Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Signs of slowing growth led markets to factor in a slowing in the pace of monetary tightening, particularly in the United States. Domestic yields fell across the yield curve, even after a late month lift on a high December quarter inflation result. Risk appetite improved, with both equity and credit markets performing strongly. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, gained 2.76%, more than offsetting December’s 2.06% fall.
Australian yields fell steadily as markets began to wind back monetary tightening expectations. Prior to the release of the December quarter Consumer Price Index (CPI), three and 10-year government bond yields fell to as low as 2.96% and 3.32%. The higher than expected 1.9% lift in the headline inflation rate saw market conviction of near-term monetary tightening firm and yields partially reversed earlier falls. Despite the late month lift, three and 10-year government bond yields still ended 32 basis points (bps) and 50bps lower at 3.18% and 3.55%.
While prices data was stronger than expected, activity-based measures like the NAB Business Survey showed that the economy began losing some momentum late last year. Labour market conditions also eased from very tight levels in December, with employment falling by 14,600, while the unemployment rate lifted from 3.4% to 3.5%.
Short-term money markets remained volatile as monetary tightening expectations shifted on data flows. The higher-than-expected inflation readings saw three-month bank bill yields end the month 11bps higher at 3.37% as tightening was brought forward. Six-month bank bill yields ended 4bps lower at 3.72%. In terms of the tightening cycle, markets are looking for the cash rate to peak around 3.75% mid-year.
In credit markets, sentiment was buoyed by evidence of peaking inflation, together with tailwinds from the abrupt re-opening of the Chinese economy. Looking ahead, investors are anticipating a downshift in the pace of global central bank rate tightening, while concurrently monitoring corporate and consumer health as forward economic indicators deteriorate and tighter financial conditions start to grip.
In the domestic primary credit market, supra-nationals and financials dominated issuance. Notable transactions included the Commonwealth Bank of Australia’s jumbo $5 billion senior unsecured issuance across three and 5-year tenors in both floating and fixed rate formats. Meeting solid demand ($6.7 billion order book), these bonds priced at credit spreads of +90bps and +115bps, and fixed rate coupons of 4.75% and 5%, respectively – attractive levels for high quality liquid assets. Lastly, towards the end of the month, the Australian Prudential Regulation Authority (APRA) approved the call/redemption of a low spread Tier 2 subordinated bond issued by Westpac and in doing so lifting a significant regulatory overhang over the domestic bank capital market.
The Australian iTraxx Index closed 10bps tighter at 82bps, while the Australian fixed and floating credit indices returned +2.19% and +0.42%, respectively.
Also read: Bounce in Fixed Income ETF Flows
Market outlook
The Reserve Bank of Australia’s (RBA) shift from the ‘heavy lifting’ to ‘finesse’ stage of the monetary tightening cycle wasn’t made any easier by the breadth of inflation in the latest CPI release.
The reason for finesse this year is that on the one hand, higher frequency activity-based data pointed to slowing growth towards the end of last year. To the extent that excess demand was behind inflation, a deceleration in growth suggests that the contribution to price pressures from this source will decline over the year ahead. Indeed, we look for economic growth to slow from 2.6% over 2022 to 1.4% for 2023. Our base case remains for a slowdown rather than a recession.
On the other hand, the breadth of inflation will be a source of concern for the RBA. While slowing demand and improving supply chains point to moderating inflation over the period ahead, direct and indirect pass through of higher gas prices and building wage pressures will act to limit the pace of deflation. Not responding to these price dynamics when policy settings are mildly restrictive would be a policy mistake.
Our base case cash rate view remains unchanged and has the RBA lifting the cash rate by 0.25% in February and then pausing to monitor the path of demand. Provided demand responds to earlier tightening, we look for a late tightening cycle 0.25% “inflation insurance” move in May. This would take the cash rate to a moderately restrictive 3.60%, making the current tightening cycle the largest and fastest in the monetary policy inflation targeting era.
We do not see the conditions in place for monetary easing until 2024. By that time an extended period of sub trend growth should see the RBA sufficiently confident that inflation was heading back towards the target band on a sustainable basis.
The value we saw building up in the sharp lift in government bond yields over late December was released as yields fell over January. While we currently see yields as fairly valued, we would regard periods of higher yields, as we enter into the maturing phase of the current tightening cycle, as potential opportunities to add duration.
In navigating the environment ahead, investors should be focused on improved compensation for risk as monetary policy tightens further. We observe that the repricing across different pockets of credit and risk premia have not been simultaneous, providing outperformance opportunities through active rotation.
Attractive yields on high quality credit spreads have seen demand return from defensive income investors. In our view, the more illiquid, structured, and levered sectors of the market are yet to adequately reprice. We believe this is a process that will occur in due course as earnings outlooks weaken.
We anticipate that as conditions tighten further, global spreads will suffer decompression. This is where high quality liquid credit outperforms lower quality as compensation for default risk and illiquidity needs to increase. We continue to favour being positioned up in quality and seniority in capital structures, leaving powder dry for when compensation for investors escalates.
