The “melt-up” period for the global equity markets appears to have ended, or at least paused, with the realisation that the inflation outlook in the US (and most of the developed world) will not allow the Federal Reserve the generosity of cutting rates three times this year. In fact, there is a growing case for another rate increase.
The US CPI data for March, released last week, showed a 0.4% increase at the headline level and a 0.4% increase for the core CPI. The CPI headline year on year rose to 3.5% and the core reading to 3.8%. The markets obviously were hopeful that the hotter CPI readings in January and February were not sustainable, so the disappointment caused a dramatic rise in US bond yields.
The PPI data released a day later was actually in line with market expectations and the market was a little relieved for a very short period. The headline and core PPI for March was 0.2%, lifting the core annual PPI to 2.4%. This now leaves the release of the PCE prices index on the 26th to complete the trifecta. The CPI and the PPI data now imply a reading of 0.3% for the March Core PCE Price index.
Technical Commentary
At this stage the fall in the US equity markets looks corrective – a retracement – rather than a new momentum downtrend. Many, with one eye on the fundamentals, the underlying economic weakness in the economy, or the resurgence of inflation, may dispute this view. However, it is a technical view only and needs to be viewed as such.
At this stage the medium uptrend since November appears to have been broken and a new short-term downtrend is forming. The market may well focus on the 5100 level of support (thin line) but we view the 5050 level (thicker line) as more technically significant.
So far in April, what we have seen appears to be profit taking by disciplined investors that have seen their quarterly profit targets met and don’t want to risk remaining invested while the reporting season upfolds over the next few weeks. There is no sign of the panic yet from undisciplined investors, but then they are always late to the party.
We are now watching the rise in the VIX index, which closed on Friday night at 17.31 after a volatile session. The VIX has spent the last eight months trading below 15, indicating low market volatility. It is now between 15 and 20 where previously we have seen periods of correction or retracement occur. If it moves above 20 this week (and it was at 19 briefly on Friday night) then we not just have a correction, but a significant market decline underway. This is where the undisciplined investors join the disciplined sellers to drive the market down rapidly. Here it is worth remembering that the disciplined seller universe does not only include long-only equity investors but also short sellers.
We will be watching for the S&P 500 to break the 5050 and the VIX to surge above 20 as a signal that the recent fall has not been just a retracement in a longer-term uptrend pattern, but a change in the medium-term trend.
The technical pattern on the ASX 200 looks like a bearish rising wedge. It is an exhaustion pattern that usually results in a short, sharp sell off. Investors have been accumulating over time while the uptrend was forming but as we reach the apex of the wedge, the selling overwhelms the buying, and we see the trend breakdown. The pattern for the ASX 200 looks actually more bearish than the S&P 500. Perhaps this is because the ASX 200 rally since October has been dominated by the bank sector and with interest rates now less likely to fall the bank valuations look stretched.
Interest Rates
All US Treasury yields surged higher last week after the CPI data. The 2-year traded briefly above 5% for the first time since The US 5 and 10-year bonds finished the weekly off their highs but still above the previous resistance levels at 4.5%. The focus will now shift towards the impending Treasury auctions with the 20 year this week and the 5-year and 2-year auctions next week. The surging USD last week may see demand for US Treasuries weaken.
Australian Commonwealth bond yields moved higher last week in line with the shift in US bond yields but are still trading in the same range they have traced out over the March quarter. Traders will be watching the 5-year for a break above 4% and the 10-year for a close above 4.3% for a signal that the curve will steepen further. The markets still expect an RBA rate cut this year and possibly now before the Federal Reserve moves. The Australian 10-year spread to the US 10-year has now widened to 27bps, but this should contract sharply this week with the AUD falling.
Major Credit Markets
The US CDS index showed margin tighter over the week, but this may be due to a lack of issuance ahead of the reporting season. US credit markets have taken a more cautious tone post the CPI data with an expectation building that spreads will widen further, to digest planned corporate issuance, post the reporting season.
The Australian credit market rallied mid-week but finished flat after global market volatility. Issuance resumed after Easter: United Overseas Bank (rated AA-) raised AUD1.25bn in a dual tranche 3-year offer of senior bonds at a margin of 0.77%; Adelaide Airport issued $200m of a 7-year senior secured bond at a yield of 5.667%, a spread of 1.42%; Westpac issue a covered bond into Europe, a 7-year issue at a market spread of 0.42%. Westpac is rated AA-, the covered bond is expected to be rated AAA.
High Yield Markets
High yield (HY) margins have risen as the HY rally looks to be ended given the rise in overall asset classes volatility especially equity markets. The VIX index has risen well off recent lows. Monies are now flowing out of HY funds.
Hybrid margins further tightened as the market prepares for the large funds from the CBAPH redemption on 26 April. The average major bank hybrid margin is 2.12%, a fall of 0.10% over the week and now near all-time lows (see next page). Over the last week the beneficiaries of the rally have been in the middle part of the hybrid curve: CBAPI, NABPH, CBAPL, AN3PI, CBAPK and WBCPK.
Listed Hybrid Market
Hybrids – margins at tights, are bank risk profiles improving?
The major bank average hybrid margin moved to lows last week driven by buying demand across the curve, despite some wobbles in the equity markets. The chart below shows the margin back to 2013 along with the iTraxx index, a measure of the average high grade senior bond margin. This index is also near lows and reflects Australian credit markets, a major influence on hybrid margins. Hybrids rank at the bottom of a bank’s credit spectrum just above equity. Hybrids are therefore quite sensitive to moves in the perception of a bank’s credit profile. An interesting article in the AFR on Saturday, 13 April (Chanticleer, page 40) discusses research by Jonathon Mott from Barrenjoey which describes how Australian bank loan books have become less risky. This has been due to “a combination of 4 structural factors: the Basel capital rules encouraging fully secured, low loan-to-value lending; macroprudential tightening introduced as house prices have surged; responsible lending laws; and the broader conservatism after the banking royal commission.”
The result is less risky loan books as lesser credits fail to get house loans from the major banks. Loans to business by the major banks also favours those who can put up housing collateral. This all leads to two things: firstly, overall less risky loan books and secondly, lower bank net interest margins, although the major banks are still wildly profitable. However, as credit investors, the risk profile is important. Hybrids will perform well as long as a bank’s balance sheet remains strong and problem loans do not strongly arise, now more unlikely given the factors mentioned above. This is good news for major bank hybrid investors.
It is little wonder then that credit spreads are now tight. This does not mean hybrid margins cannot rise from current levels. There will still be variation in margins over time, driven by the usual factors of wholesale market credit spreads, equity market volatility, and volume of hybrid issuance. Note, currently all these factors are positive for hybrids. However, the nuclear event of a major bank breaking the CET1 capital ratio trigger or being deemed “non-viable” by the regulator is becoming now more remote. Major bank hybrids are popular because individual investors are very confident a major bank will not falter. This line of rationale is now stronger thanks to the regulatory oversight forcing bank lending to effectively derisk.
Forward Interest Indicators
Australian rates
Swap rates leap following large rises in bond rates.
Swap rates:
- 10-year swap 4.41%
- 7-year swap 4.27%
- 5-year swap 4.18%
- 1-month BBSW 4.30%
