seasonally adjusted and de-trended the credit card data. The data is clearly seasonal and this effect should be removed. We also needed to de-trend the data to take out the effect of population growth and other consistent changes in behaviour. The result is a set of residuals that represent the surprise within our credit card data. We can then test to see whether this surprise can be used to forecast the behaviour of CPI. Although the results for the total credit card spending are not that strong, some of the major sub-categories have quite strong results. We present the 20 strongest results in Figure 4. Figure 4: Results of our model for quarterly CPI
Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Credit Card Merchant Category Home/Office Furnishings Association/Membership Liquor Home Improvement Arts/Crafts/Hobbies Apparel/Clothing Entertainment Hotels Governmental Transportation Utilities Cleaning/Laundry Business to Business Construction Personal Services Direct Marketing Travel/Tours Totals Financial Services Eating/Drinking Co-Eff 0.02 -0.04 0.12 0.08 0.07 0.13 -0.05 -0.05 -0.02 -0.22 0.01 0.02 0.01 0.01 0.02 -0.02 0.00 0.11 0.00 0.11 Co-eff T-stat 2.74 -2.46 2.32 2.32 2.28 2.12 -1.99 -1.76 -1.62 -1.53 1.53 1.41 1.32 1.27 1.23 -1.23 -1.23 1.22 1.21 1.19 RSquared 0.46 0.40 0.37 0.37 0.37 0.33 0.30 0.26 0.23 0.21 0.21 0.18 0.16 0.15 0.14 0.14 0.14 0.14 0.14 0.14 Error in Q4 -27.39 6.76 -2.58 2.21 0.72 -0.45 -4.80 -2.38 11.81 -0.72 -44.51 7.58 0.72 -13.91 -7.02 1.68 1.80 0.12 56.64 -1.53 Prediction for Q4 2011 CPI 0.25 0.41 0.37 0.89 0.76 0.64 0.94 0.84 0.49 0.88 0.31 0.87 0.72 0.61 0.54 0.68 0.70 0.72 0.89 0.53

Then we compare the residuals against CPI

Source: CBA, Bloomberg

Global Markets Research

Fixed Income: Inflation Market Update

At this point, we should acknowledge that there is a good chance of some of the significant results occurring through pure chance. We ran 41 models and have found six which are significant at the 95% confidence level (the ones above the line in Figure 4). A random assortment would find two which are significant at the 95% confidence level (5% of 41). See Appendix 1 for one of my favourite cartoons on this topic. When testing so many hypotheses, you need to wary of random chance causing significant results Knowing which results are real and which are random is a matter of judgement (until we can get more data!). However, we suspect that the strong performance of Association/Membership costs is probably purely random. The Association/Membership category has a negative correlation with CPI. There seems little reason to believe that the price of jointing Associations should vary inversely with CPI for a structural reason. However, most of the other top rankings are broad categories that noticeably overlap with consumer spending as measured by the CPI. Apparel/Clothing and Home Improvement seem more likely to represent real relationships while the Liquor category appears to be driven by two strong single results which is characteristic of liquor in the CPI too. This is entirely a judgement call, but does seem reasonable. Figure 5 shows the relationship between the residuals from the Home and Office furnishings sectors and the CPI. This is particularly important because the home and office furnishings spending has been very low in Q4. In both October and November the actual average spend was $9 less than predicted. If repeated in December, that would be $27 less than expected and would imply a very low quarterly CPI (see Figures 4 and 5). However, the result from the Apparel and Clothing category presents a stronger result. The Q4 results in clothing are much better, with average transaction volumes only just under expected results. (See Figures 4 and 6.) So which do we believe? An actual forecast for CPI in Q4 Our models suggest CPI of 0.58%, but thats before the substitution bias is included We have six models for Q4 CPI that seem worthy of consideration. (See Figure 4.) However, we choose to discount the Association / Membership category. Using the wisdom of crowds, the average prediction for Q4 CPI from the remaining five models is a CPI result of 0.58%. However, our models are implicitly assuming that the Q4 CPI is produced using the same procedure as was used in 2009-2011. Its not going to be though. The new methodology for CPI has created a systematic change in the CPI, known as substitution bias (see the 11 November Inflation Market Update). The new basket could lower CPI by as much as 0.5% per annum. Our estimate of +0.58% for Q4 is before that change in methodology is taken into account. As such, the CBA credit card data is suggesting a Q4 CPI print closer to 0.45%. Our model suggests a print of 0.45%, not far from the economists at 0.2% Our economists, using a completely different method, come up with an estimate of 0.2% q/q. (See page 7) No matter which way you look at it, Q4 CPI should be low.

