As foreshadowed last week the US ISM services index results supported a forecast of increased economic activity over the next 6-9 months. Gone now is the talk of a recession by anyone with a shred of integrity or credibility. The following chart shows the manufacturing and non-manufacturing ISM PMI data.

The jump in the non-manufacturing prices index should have scared the bond market. The ISM PMI data is very important to the media/market participants’ narrative that the US will achieve the “Goldilocks” soft landing and the “immaculate” disinflation. The media/market participant storytellers (note not all market participants) relied upon the combination of an inverse benchmark yield curve and the ISM PMI readings below 50 to predict that the US would be in recession by the March quarter of 2023. It is cute then that they now predict a “soft” landing because the yield curve is “less” inverse, and the ISM PMI data has “started” to recover.

We prefer an alternative view of the US economy:

  • The inverse nature of the US inverse yield curve reflected the bond market believing that inflation was induced, on a “transitory” basis by the pandemic lockdowns damaging supply chains. The market then with a “less” inverse yield curve is now predicting that the recent disinflation caused by the abatement of the “transitory” factors is nearly complete.
  • Post the pandemic lockdowns, the ISM PMI data was not a reliable indicator due to the way the economy was disrupted by the pandemic lockdowns. Prior to the lockdowns an ISM PMI reading below 50 was a signal that in 6-9 months the economy and employment would contract. Post the pandemic, this has not happened. Until we know why the ISM PMI data, alone, has not successfully predicted an economic contraction, it should not be used to forecast US economic activity but used in conjunction with other leading indicators.

The performance to date of RBA Governor Bullock has exceeded all expectations (at least ours anyway). Her public statements on monetary policy have been carefully and correctly balanced to leave enough ambiguity for the RBA to have the flexibility to make policy adjustments as required. Under her stewardship it does not look likely that the RBA will make the same mistake made in the midst of the pandemic lockdowns when it stated that interest rates would remain on hold and not increase until April 2024 (when the TFF expired).

The Governor’s ambiguous statements then leave room for the biased bank economists to claim interest rates are about to fall and the desperate Victorian Premier Allen to openly call for interest rate cuts. Victoria is drowning in a deep pool of its own debt so Premier Allen’s conflict of interest is obvious. The behaviour of the banks, however, is more nuanced, but still reflective of their natural business bias to more lending activity. Already we are seeing borrowers buying what the media and banks are selling with home loan growth and home prices rising… again.

Interest Rates

US rates shifted modestly higher last week after the stronger than expected ISM PMI services confirmed that the outlook for the US economy remains robust. US 10-year Treasuries rose by 2pts over the week to finish at 4.17%. The curve steepened with a 1bp move at the 3-month level, 11bps at the 2-year, 16bps at the 5-year and 14bps at the 10-year point of the curve. Various Fed officials pushed back on rate cuts, preferring a wait and see approach rather than rush in and cut. Markets are now at a 50% probability of a cut by June whereas it was a lot higher the week prior.

10-year yields moved broadly in line with US rates, however, the market appears to have interpreted Governor Bullock’s speech following the RBA meeting as hawkish. The 2 to 5-year part of the curve steepened from -7bps to + 2.40bps and the 5 to 10-year part of the curve flattened from +39bps to +22.50bps. The market appears to be pricing more rate increases in the short term and then an economic contraction.

Major Credit Markets

US credit spreads remained very firm despite recent record levels of issuance. Investors are lapping up primary and secondary paper focusing more on the absolute yield level (now that rates are higher) rather than the credit spread. Not a good investment mantra.

We have been seeing a wave of issuance of 3 and 5-year senior debt from the mutual banks and smaller regionals over recent weeks. These have come at credit spreads not seen for a few years now. Last week’s Newcastle Permanent 5 year issued at 185bps with a bookbuild of $1.2bn for an issue size of $400m marks an important milestone for this respected mutual. This is an issue size that 7 years ago we would have seen from a major bank. The bond margin was rapidly bid into 165bps at weekend with buyers happy to purchase in the secondary. In the week ahead we expect to see issuance announced by CBA following their results that could be Senior or Tier 2.

High Yield Markets

The rally over the past 12 months in US high yield (HY) resumed, driven mainly by strong equity markets and an ongoing thirst for yield. HY issuance has been strong given the lower yields and the 1% drop in long rates, allowing higher risk credits a window to capture lower re-financing costs.

Hybrids margin widened over the week essentially going against the trend of strong US HY and strong local bank share price performances. The average major bank hybrid margin rose 0.03% for the week to 2.50%. This is also a rise of 0.19% since ANZ announced on 24 January an upcoming hybrid issue.

Turnover in the hybrid sector has remained low, similar to January levels. Average daily turnover over the past week has been $25m, whereas for the same week in 2023 the average turnover was $30m. Average daily turnover in 2023 was $34m.

Listed Hybrid Market

Hybrids – state of spreads

Last week we showed 2 charts of relative hybrid valuations to equities, with hybrids looking cheap on a raw share price performance basis and cheap given bank stock grossed yields have now fallen to equal hybrid yields. This week we look at hybrids relative to credit markets. The chart below shows hybrids relative to the iTraxx index, a measure of the top 25 Australian corporate bonds spreads, a good proxy for bank credit margins. The most recent ratio is spot on the long-term average, back to early February 2013 just after the current hybrid structure was introduced (based on Basel III/IV). Hence on this basis hybrids are fair value compared to credit markets. However, if we look at the past 2 years, the environment where cash rates have rebounded from almost zero to 4.35%, hybrids have performed strongly relative to credit (as shown by the low ratio since February 2022, the green line). The average ratio over this period was well under the current level.

Source: Refinitiv, Arculus

Turning to the margins of longer-dated hybrids, the chart below shows the average margin of longer-dated hybrids. The chart shows the pricing at the times of four major bank issues in 2023: AN3PK, CBAPM, NABPJ and WBCPM. These issues were priced between 2.80-3.10%, depending on margins at the time of issue. Note the peak in margins caused by the issues. In past weeks the average margin for long-dated hybrids has widened to 2.93% (arrowed), the 2-year average being 2.80%. Buying above the average is good value especially given the strong state of equity and credit markets.

Source: Refinitiv, Arculus

Forward Interest Indicators

Australian rates

  • Swap rates rebound with long bond rates. Short-term rates are steady as the RBA maintains a neutral to hawkish stance.
  • Swap rates:
  • 10-year swap 4.39%
  • 7-year swap 4.23%
  • 5-year swap 4.14%
  • 1-month BBSW 4.31%
Source: Refinitiv