2Yield curve (March 2004)Very steep at short end and flat further out“It is a confused looking yield curve at the moment… Strong growth and rising cash rates now argue for higher bond yields across the curve, but signs of slower activity in the housing sector could be signalling lower economic growth and interest rates over the medium term. On top of that though, the international pressures look to be for higher interest rates in the immediate future given the improving growth prospects.” (pg 2 March 2004)Remember, a flat yield curve suggests a pessimistic outlook with investors suggesting long-term rates are as good as it getsTrading Game – QTR 1 Review3Yield curve – short endThe bulge in the yield curveat the short end suggests market expectation of RBA increase in cash rateBut, RBA focuses on keeping inflation within its 2-3% target range, and the inflation outlook suggests it to be settling toward the bottom of the rangeSo, perhaps market expectation of rising RBA cash rate not justifiedTherefore, short-term yields may fall back if market re-assesses likelihood of RBA increase to cash rateTrading Game – QTR 1 Review4Yield curve – mid curve“A fall in building approvals…”Economists suggest building approvals as a leading (2-3 qtrs) GDP indicator and..…indicate that the effect of this would most likely first be seen in the middle part of the yield curveYield curve – long endInflation is key driver here, but long-term economic growth outlook also importantInflation outlook is benign suggesting no upward pressure on long term yieldsLong-yields likely to lift if investors become more confident about sustainability of economic recover Trading Game – QTR 1 Review5The yield curve returned to a more normal shapeduring the past three months. No further moves on the official cash rate and signs of slower domestic economic growth forced traders to re-assess expectations of continued RBA tightening going forward, which brought down the yields at the short end of the curve. Despite steady to falling domestic inflation, though, longer term yields still roseduring the quarter because of the influence of the international financial markets on our own. In particular, better US economic data liftedbond yields, but the rise was probably capped relative to the strength of the datadue to lingering concerns about the sustainability of the recovery that the data is indicating. Most traders are predicting that a Federal election will be called in the next three months, but predictions about what this might do to the yield curve are thin on the ground. What we know is that solid economic growth last year has delivered a substantial budget surplus this year, and politicians on both sides have promised income tax cuts should they get elected. Tax cuts at a time when the economy is already going well are unambiguously negative for the bond market (ie. higher interestrates), but if the economy is truly slowing, then maybe tax cuts would be more appropriate.