Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Convicted moves and signalling by central banks to front-end load monetary policy tightening cycles look to have capped the rise in offshore and domestic yields. After peaking earlier in the month, yields began to fall as the focus shifted from central bank inflation-fighting resolve to the consequences of tighter policy for growth. Equity and credit markets were weaker, while inflation expectations edged lower. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index fell by 0.89%.
“The RBA has joined other central banks in a pivot to a quicker return to neutral policy settings at a minimum to quell cyclical inflation pressures and just as importantly, anchor longer-term inflation expectations.”
Domestic yields peaked following the Reserve Bank of Australia’s (RBA) decision to lift the cash rate by 0.25% to 0.35% early in the month and signal further moves over the period ahead. At the shorter end of the yield curve, the three-year government bond yield peaked at 3.125% following the RBA move, before easing back to close the month 13.5 basis points (bps) higher at 2.84%. There was some steepening in the mid-to-longer part of the yield curve, with the 10-year government bond yield finishing 23bps higher at 3.35%. Further out along the curve, 30-year government bond yields finished 22.5bps higher at 3.68%.
Partial demand indicators point to consumption and public demand being key sources of growth in the upcoming release of the March quarter National Accounts. The external sector is set to be a large drag on growth following strong import growth as the economy restocked. COVID-19, supply chain issues and weather events look to have hampered construction and investment and some catchup is likely over the quarters ahead.
While cost of living pressures continue to depress consumer sentiment, the April NAB Business Survey points to underlying strength, with business conditions at elevated levels. This momentum continues to drive labour demand, with RBA’s business liaison reporting rising labour costs. These had yet to show up in the March quarter Wage Price Index, which rose by a less than expected 0.7%. Indicative of labour market tightness, the unemployment rate fell to 3.9%, levels not seen since 1974.
Short-term money market yields rose as nearer-term monetary tightening was factored in. The three-month bank bill yield ended the month 46.5bps higher at 1.18%, while six-month bank bills ended 47bps higher at 1.93%. In terms of the tightening cycle, markets are looking for a 2.5% cash rate by year end and around 3.25% by mid-2023.
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Aggressive global central bank policy action to tackle soaring inflation “at all costs”, hurt risk assets. Concerns around weakening sentiment, demand and growth outlooks intensified, just as corporates offshore began their first quarter reporting cycle. Cost inflation on multiple fronts was evident in results, with margins and earnings coming under downward pressure even for top-tier companies. Global credit markets reacted violently to a combination of rate volatility, weakening fundamentals, and recession fears, with spreads pushing wider across the course of the month. The Australian fixed and floating credit indices were not immune, both closing the month 9bps wider. The Australian iTraxx Index widened sharply, before retracing in the final days, closing the month flat at 95bps.
Amid choppy conditions, the major banks were active in primary markets, both offshore and domestically, and across senior unsecured and covered bond formats. Significant new issue concessions paid by ANZ, Westpac and NAB, led to a re-pricing of Australian dollar major bank three- and five-year senior unsecured spreads to approximately ASW+90bps and +105bps, respectively. Approximately 15bps wider over the month, these high quality, liquid instruments are being offered at increasingly attractive all-in yields. Other notable non-financial corporate transactions included a six-year green bond issued by top quality “A” rated mall operator, Vicinity Centres, at ASW+165bps, and inaugural Australian dollar bonds issued by majority New Zealand Government-owned Air New Zealand (rated Baa2) in four- and seven-year tenors at ASW+240bps and +300bps, respectively.
Market outlook
The RBA has joined other central banks in a pivot to a quicker return to neutral policy settings at a minimum to quell cyclical inflation pressures and just as importantly, anchor longer-term inflation expectations.
In choosing to move by 25bps in early May, the RBA noted that it wished to signal “business as usual” increments and that further moves were likely in the months ahead. We expect the RBA to tighten consecutively at its next three meetings, with a ‘‘not business as usual’’ 40bps move on the cards in response to either a strong lift in the minimum wage at the next Fair Work Commission hearing or strong Q2 CPI print. Such an outsized move would help tidy the cash rate up to a more normal 0.25% multiple. We have also pencilled in another 25bps move in November, which means we are looking for a 1.5% cash rate by year end. With the cash rate still below neutral, we look for further tightening over 2023, which takes the cash rate to 2.75%. In our estimate, monetary settings would be slightly restrictive at that level.
To get a sense of the responsiveness of the economy to higher rates, it’s worth noting that the May Statement on Monetary Policy technical cash rate assumptions used to generate the RBA’s 4.25% economic growth forecast for 2022 and 2% for 2023 (slightly below trend) were a cash rate of between 1.5% to 1.75% by year end and 2.5% by end 2023. Such a profile sees the headline and core inflation rate lift to 6% and 4.75% by the end of 2022, before falling back to 3% mid-2024 as tighter policy grips.
Given that the RBA sees a cash rate of 2.5% as normal, market pricing in early May was extreme, discounting a 3% cash rate by December and almost 4% by late 2023. Such a rate profile would most likely have tipped the economy into recession and saw value emerging at the shorter end of the yield curve.
By month end, tightening expectations had been wound back by around 50 to 75bps to a 2.5% cash rate by year end and 3.25% by late 2023. These still appear too aggressive, with markets holding onto the narrative that outright tighter policy is needed. While we remain agnostic on the longer end of the yield curve, we are mindful that term compensation is improving and that there is ultimately scope for capital gain if central banks overdo tightening and trigger a recession.
Uncertainty about the durability of the current expansion and cyclical cost pressures are likely to contribute to ongoing volatility in credit markets. These periods can provide opportunities when spread widening is in excess of fundamentals. We remain active and selective, favouring relative value within sub-sectors, whilst being judicious on overall credit beta. Recent spread widening has allowed us to access high quality names at attractive levels.
