Inflation will be higher for longer than the market expects | Economic Update

Another rough week for the now very stale bond bulls that show a startling level of misunderstanding of inflation. The reality is something we have written about many, many times since our first early warning in June 2020 that the unique pandemic shutdown conditions had the potential to let the inflation genie out of the bottle. Right here, right now all you need to remember is that inflation will be higher for longer than the market expects.

Last week the benchmark US 10-year treasury yields briefly breached the 4.50% level. There is a great deal of focus on the US 10-year bond yield for a number of reasons that include:

1. A yield of 4.50% is the highest level since 2007. The current 2-year yield is the highest since 2006.
2. A belief that the US central bank will begin cutting rates in 2023 and continue in 2024. This is based on the hope that inflation will evaporate – magically.
3. Most importantly, however, a belief that the yield on long-duration bonds will fall by 200bps to trigger an ~18% capital gain for a 10-year duration or 9% for a 5-year duration portfolio. 

Taking each of these arguments in turn:

1. While the 4.50% yield looks attractive relative to the last 10 years (a period in which inflation struggled to get to 2%), it is in fact the long-run average (25 years or more). It may not then be such a great opportunity if rates – due to inflation – have returned to their normal range. Investors should also make a comparison to the equity dividend yield on the ASX 200, that is ~4.5% nominal plus franking credits and better still look at a floating rate bond portfolio where even a senior repo bond will get over 5%.
2. Now that inflation has become embedded with wages growth now feeding into services prices it will take a much longer period to grind inflation out of the economy. There is still a distinct possibility that we will see a wage price spiral that will see inflation shortly begin to increase again. Inflation is not going to evaporate, magically, this time.
3. A fall in the 5-10 year part of the curve will be muted to a large extent by the Federal Reserve QT plan. The QE bias that has dominated central banks over the past 10 years is now dead and buried. The Federal Reserve Put is dead because no central bank can engage QE while inflation remains above target.
   

Last week the US 5-year yield broke upwards through a key technical resistance point. This suggests that the 5-year yield will rise to over 5% in the short term. Fixed rate duration funds that generally have a modified duration number of near 5 will be impacted.

Interest Rates

The US treasury market continues to struggle under the weight of new treasury issuance. The US 2 year surged to a 5.20% (a level not seen since 2006) while the US 10 year briefly traded above 4.5% (a level not seen since 2007). The US Fed kept rates on hold but flagged a potential rise by year-end. Expectations of US rate cuts in 2024 have been pared back given economic data remains strong and a pullback in US inflation is not observable.

Britain’s high inflation rate unexpectedly slowed; the Bank of England paused its long run of rates hikes.

Recent RBA meeting minutes show that a rate rise was considered in September, this raises expectations of a rise by year-end. Australian fixed rate sovereign bonds were dragged higher by the rise in the US yields. The Aussie 10 year is still trading at an 11bp discount to the US at 4.32%. With increased sovereign risk for Australia the 10-year gov bond should be a premium to US rates, not a discount.

Major Credit Markets

Investment grade issues traded in a narrow range last week ahead of $16bn of new issuance expected this week. It was actually new high yield issues that dragged the US margin index wider and with it the Australian iTraxx (which rose by 0.10% on Friday). New floating rate credit issuance will be under some pressure in the weeks ahead with new issuance coinciding with equity market weakness and rising treasury yields. 

New issuance last week was dominated by Kangaroo issues and the Suncorp 10.75NC 5.75 year Tier 2. Suncorp is caught in no man’s land at the moment with ANZ and Suncorp appealing the ACCC merger block while it has a $600m Tier 2 issue reaching its first call date in December. The new Tier 2 priced at 235bps and has traded in the grey as tight as 225bps. Suncorp as a bancassurance has an A+ rating and if ANZ buys Metway then the Tier 2 bonds will transfer to ANZ.

Forward Interest Indicators

Swap rates jump significantly with large government bond rises.

Swap rates:

• 10-year swap 4.58%
• 7-year swap 4.45%
• 5-year swap 4.35%
• 1-month BBSW 4.14%

High Yield Markets

Bond market volatility and subsequent equity market wobbles forced a jump in US high yield (HY) markets. Average HY spreads widened by 0.12% on Thursday and a further 0.04% on Friday. In context however HY spreads are tighter by 0.90 YTD, hence there is a lot of room for wider spreads in the bond and equity market volatility continues.

Hybrids were tracking sideways until Friday were margin rose by 0.13% on average. Weakness was evident more so in ANZ and Westpac hybrids. Outside CBAPH, CBA and NAB hybrids were nearly steady. The new NABPJ closed an issue low of 2.71%. In the non-major hybrids, the BOQ issues were both weak whereas most others were only slightly weaker.

Listed Hybrid Market

It’s early days with the jump in hybrid margins on Friday. Pricing yardsticks of equity prices/volatility and credit spreads have only moved negatively by a small amount. How these measures trade this week will be critical. 

One other factor late in the week that may have impacted hybrid margins was the release of an APRA report flagging a review of how Australian bank hybrids will enhance bank balance sheet resilience under stress. The review may have been driven by the Credit Suisse debacle in May this year which saw hybrid holders wiped out before equity holders. APRA gave an overview of current structural features and how it feels these may undermine the effectiveness of hybrids to give some stability to a bank as a going concern under stress. The APRA paper calls for comments regarding the level to which capital triggers occur as well as who should be the targeted investors’ audience. Any changes however will not affect current hybrids. Any major structural changes would not be expected until 2025. APRA is being consultative which is good. Arculus Funds management will be contributing to the APRA discussion and hence are happy to discuss with clients.