Figure 5: Relationship between Home and Office furnishings and the CPI
Qrtly CPI Change 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 -40 -20 0 20 40

Quarterly CPI Change

Residual from CBA credit card data (Home and office furnishings)

Source: CBA, ABS

Figure 6: Relationship between Apparel and Clothing card spending and the CPI
Qrtly CPI Change 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 -4 -2 0 2 4

Quarterly CPI Change

Residual from CBA credit card data (Apparel and clothing)

Source: CBA, ABS

Global Markets Research

Fixed Income: Inflation Market Update

A Strategists perspective:
As just explained, for multiple reasons we are looking for a very low CPI print in Q4-11. In November we recommended receiving the 1Y ZCS to implement this trade. To be honest, little has changed. Happy to stay received 1Y ZCS The 1Y ZCS has rallied a little but still sits around 2.70%. Thats pretty high if the first print of four is going to be around 0.2% or 0.4%. We would like to hold our ZCS position over the CPI print and well reassess the trade then.

Figure 7: Real Yields and 10Y BEI

Aug-15 Sep-30 3.00 2.50 2.00 1.50 1.00 0.50 0.00 Feb-11Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Aug-20 10Y BEI Sep-25

The Outlook for BEI

Breakeven inflation has actually been trending up in the last few weeks as nominal bond yields have increased. Real bond yields havent changed though, leading to a small widening in BEIs. (See Figures 7 and 8.) However, this small recent widening is against the larger trend of tightening BEIs. (See Figure 8.) We have previously recommended receiving the BEI against paying the ZCS at the 5Y / 2015 point. This trade continues to perform well and we wish to maintain it. The real driver of this trade has been the fact the 2015 linker bond has struggled to keep pace with the rally in other bonds in late 2011 (Figure 7). We expect that dynamic to continue if bonds rally further.

Source: Bloomberg, CBA

Figure 8: BEIs of 3 bonds

2015 BEI 2025 BEI (vs 22) 3.20 3.00 2.80 2.60 2.40 2.20 2.00 Feb-11Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 2020 BEI

The NZ CPI release

NZ CPI was very low too. We are not huge believers in the NZ CPI predicts Australian CPI as a general rule, but the most recent NZ release has got as thinking. The NZ CPI fell -0.3% in Q4, against expectations of +0.4%. Thats a huge negative surprise of -0.7%. We tend to think that the NZ surprise is more important than the absolute level of NZ CPI. This time, of course, both the NZ CPI print and the surprise were negative, so its a moot point. Either way, the NZ CPI print suggests that the Australian CPI print should be low.

Source: Bloomberg, CBA

Tenders and Issuance

We are not aware of any imminent planned issuance in linkers. The AOFM is planning to issue a new line of linkers (with a maturity less than the 2025). However, this will not be until 21 February at the earliest.

Global Markets Research

Fixed Income: Inflation Market Update

Long-term Charts
Figure 9: Long term AUD bond yield and BEI
% 12 Nominal 10yr 9 Asian crisis (onset of global 'savings glut') Suspension of C'wealth issuance

Figure 10: Long term global Breakevens

% 6 5

New issuance

UK 4 3

Australia

6 Real yield 3

2 1

BEI 0 95 97 99 01 03 05 07 09 11

United States 0 95 97 99 01 03 05 07 09 11

Source: CBA, Bloomberg, RBA

Source: CBA, Bloomberg, RBA

Figure 11: Drivers of main CPI moves since 1990 Long-term moves in CPI
% 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 -1.00 -2.00 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 The recession we had to have Cyclone Larry banana trough The GFC AUD Headline CPI year-on-year Rising cash rates trigger rising CPI * Introduction of RBA 2-3% inflation target GST Introduced AUD Underlying Inflation year-on-year GST rolls out of Y/Y Cyclone Larry banana spike Cyclone Yasi Commodity boom and utility prices trigger widespread inflation response

Falling cash rates trigger a fall in CPI*

Year Ended
* The CPI used to include a measure of mortgage interest rate costs in outright terms. As such, change s in the RBA cash rate were immediately reflected in CPI and tended to create feedback loops.

Source: CBA, Bloomberg

Global Markets Research

Fixed Income: Inflation Market Update

Economists Preview: the QIV 2011 CPI

We expect the headline CPI to rise by 0.2% in QIV (3.3%pa). The underlying CPI on our forecasts will print at 0.7% (2.6%pa). The focus on European woes has reduced the importance of CPI readings in the rates debate. QIV price data is coming up. The price data to round out 2011 is coming through in a series of QIV releases over the next few days. The focus as always will be the CPI readings (due 25 January). The inflation story shifted dramatically in 2011. What looked like a clear acceleration in HI had the RBA debating rate rises up until August. But a new estimation methodology that revised away some of the acceleration and a surprisingly low QIII CPI outcome allowed the RBA to revise down its inflation forecasts. This lower trajectory opened the door to rate cuts by year end. And the RBA quickly stepped through that door, delivering 50bpts of rate cuts over November and December. Price readings are likely to have little impact on the RBA rate trajectory given the dominance of European woes. The CPI would normally shape views on what the RBA will do next. But the focus on European woes means that the status of the QIV data has been reduced. Those woes mean markets have effectively fully priced a rate cut for February. And economic commentators, including ourselves, agree. On current figuring, the QIV price readings would not stand in the way of a rate move anyway. Trade prices. Data on international trade prices, for example, was released today. That data suggests that the terms-of-trade declined at the end of 2011 for the first time since 2009. The terms-of-trade remains close to 140-year highs. But the stimulus from a rising terms-of-trade has eased. Looking ahead, we expect the QIV PPI (due 23 January) to rise by 0.6% in QIV. Annual growth would stand at 3.2%. But the overall impression should be one of upstream price pressures remaining relatively contained. The headline CPI (nsa) should look benign. We are expecting an increase of only 0.2% in QIV. The annual growth will remain uncomfortably high, at 3.3%, but should slow quickly in HI 2012. The QIV outcome is favoured by the seasonal pattern of price moves and assisted by a large drop in fruit & veg prices. So the new ABS seasonally-adjusted CPI should print higher (we expect a rise of 0.6%) and the underlying measures should also exceed the headline result.

