Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
Bond yields lifted across the month as growing concerns over the US debt ceiling negotiations came up against inconsistent signals from the local and global economy. Markets were leaning towards the more positive data sets, inflation concerns, and downplaying signs of policy gripping. This drove a rise in volatility, and a re-pricing of higher terminal cash rates. Short and longer dated government bond yields rose sharply after last month’s modest moves. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 1.20%.
As we approach the end of the Reserve Bank of Australia’s extraordinary tightening cycle, the immediate path is often murky.
The Reserve Bank of Australia (RBA) raised interest rates another 25 basis points (bps), to 3.85% and warned that they are now highly data dependent. They are no longer committed either way between pausing or hiking, but want to see clear signs that inflationary pressure is abating, particularly in the wages sector. Three- and 10-year government bond yields ended the month 37bps and 27bps higher at 3.37% and 3.60%.
Governor Lowe is now focused on four main data points: retail sales, employment, the NAB business survey and Consumer Price Index (CPI). May brought about decidedly mixed reviews. Retail sales are slowing back to normal levels, and the growth is being driven by prices, not volumes. The May employment report also showed signs of normalisation from highs, with negligible employment growth and a tick up in the unemployment rate. The NAB business survey continues to show resilience, albeit coming a little lower.
The monthly CPI was a little higher than expected but still consistent with moderating headline CPI, while the RBA had nothing to fear from the quarterly wage price data, at 0.80% quarter on quarter (qoq). They are cautious about the upcoming annual award wage setting, and are focused on productivity, as a guide to how inflationary wages growth may be. Overall, we are seeing the first impacts of policy gripping, and it will be the stickiness of inflation that may drive policy from here.
Short-term money markets progressively incorporated nearly one more 25bps into the cash rate. Against the current cash rate of 3.85%, three-month bank bills ended 5bps higher at 3.98%. Six-month bank bill yields ended 7bps higher at 4.17%.
In credit markets, investors remained focused on the likely trajectory for credit fundamentals and spreads in a slower growth, higher cost of funding environment. In global Investment Grade credit, corporates took advantage of strong investor appetite for quality yield to issue bonds ahead of the US debt ceiling deadline. These deals generally attracted healthy levels of oversubscriptions. Conversely, in the more leveraged sectors, ratings downgrades have started to pick-up, as have bankruptcies particularly in the US. Consensus is for defaults to continue to increase from here, as forward-looking economic indicators deteriorate.
Domestically, primary markets were active. Of the major banks, post their half year results, NAB issued $5.25 billion of senior unsecured bonds across three- and five-year tenors in both floating and fixed rate format. Meeting solid demand (~$6.9 billion order book), these bonds priced at attractive credit spreads of +78bps and +100bps respectively. Lower down the capital structure, ANZ issued $1.15 billion of Tier 2 subordinated debt callable in five years also in dual format, at a credit spread of +235bps. Lastly, CBA issued its latest ASX Listed hybrid, Perls XVI. Sized at $1.55 billion and callable in seven years, these notes were issued at a floating rate credit spread of +300bps.
The non-financial corporate bond market also fired up for the first time in months. Notable transactions included “A-“ rated shopping mall REIT QIC Town Centre Fund issuing $200m of six-year fixed rate bonds at a credit spread of +180bps (yield of 5.50%). Regulated NSW electricity transmission utility Transgrid issued $250m of “BBB” rated seven-year fixed rate senior secured bonds at a credit spread of +192bps (yield of 5.77%). Lastly, regulated VIC transmission and distribution utility Ausnet issued $700m of “BBB+” rated 10-year fixed rate senior unsecured bonds at a credit spread of +205 (yield of 6.13%).
Markets rallied towards month-end on news that a tentative agreement on the US debt ceiling had been reached. The Australian iTraxx Index closed 6 bps tighter at 83bps, while the Australian fixed and floating credit indices returned -0.51% and +0.34% respectively.
Also read: How to Position Your Fixed Income Portfolio
Market outlook
As we approach the end of the RBA’s extraordinary tightening cycle, the immediate path is often murky. The economic data tends to be inconsistent, as the famous long and variable lags tend to grip some sectors sooner than others. This drives market volatility, amid policy uncertainty. As the news starts to come in consistently, that enables markets to price the next, downward, phase.
We see the current RBA level of 3.85% as the most likely peak in the cash rate but acknowledge the myriad uncertainties. The key swing factor is the speed of adjustment in the CPI toward the RBA’s 2-3% target. For this reason, we have a solid tilt to the alternative RBA path, of a terminal cash rate of 4.35% by August 2023. We see the mostly likely outcome of the June meeting as a pause in both scenarios.
The Federal Budget showed little signal either way in terms of being expansionary or overly contractionary, and as such did not greatly change the growth profile. However, there were a series of measures that will adjust prices over the year, allowing our estimate of CPI to hit 3% in early 2025. Although, wage negotiations will be a key determinant of inflation risks in the months ahead.
We currently see market pricing of nearly one further tightening as reasonable, however the easing delayed until nearly October 2024 we would consider as somewhat stretched. We currently see the Australian yield curve as broadly fairly valued. 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 May 2023.
