The week ahead may prove pivotal for the global bond markets.
The US has roughly $33 trillion in Federal debt, at an average interest rate of roughly 3%, which generates around $1 trillion per year of interest cost. Based on current expectations, the Congressional Budget Office guesses that the government deficit from 2024 through 2033 will average $2 trillion per year (meaning net U.S. debt will increase by $2 trillion per year). A trend of $2 trillion per year deficits as far as the eye can see is simply not sustainable. At some point, we can be sure it will end, we just can’t tell when that point arrives.
There are a number of scenarios that could play out:
- The Federal government learns to exercise fiscal restraint which would imply very slow, or even negative GDP growth.
- The bond market shuts the borrowing door and government responds with fiscal restraint. This is effectively the same outcome as above, but starting with a higher debt load, and therefore a more severe growth reduction.
- The Fed circumvents the bond market and renews quantitative easing, which will lead to much higher inflation.
This is a ticking time bomb because either we will see much higher inflation because the Federal Reserve re-engages with Modern Monetary Theory and finances fiscal debt expansion through QE, or we will see either the government or the bond market force a dramatic and prolonged economic contraction.
What keeps us up at night or waking in a bath of perspiration (Renny with another migraine) is a failed US Treasury bond market auction. In November 2022 we saw the global bond market revolt against the UK budget outcome under Truss and this is something that we see as inevitable in the US. The US 30-year Treasury auction last week showed some cracks with primary dealers forced to take 25% of the offering – more than double the average last year. The week ahead could prove pivotal because the Congress faces a deadline on Friday to avoid a government shutdown. A shutdown or a new increased spending agreement are the most likely outcomes because Congress to date has shown no ability to curtail its spending. Last week Moody’s put the US on negative watch citing the inability of Congress to agree on spending cuts as the main reason.
Higher treasury yields – even with the Federal Reserve anchoring the short end of the curve with rates on hold – seem inevitable with the ever-increasing treasury issuance to fund fiscal spending and with the 3 biggest buyers of the US Treasury market over the past 30 years no longer participating:
- The US Federal Reserve is tapering QE – QT.
- Chinese buyers have withdrawn.
- Japanese buyers are preferring Yen bonds with the Yen weakening.
Tactically, we are using the US 5-year yield chart for trading signals. Here this key level is 4.50%. This was a resistance point previously and proved to be an important support point last week. Our view remains that US treasury yields are going to keep rising – through 5% at the 5-year level.
The week began with the key 5-year yield touching support at 4.50% after a slightly weaker non-farm payrolls emboldened an increasingly desperate section of the market that is hoping for a US recession. The economic data continues to suggest a recession is not yet on the cards. By the end of the week the US 2 year had broken back above 5% and the US 10 year reversed early gains to finish at 4.65% after Powell, once again, stated that inflation is not dead yet.
The RBA decision to increase rates by 25bps was painted by some parts of the market as making a statement about independence rather than a sign that the RBA was wrong to have moved earlier in the year to hold rates states steady. Others read the RBA statement as quite dovish and this reduced the Australian 10-year premium over the US 10 year to just 1 basis point. The real test of RBA independence will come when the government announces the appointments to the new RBA interest setting board that commences in February.
Major Credit Markets
US investment grade (IG) spreads rallied strongly with risk-on sentiment and very strong IG issuance as issuers acted quickly to issue at lower rates than weeks earlier. Thirty companies issued more than $40 billion of IG bonds. Is this a signal that corporates expect rates to resume their strong rise? Meanwhile investors pulled record amounts out of corporate bond ETFs in October on fears of rate rises, given most US corporate bonds are fixed rate.
Australian IG credit markets also rallied with the iTraxx index falling by 0.04% to 0.80%, getting close to recent lows. However, major bank senior margins continue to drift higher with increased supply hitting the market. Last week Westpac surprised the market with a very large $1.5bn Tier 2 15NC10 offer at a fixed +240bps over SQW and then 2 further USD tranches. NAB came with a senior 5 year at +110bps that was sought after.
High Yield Markets
The US high yield (HY) market also rallied strongly with strong equity markets. As with IG markets, US HY issuance has been strong as corporates take advantage of the recent 0.50% fall in long bond rates.
The hybrid market sold off last week continuing the trend of recent weeks and exacerbated by Westpac’s announcement that it intends to issue a new hybrid potentially with a reinvestment offer for the June 2024 maturity, although the logic for holders to roll is absent given this issue trades at a $0.60 premium to accrued interest and pays a 3.70% margin dividend rate.
Post the RBA rate rise 90-day bank bills are now at 4.41% which is a new high base for hybrid margins. Dividend rates will increase by 0.25% p.a. December is a good month for dividends. Those paying earlier will get the higher dividend rate set more quickly.
Listed Hybrid Market
Westpac flags an issue and will pay for it!
As mentioned above, hybrid margins have moved wider since Westpac announced a prospective hybrid issue. We have also previously described that large new issuance has a significant impact on current hybrid pricing. This is simply a supply and demand issue with investors selling current issues to fund the new (and often not optimally).
Westpac with its result on Monday said it is considering a new Capital Notes (hybrid) issue. The result of this announcement is starkly seen in the chart. The blue dots are the latest margins for the major bank hybrids as labelled. Directly below each blue dot is a red dot that is the same hybrids’ margin close on Friday, 3 November. All blue dots are well above red dots across the curve illustrating that margins have risen. Hence the gap (rise) in margin represents moves post the announcement in a week that was positive for credit and equity markets. This has been singularly because of the Westpac announcement. Typically, this margin rise is accompanied by the IPO, however Westpac not yet starting the issue, but increasing margins across the curve will cost the bank extra spread. Margin changes ahead or during an issue always opens opportunities for investors to gain mis-priced (because of the announcement) hybrids. At the short end, AN3PG is a standout and the longer-dated WBCPL good relative value.
Forward Interest Indicators
Swap rates fall along with Comm. Gov. bond rates. Bank bills firm before RBA meeting.
- 10-year swap 4.96%
- 7-year swap 4.80%
- 5-year swap 4.67%
- 1-month BBSW 4.19%
The US inflation data may prove to be the most important data release in the week ahead. This is because it is the first inflation reading after the very strong 4.9% consumer spending-led GDP growth in the September quarter and the first inflation reading that will have been impacted by the rise in the oil price in August that pushed petrol pump prices up over 20% in September and October. There is normally a lag of 60-90 days between a rise in the petrol price and final prices.
A strong inflation result would also confirm that the consumer, post the pandemic, is not as dependent on the employment data than it has been historically. This is because wages growth, post the pandemic, has been very strong and the pandemic lockdown increase in welfare has remained in place. The following chart depicts this. This level of wages and welfare is inflationary.