Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Volatility flared again, with a rapidly evolving offshore banking crisis eliciting policy support and a fall in shorter-term yields as markets began to price in a pivot to monetary easing. The longer end of the government yield curve also benefitted from flight-to-quality flows. Equity and credit markets were very volatile, but regained some composure following support measures. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, had a very strong month, gaining 3.16%.
We suspect the RBA will take the pragmatic path and leave monetary settings unchanged in April. However, a brief pause doesn’t mean the tightening cycle is over. We look for the RBA to lift the cash rate by 0.25% in May to 3.85%.
The Reserve Bank of Australia (RBA) lifted the cash rate by another 0.25% to 3.60% in early March. While maintaining that further tightening was likely, the tone of the RBA’s commentary was less hawkish than February’s communications. Offshore, banking sector stress led to a sharp fall in yields as markets reassessed the outlook for monetary policy and growth. Three- and 10-year government bond yields ended the month 66 basis points (bps) and 55bps lower at 2.94% and 3.30%.
Economic data played second fiddle to offshore events, but revealed ongoing resilience as the economy grew by 0.5% in the December quarter. In addition, strong business conditions in the NAB Business Survey over January and February, along with a hefty rebound in the labour market over February, suggest that the economy may have gained some momentum over the March quarter. According to monthly CPI readings, inflation looks to have peaked late last year, but the yearly rate of 6.8% in February remains elevated.
Short-term money markets remained volatile as offshore banking sector developments led markets to shift from pricing in further monetary tightening to pricing in a 3.60% cash rate peak for this cycle, with a high chance of a 0.25% cut in the cash rate by year’s end. Three-month bank bill yields ended 15bps higher at 3.72%, a little over the prevailing cash rate. Six-month bank bill yields picked up the change in monetary policy expectations, ending 14.5bps lower at 3.79%.
Credit markets were also gripped by the banking crisis in the US which spread rapidly to Europe. The collapse of three US regional banks, together with the forced take-over of Credit Suisse by UBS over the course of a single weekend, marked the most significant period of financial sector stress since the Global Financial Crisis. While regulatory / government intervention and support has been swift, significant losses have been imposed on certain debt and equity holders.
Investors remain on edge as aggressive market participants continue to probe for and attack weaknesses exposed by the unprecedented speed at which interest rates have risen. Caution within bank board rooms and credit departments was already evident coming into this this year. Investors are assessing if this caution will translate into tightening lending standards, leading to a rolling credit crunch, with significantly negative implications for economic growth.
Domestically, the primary market was effectively shut for much of the month. Taking advantage of a relative period of calm into month-end, ANZ issued $4.25 billion of senior unsecured bonds across three- and five-years in both floating and fixed rate formats. Meeting solid demand (approximately $5.7 billion order book), these bonds priced at attractive credit spreads of +83bps and +106bps, respectively.
Further down the capital structure, ANZ’s Capital Notes 8 transaction commenced trading towards the end of the month. Printing at a tight credit spread of +275bps before the banking crisis, interestingly these are trading close to par. Gyrations in global bank capital markets, catalysed by the unprecedented write-off of Credit Suisse’s AT1 bonds, appears not to have materially impacted the ASX-listed hybrid market to date. Elsewhere, non-financial corporate issuers remain on the sidelines. In residential mortgage backed securities (RMBS), AMP printed a $750m transaction, the first transaction by a bank in some time. Senior AAA notes priced at a credit spread of +145bps, reflecting heightened volatility.
Adjusted for the quarterly roll, the Australian iTraxx Index closed 4bps tighter at 91bps, while the Australian fixed and floating credit indices returned +1.85% and +0.26%, respectively.
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Market outlook
The RBA notes that as it meets monthly, it has more optionality than other central banks. With much of the heavy lifting already done and banking sector sentiment still skittish, we suspect the RBA will be inclined to take the pragmatic path and leave monetary settings unchanged in April.
However, a brief pause doesn’t mean the tightening cycle is over, especially given ongoing strength in activity indicators, the bounce in the labour market and calls for higher wages. We look for the RBA to lift the cash rate by 0.25% in May to 3.85%, using March quarter CPI data as a smoking gun. Thereafter, we look for the RBA to pause and wait to see how the economy responds to the quickest and largest tightening in monetary conditions in the inflation targeting era.
Flaring volatility is a feature of a maturing tightening cycle as markets periodically reassess the peak of the cycle and the proximity of the easing cycle. Our sense is that market pricing of a 3.60% peak in the cash rate is too low and pricing of an easing cycle starting late this year/early next year is too early.
Recent data readings remain consistent with our central case view of a growth slowdown, rather than recession, and gradual fall in inflation. Current market pricing is more consistent with a developing recession that crunches inflation and allows the RBA to ease sooner. Accordingly, we see the shorter end of the government yield curve as getting expensive, while the longer end is heading that way. We remain on the lookout for tactical opportunities to add duration on spikes in yields on central bank signalling and data flows.
As the cumulative impact of tighter financial conditions continues to grip and the cycle ages, our focus in the credit space is towards defensiveness, with a keen focus on risk-adjusted returns. Our strong bias is towards high-quality, liquid credit and issuers that can survive and thrive through a range of macro-economic scenarios.
We are avoiding illiquidity, complexity and leveraged sectors, where we anticipate balance sheets will have to contend with a painful period of adjustment in a higher cost of capital environment. Lastly, by adopting a patient and disciplined approach to extending risk and reserving ample investment capacity we will be well placed to take advantage of any further market dislocations.
Views as at 31 March 2023.