CONSUMER PRICES
% 5

(% change)
Annual

% 5

Quarterly

0
CBA (f)

-1 Sep-01

-1 Sep-03 Sep-05 Sep-07 Sep-09 Sep-11

CONSUMER PRICES
%

(annual % change)
Headline inflation (exc GST)

2
CBA (f)

Underlying inflation

The PPI.

0 Sep-98

0 Sep-01 Sep-04 Sep-07 Sep-10

The CPI.

Release date PPI 23 Jan

CBA (f) 0.6% (3.2%pa) 0.2% (3.3%pa) 0.7% (2.6%pa)

Market consensus

Market range

na

na

CPI

25 Jan

na

na

Underlying 25 Jan CPI

na

na
As at 20 Jan

Global Markets Research

Fixed Income: Inflation Market Update

We expect the average of the RBAs trimmed mean and weighted median CPI measures to rise by 0.7% in QIV. Annual growth would print at 2.6%. An alternative measure also favoured by the RBA, the CPI excluding volatile items, should rise by 0.5% (or 2.7%pa) on our figuring. Sensitivity. On a six-month-ended basis that smooths out quarterly volatility: Seasonal issues. a QIV CPI of 0.6% would keep underlying inflation at the middle of the band. it would take a QIV CPI of 0.9% or more to get inflation up to the top end of the band.

UNDERLYING CPI
%

(annual % change)

5 QIV scenarios 4 0.9% 3

The new ABS seasonal-adjustment methodology complicates the analysis. Seasonal factors are re-estimated each quarter and recent quarters can undergo significant revision. The QIII underlying CPI rise averaged out at 0.3%. This outcome was the smallest rise in the ten years for which the new measures are available. It pays to be suspicious of extreme readings (in either direction). So part of our thinking on the QIV outcome reflects the likelihood of a bounce back (or revision to QIII). A top-down modelling approach shows the QIV CPI outcome driven by a lift in unit labour costs partly offset by lower import prices and a small output gap. The importance of unit labour costs in driving core inflation outcomes highlights the need to lift productivity growth. The key price move in QIV is the unwinding of the weather-induced spike in fruit & veg prices earlier in 2011. The infamous banana effect has reversed (and the run down now actually exceeds the preceding run up). Lower fruit & veg prices should reduce CPI growth by 0.32ppts. The other traditional volatile item, petrol prices, should have little impact in QIV. Seasonal influences will be quite important in driving the QIV outcome. Seasonally low increases in property rates & charges, utilities, education, clothing, household appliances, utensils & tools and pharmaceuticals will help hold down the headline CPI. Categories set to record above-average outcomes include dwelling rent, new dwelling purchase, alcohol & tobacco, some transport components, holiday travel & accommodation, some recreation and culture items, some household services and insurance services.

2 RBA target 0.6%

1 Sep-02 Sep-04 Sep-06 Sep-08 Sep-10 Sep-12

SELECTED FRUIT & VEG PRICES

Index 300

(Oct'01=100)
Source: CBA/Ausmarket Qld floods & Cyclone Yasi "banana effect"

Index 300

Model results.

250
Cyclone Larry "banana effect"

250

200

200

The detail.

150
Dec '11

150

100 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

100

Table: CPI Components (nsa) QIV 2011

% change Food & non alc bev Alcohol & tobacco Clothing & footwear Housing Furnishings, h/h equip etc Health Transport Communication Recreation & culture Education Insurance & financial serv -1.5 0.6 0.1 0.6 0.4 -0.5 0.4 0.1 0.9 0.0 0.7 Contrib (ppts)

-0.25 0.04 0.00 0.14 0.04 -0.03 0.05 0.00 0.11 0.00 0.03

The risks.

Fluctuations in the degree of discounting at the retail level are the key source of risk to the forecasts. The New Zealand CPI outcome (0.3%in QIV) also suggests some downside risks.

Michael Blythe Chief Economist T. +612 9118 1101 E. michael.blythe@cba.com.au

Global Markets Research

Fixed Income: Inflation Market Update

Appendix 1: Significant (courtesy xkcd)

Global Markets Research

Fixed Income: Inflation Market Update

Source: This cartoon is from the webcomic xkcd.com.

See http://xkcd.com/882/

10

Global Markets Research

Fixed Income: Inflation Market Update

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Global Markets Research

Fixed Income: Inflation Market Update

Research
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