It was a very interesting week for market strategists with the equity and bond markets simultaneously rallying after economic data that only confirmed that inflation is increasing and the economy remains robust. This interpretation of the key data releases deserves some explanation as it flies in the face of the actual market outcomes.
Firstly, the US inflation data last week. The PPI data at +0.5% for April was much stronger than expected at both the core and headline levels. There were downward revisions to prior months so that year on year the core PPI was 2.4%, in line with expectations, but the stronger price momentum suggests that wages are now feeding into producer prices and these are being passed onto the buyers. The CPI data then on Wednesday night was interpreted very favourably by the markets because after 3 months of upside surprise the result was in line with expectations. There was always an expectation that the CPI data would show a decline in April for seasonal reasons to the market’s reaction here is puzzling. When you look at the super core inflation level, which excludes shelter costs that are still increasing at 5.5%pa, it shows that underlying inflation actually rose in April to 4.7%pa. The truth here is that inflation is still rising despite all the rate increases and the rise in the USD over the past 18 months. The market has been wrong about inflation since November last year.
Secondly, the Australian employment data showed an employment increase – yes, an increase – of 35,000 last month but the market and our media focused only on the increase in the unemployment rate from 3.8% to 4.1%. The increase in the unemployment rate can be explained by:
- The increase in the labour participation rate;
- The ABS method of determining that those unemployed includes those that are transitioning between jobs.
Next month’s jobs data could easily show a slight decrease in the labour participation rate following the Federal Budget handouts and sharp fall in the job transitions that will push the unemployment rate sharply lower.
Lastly, the Australian wage price index that unexpectedly showed a fall in wages growth in the March quarter from 4.2% to 4.1%pa. We remain quite confident that post August 20 when the new IR laws come into effect the unions that represent less than 15% of the workforce will successfully use the new “same work, same pay” clauses in the new laws to increase the average wages level and also increase union membership levels.
Putting the new IR laws to one side, the fall in wages growth in the March quarter was due to the modest increase in public sector wages. Wages growth of just 2%pa when inflation is still at 3.6% does not look sustainable in the public sector where no-one can even define labour productivity let alone engineer a way to increase it. One explanation for why public sector wages are lagging inflation in the March quarter might be the parlous financial condition of the Victorian government. Anecdotally, government contracting work is being delayed until the new financial year (a good explanation for the higher level of workers in transition) and expected wage increases for the 3 main state public service sectors (Police, Nurses & Teachers) are being delayed. Just in the past week we have had the extraordinary strike action taken by the nurses that resulted in 25% of the hospital beds being closed. It seems highly likely that once we get into the new financial year organised public sector services employees will receive a large increase in wages and wages growth will surge.
The modest 0.8% increase in private sector wages also looked odd because all the negotiated wage outcomes during the quarter were close to 5%. A simple explanation is that these increases do not begin until the start of the June quarter. This theory is supported by the fact that the employment data showed a significant number of workers transitioning between jobs in April. After all, the only reason for a worker to transition to a new job is for a higher pay packet, in an economy operating beyond full employment (where the RBA defines full employment as an unemployment rate of 4.5%).
Interest Rates
The market’s reaction to the in-line CPI data last week may be better explained by the quietly announced dual decisions of the Federal Reserve to reduce QT from $60bn to $25bn per month of US treasuries and the US Treasury announcement that it would buy back bonds for the first time since 2002. Back then Treasury justified the buyback as necessary to preserve the size of the bond auctions when the budget was in surplus. However, today with a budget deficit they look like Yellen has returned to trying to manipulate bond yields. Last November when the US 10 year was near 5% the Federal turned dovish and the Treasury switched from selling bonds to selling short-dated bills in order to alter supply and put downward pressure on the long end of the curve. As we said then and since then, they can get away with QE only as long as inflation is benign. Despite commentators calling for a bond rally, 10-year treasuries rose at week-end to 4.42%.
Most Australian bond rates fell over the week by about 0.13% across the curve.
Major Credit Markets
The Chicago Fed’s National Finance Conditions index last week confirmed that corporate borrowing conditions have reached the loosest level since January 2022 despite the Feds fund rate having been at 5-5.25%, the highest level in 23 years. The expectations that these higher rates would have a broad impact on the economy have been proven wrong with the impact only being felt by companies with lower credit quality. Tighter credit margins and higher equity prices are signalling that the US economy remains robust. The USA iTraxx index has rallied back to a new low for this cycle, 0.489%. This has led all other credit markets lower, the European iTraxx at 0.58% and the Australian at 0.638%. All must be good in the corporate world!
So far, the Australian market has absorbed the new corporate issuance that has ramped up since the consensus moved away from rate cuts in 2024. Financial and corporate credit margins remain at tight levels despite the Federal Budget that was poorly received.
High Yield Markets
Despite major credit rallying, US High Yield (HY) was flat for the week, the insurance sector underperforming. Other the other hand BBB securities continue to rally, the average US BBB at a margin of just 1.26%.
NAB announced a new out-of-cycle hybrid, $1bn of a March 2032 maturity (7.8 years) at a 2.60% margin, historically tight for a major bank Basel III/IV issue. The book build was strongly bid. There was no reinvestment offer.
Hybrids had a topsy week with good volumes early as large long-dated lines were sought and short dated sold heavily (CBAPH and AN3PH). However, the new NAB issue caused selling across the sector, resulting in the average major bank hybrid moving from a tight 1.99% on Monday to 2.20% at week-end.
Listed Hybrid Market
Hybrids – curve games
NAB’s $1bn hybrid issue last week without a reinvestment offer sparked selling to fund the issue. This is typical for a large major bank hybrid issue. The chart below shows the rise last week in margins of the 4 current NAB hybrids. The shorter-dated NABPF was the most impacted.
Recent heavy selling of short-dated hybrids has opened up opportunity for buyers to de-risk their hybrid exposures. Short-term hybrids offer good yield without the repricing sensitivity if equity and credit market sour. Hybrids credit margins are currently close to long-term lows. Negative repricing is a possibility. If credit or equity markets deteriorate hybrid prices will fall. One way to remain invested but get some repricing protection is to hold shorter-term hybrids. Short-term hybrids are not as prone to negative repricing as they contain much lower credit duration; investors are confident repayment will still occur and soon. Further, holding a hybrid close to its maturity date can be rewarding as typically the bank will offer a reinvestment option. Currently, CBAPG is the pick of the bunch with an April 2025 maturity and yield near 6%.
Forward Interest Indicators
Australian rates
Swap rates steady after recent rises.
Swap rates:
- 10-year swap 4.43%
- 7-year swap 4.30%
- 5-year swap 4.20%
- 1-month BBSW 4.30%
