Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
The decision by the Bank of Japan (BOJ) to lift its 10-year governmentbond yield curve control target from 0.25% to 0.5% roiled global bondmarkets. Australian government bond yields initially moved lower onsigns that growth was slowing, before rapidly rising following the BOJmove. Flaring volatility saw risk appetite wane, with equity marketsweaker and credit markets mixed. Against this backdrop, the Australianbond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index,fell 2.06%.The Reserve Bank of Australia (RBA) lifted the cash rate by a widelyexpected 0.25% increment in early December, taking the cash rate to3.1%. While noting monetary policy was not on a pre-set path, the RBAsignalled that further tightening was likely over the period ahead, withthe interval and size of moves to be guided by incoming data and theRBA’s assessment of the labour market and inflation outlook.Australian yields initially fell as markets saw the prospect of a 0.50%move in the US cash rate as signalling that the tightening cycle wasslowing. While the US Federal Reserve (Fed) lifted the Fed funds rate bythe expected 0.50%, forward guidance remained hawkish and halted thefall in yields. Thereafter, yields lifted dramatically before Christmaswhen the BOJ unexpectedly adjusted its yield curve control settings.At the shorter end of the yield curve, the three-year government bondyield fell to as low as 3.01%, before ending the month 34 basis points(bps) higher at 3.50%_._ Further out along the curve, 10- and 30-yeargovernment bond yields declined to 3.30% and 3.59%, before ending at4.05% and 4.34%.On the data front, the 0.6% lift in economic growth over the Septemberquarter affirmed the signal from activity-based measures that growthremained solid but was moderating going into year-end. Businessconditions eased further in the November NAB Business Survey butremained at elevated levels though there was some further easing inforward orders and business confidence.Labour market conditions remained tight, with employment lifting by astronger than expected 64,000 in November. The participation rateclimbed back to an historically high 66.8%, which left the unemploymentrate unchanged at 3.4%. Consumer sentiment remains depressed, with costof living pressures and tightening monetary conditions taking theirtoll.Volatility returned to the short-term money market as markets reassessedthe outlook for monetary policy. Three- and six-month bank bill yieldslifted by 17.5bps and 20.5bps to end the month at 3.26% and 3.77%. Interms of the tightening cycle, markets are looking for the cash rate topeak close to 4.0% in late 2023.In credit markets, investors await further feedback as companies moveinto early 2023 reporting season.Cognisant of the impacts of tightening policy, slower growth will beunevenly distributed and disproportionately felt across sub-sectorcredit fundamentals. The grip of macro settings on corporate earningsoutlooks and employment intentions will be closely scrutinised bycentral bankers and investors alike.Primary markets moved into ‘holiday mode’, with Suncorp-Metwayissuing a new five-year note early in December which was well received.The waning supply of new issuance allowed domestic spreads to firm anddeliver some healthy excess returns from elevated spread levels viaincome advantage. The Australian iTraxx Index closed largely unchangedat 91bps along with floating rate spreads, while fixed rate creditspreads rallied up to 8bps as swap yields tightened to government bonds.Australian fixed and floating credit indices returned -0.62% and +0.34%respectively, with benefits of credit excess returns offset by the risein broader bond yields for the fixed rate market.We anticipate Q1 2023 new issuance will resume strongly, with Australianbanks looking to navigate their term funding facility refinancing earlyin the year. The strong level of income coming through from high qualitycredit securities provides investors some return buffer for likelyconcessions into primary supply.
Also read: Three Lessons From the 70s’ Great Inflation
Market outlook
The move by the BOJ threw a curve ball at markets and resulted in higheryields at the longer end of the curve. The rally in yields across theyield curve in early December proved to be premature given the hawkishstance of central banks and no signs of a definitive softening in labourmarkets or gap down in inflation. However, the rally was a harbinger ofwhat to expect once markets look through the final phase of thetightening cycle.Our base case has the RBA tightening by 0.25% in February and thenpausing before delivering a late tightening cycle 0.25% “inflationinsurance” move in May. This would take the cash rate to a moderatelyrestrictive 3.6%, making the current tightening cycle the largest andfastest in the monetary policy inflation targeting era.By mid-2023, almost a year after the first tightening, we expect to seemore definitive signs of the economy responding to monetary policy’slong and variable lags. The overall profile for growth over 2023 is oneof deceleration rather than outright recession. That said, the risks aretilted to the latter given the uncertain paths for the Ukrainian War,energy prices and offshore central bank tightening.While we do not see the conditions in place for monetary easing in 2023,the window opens for the RBA to take its foot off the monetary brakesover 2024 provided core inflation eases in response to a period of subtrend growth. After pricing in a cash rate peak closer to our profile inearly December, market pricing has pivoted back to a 4% cash rate peaklater in 2023 and 4.4% long-run cash rate (using the 8-year rate 2-yearsforward as a proxy). In our view such a cash rate is more in line with acyclical peak rather than the ‘new’ long-run normal cash rate.Accordingly, we see the recent lift in yields as beginning to restorevalue.In navigating the environment ahead, investors should be on the lookoutfor improved compensation for risk as monetary policy tightens further.We observe that the repricing across different pockets of credit andrisk premia have not been simultaneous, providing outperformanceopportunities through active rotation.Attractive yields on high quality credit spreads have seen demand returnfrom defensive income investors. In our view, the more illiquid,structured, and levered sectors of the market are yet to adequatelyreprice. We believe this is a process that will occur in due course asearnings outlooks weaken.We anticipate that as conditions tighten further, global spreads willsuffer decompression where high quality liquid credit outperforms lowerquality as compensation for default risk and illiquidity needs toincrease. We continue to favour being positioned up in quality andseniority in capital structures, leaving powder dry for whencompensation for investors escalates.
