Australian Interest Rate Swaptions.....(Huh, you what?)

Some time ago, Our Man mentioned his bearish views on China (see A, B and C) and how he was looking at Australia (and especially Australian Interest Rate Swaptions) as a way to play any China slow-down.  Since Our Man is trying to pitch it to a few people, here's the thinking behind that idea, in all it's glory.

Thesis:
The markets expect that Australian interest rates will exceed 5% in 2-years time but I believe that they will be substantially lower.  Thus by purchasing an interest rate swaption that gives one the right (but not obligation) to receive, in 2-years time, interest at the rate of 4.5% on 1-year money will prove spectacularly attractive. 

Why do I believe it is mispriced?
a. Australian GDP growth isn’t entirely what it seems:
Australia is viewed as having escaped the Financial Crisis, with only 1 quarter of negative real GDP growth.  However, this belief ignores that Australia had 3 quarters of negative nominal GDP growth (please see graph below on right), implying that in 2 of those quarters prices fell even as volumes increased.


Australian growth benefited directly from an aggressive stimulus package (c$30bn, or 3% of GDP) and through the RBA cutting interest rates.  These measures had a significant impact on household disposable income, causing it to rise by 10% y-o-y to Sept-09, despite labour income (the largest component) contributing a mere 0.4% (per Gerard Minack of Morgan Stanley Australia, February 24, 2010: The Odd Expansion).  Minack estimates the primary factors behind the household disposable income growth were the stimulus package (4% increase to household disposable income) and the RBA’s rate cuts (5% increase).

b. Australian Private Debt Levels are similar to the US Peak
While Australia’s government debt (<25% GDP) is in good shape, the same cannot be said of Australian Household Debt, which has just crossed 100% of GDP, and over the last couple of years has surpassed even that of the US (please see graph below on the left; courtesy of Steve Keen's Debtwatch). 

The increase in this debt during 2009 was largely driven by an increase in the Australian First Home Owners Grant both at the federal (A$7,000) and state (e.g. New South Wales – A$3,000) levels.  However, unlike the US equivalent, the Home Owners grant can be put towards the deposit on a house, meaning that it is quasi-leveragable by reducing the down payment that the buyer must provide, from their own funds, in order to meet a bank’s LTV target.





c. Australian House Prices are in a larger bubble than the US was at peak!
The impact of the sharp rise in household debt on house prices is clearly visible; after consistently tracking CPI since the mid-80s, house prices in the major Australian cities rose sharply as household leverage increased (please see graph on right).

Given that sharp move in nominal house prices, it is not surprising that the recent 6th Annual Demographia International Housing Affordability survey ranked 3 Australian cities amongst the worst 4 globally (and 10 in the top 20).

The size of the move in Australian house prices is particularly stark, even when contrasted to other countries where we’ve seen housing bubbles (please see graph on left, courtesy of Steve Keen's Debtwatch and The Economist). 

In particular, it’s noticeable how the reintroduction and increase of the First Home Owners Grant by the Australian government in 2009 has had a far more pronounced impact than the US equivalent, and succeeded in not only arresting the fall in house prices but managed to drive them higher.

d.  China
Australia has been a major beneficiary of China’s aggressive stimulus during 2009; with China representing 25% of 09-10 exports of which around 2/3 are natural resources.  Thus the Australian economy, and Australian households, would be significantly impacted by any slowdown in China.  Since there is much discussion in the financial world regarding whether China is or is not a bubble, and as I personally believe that it is (see A, B and C), this trade represents a cheap and effective way to play the possible unwinding.

Timing
Now is the perfect time to put the trade on:
I.     Australian economic data has started becoming more mixed (e.g. Feb’s weak retail sales numbers).
II.    Australian banks have started to tighten credit and cut their Home Loan-To-Values (Westpac has cut their LTVs from 92% to 87%).
III.    The expiration of the increases to the Australian First Home Owners Grant during 2010 (many of the State supplements, such as those in Victoria and New South Wales, expire in June-2010).
IV.    The emergence of inflation in China, which is likely to lead to tightening of credit and rates there.

Why Australian Interest Rate Swaptions?
I believe that this trade represents an exceptional opportunity and the most efficient way to play both a slow-down in China and a decline in the Australian housing/credit markets.  The underlying reasons are:
1)    Time Horizon: The nature of the instrument means that the trade has 2-years, an exceptionally wide window, in which to work. 
2)    Risk/Reward:  As the trade is a swaption, the maximum loss is limited to the premium.  Furthermore, the swaption offers a large time window for my opinion to be correct, yet (like CDS but unlike equity options) the cost does fully represent the width of the time window.  Finally, interest rate swaptions (like CDS) do not price in significant tail events (e.g. Australia being forced to institute a zero-rate policy) due to their expected improbability.
3)    Liquidity/Reducing Counterparty risk:  Interest rate swaps, options and swaptions are exceptionally liquid products and traded by numerous banks, meaning the trade can be put on in large notional size and counterparty risk can be limited with each bank.
4)    The willingness of Western Central Banks to aggressively cut rates to support economic growth and to head off solvency/credit events (as seen in 2007-09) makes interest rate options an attractive investment.  This is even more true of Australian interest rate options because of the predominance of floating rate mortgages there, which means that interest rate cuts will directly increase disposable income.

For illustrative purposes (based on contacts from a number of investment banks):
Instrument: AUD2y1y 4.5% Receivers 
Cost: 12bps of notional; this also represents the maximum loss on the position
Return (if option exercised): (4.5% - Bank-Bill Swap Rate ) * Notional

Example: If Bank-Bill Swap Rate fell to c3.25% (i.e. the levels seen in 08-09), the return would be 125bps of notional, a c10x return on the invested capital.



Huh, you what?
You lost me at interest rate...let alone that whole swaption thingy...besides, even the E*Trade baby won't sell me those things.  Well, Our Man is in the same happy little boat, as far as this portfolio is concerned....it's just not easy to play a short thesis on Australia (and its banks/construction sector/home builders/etc).  The way Our Man's looking to implement it is probably be through options on EWA (iShares Australia).  However, given the general lack of options, the liquidity of EWA and their cost, it's a less attractive trade than the interest rate swaptions.  What does that mean?  Well, it means our timing has to be a lot better and our sizing is going to be smaller.  Rather than spent 100bips of premium steadily buying swaptions (that don't kick-in until 2-years after the purchase date) over the next 6-12months, Our Man's going to be looking at 3-6month options on EWA.  That means Our Man's certainly going to wait until the trend in EWA is down and the Australians have made their first rate cut, before looking at putting 25-50bips into the trade over the following months.