Emma Lawson, Fixed Interest Strategist – Macroeconomics in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Market Review
A global rise in term premium, and increased factoring of an elevated Reserve Bank of Australia (RBA) policy rate has increased yields through October. Despite a mid-month rally, yields have reset higher and curves steepened. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell -1.85%.
A global rise in term premium, and increased factoring of an elevated RBA policy rate has increased yields through October.
Bond market volatility refuses to ease, and markets remain wary of the outlook. Big global themes are driving long-dated yields higher and curves steeper. The RBA remain uncertain, and continued their cautious pause, at 4.10%, at their October meeting. Three-year government bond yields ended the month 32 basis points (bps) higher at 4.40%, while 10-year government bond yields were 44bps higher at 4.93%.
The move to embrace an elevated central bank rate, where policy cycles are removed, continued. RBA pricing shows a peak in the cash rate just shy of two 25bps rate hikes in mid-2024, and then holding until November 2024, with a very modest easing factored from there. Along with this is a steep repricing of US, and Australian, term premia in longer dated bond yields. Market inflation pricing has only moved marginally higher, but term yields are being driven to multi year highs due to term premia. The rise in term premia reflects global geopolitical uncertainties, US fiscal concerns, and broad bond supply as quantitative tightening continues. Not all of this directly impacts Australia, but broader moves pull Australia along.
A higher-than-expected Australian Q3 2023 consumer price index (CPI) outcome was enough to expect the RBA to raise interest rates at their next meeting. The annual CPI is moderating, now 5.4% year on year (yoy), down from 6%yoy. But with the quarterly increase rising to 1.2% quarter on quarter (qoq), from 0.8%qoq, the RBA will be concerned about reaching their target range in the forecast timeframe. Services prices, such as rents and electricity remain high. The labour market is slowing at the margins, but still sitting at solid levels. Indeed, this theme is consistent across the economy: signs of modest slowing from high levels.
Against the current cash rate of 4.10%, three-month bank bills ended 21bps higher at 4.35%. Six-month bank bill yields ended 34bps higher at 4.74%.
Negative risk sentiment continued into October driven by a combination of surging bond yields and war breaking out in the Middle East. Macro-economics and geopolitics largely overshadowed the commencement of northern hemisphere 3rd quarter earnings and gave investors much to fret about. Despite these concerns, primary markets remained active.
Domestically, non-financial corporates returned in a material way as corporate treasurers who had been hanging-on for a lower base-rate funding environment appeared to have a mindset shift contemplating higher for longer rates. Infrastructure issuers Port of Brisbane and Transurban Queensland came to market and issued $200m seven-year and $250m six and a half-year BBB rated fixed rate bonds at attractive yields of ~6.4% and credit spreads of +165bps and +160bps respectively. In the consumer staples space, grocer Woolworths issued $450m of seven and a half-year BBB rated fixed rate bonds at a yield of ~5.8% (credit spread of +135bps).
In the financials space, two notable transactions were both undertaken by CBA. The bank issued $1.25 billion of BBB+ rated Tier 2 subordinated debt callable in five years in both fixed and floating rate formats. These came with a coupon of ~6.4% and credit spread of +205bps. This was followed by CBA’s Medallion 2023-2 residential mortgage-backed security (RMBS) transaction, in which Senior AAA notes came with an attractive floating coupon of +105bps over the bank bill swap rate.
All these transactions were highly popular with investors. They attracted significant oversubscriptions, once again demonstrating healthy investor appetite for high quality investment-grade yields.
Reflecting elevated volatility, the Australian iTraxx Index ended 10bps wider at 97bps, while the Australian fixed and floating credit indices returned -0.77% and +0.37% respectively.
Also read: Millennial ETF Investors Turning Towards Fixed Income
Market outlook
We have increased our expectation for the RBA to include a rate hike at the November meeting, taking the cash rate to 4.35%. The RBA are cognizant of the pressures building in the economy, but they cannot ignore the persistent inflation pressure. We see them holding the cash rate at contractionary levels until September 2024 before commencing a modest easing cycle.
We see an increased risk to the upside for the RBA from our baseline scenario. We have a stronger tilt to the higher case of a peak in the cash rate of 4.60% if services inflation persists. This is most likely to occur if productivity in the economy remains moribund.
The RBA continue to monitor the balance between the slowing household sector, the strong labour market, and high wages growth. The economy has peaked, and we continue to believe that policy will continue to grip and slow economic growth further, with a shallow recession starting next year not off the table. The RBA are closely monitoring the rise in oil prices as well as global economic slowing as risks to the outlook.
We see the very near-term RBA pricing as reasonable, but the expectation of policy rates held at contractionary levels over a period of years as underestimating the cyclical risks. We currently see the Australian yield curve as under-valued at points in the curve. We remain on the lookout for tactical opportunities to add further duration on spikes in yields triggered by central bank signalling and data flows.
In recognition of the increasingly complex global investment environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. We have been actively and selectively taking advantage of the attractive yields on offer in highly rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions. While we believe that the cumulative impacts of tightening financial conditions will become evident, we are mindful of a healthy starting point of above full employment and remain open-minded to a wider range of potential economic outcomes that include scenarios less dire than ones revolving around deep recession.
Backed by fundamental research and experience, we also continue to identify pockets of opportunity where perceived risks have been overly discounted into the valuations of what would traditionally be considered stable and sustainable credits. In such instances, a strong case can be made for capital gains over-and-above already attractive cash yields, setting up for outstanding risk-adjusted returns for patient investors with a medium term investment horizon. We have judiciously begun to access such opportunities, while also preserving significant capacity to take advantage of opportunities arising through future market dislocations.
Views as at 31 October 2023.
