As we expected the US inflation data surprised to the upside with confirmation that services prices remain sticky and that the rise in gasoline prices is now drifting into final prices. The CPI data should have had a greater impact on the bond markets than it did, with the market dismissing the second monthly increase of 0.40% in core CPI confirming, at least the risk, that US inflation has stopped falling and has begun to rise again. It was only until the US producer prices index data was released on Thursday that the bond market began to truly re-price this risk of inflation being higher for longer. Like the CPI data, the PPI data is beginning to show that strong wages growth is now seeping into services prices to create a wage price spiral. It is early days in this journey and the market still expects that the Federal Reserve’s preferred measure of inflation will continue to ease in the months ahead to move below 2% and allow the Federal Reserve to achieve its forecast (dot point from FOMC) of the 3 rate cuts this calendar year. The market may well suffer a rude awakening shortly.
The bond market’s assumption that the US economy will achieve a “no-landing” or at least a “soft landing” outcome still remains the most likely outcome in 2024 but it will not be done with the Federal Reserve’s inflation target having been achieved. The equity market with its records and the credit market with its tight margins appear to conclude that the economy will keep growing at a nice pace and that higher inflation can be accommodated. This hinges on the Federal Reserve sticking to its dot point chart plan of three 25bps cuts this year.
There are a great deal of political influences at work this year because it is an election year with a record number of electoral ballots scheduled. The easing of inflation pressures in the Euro Area does give the ECB some room to move on rates this year but it is unlikely to now move prior to the June Euro Government elections without a dramatic increase in unemployment and it may then find due cause to remain on hold well into 2025. The Federal Reserve will be more cautious about being seen to cut rates too close to the Presidential election so if a rate cut does not occur by May we see them also on hold until the December meeting. This will force the markets to adjust their rate cut expectations and hopefully focus back upon the fiscal expenditure plans of both parties.
One grey swan this year, is perhaps, the oil price. A few weeks ago, we pointed out that it had broken a resistance point at $79.26 and was looking to test the significant resistance level at $81.50. It did in fact test this resistance level and retraced last week but the fall looks unconvincing from a technical aspect so the price could retest and break $81.50 over the Easter period. The inflationary consequences of an oil price surge are significant.
A second grey swan is the Australian dollar. The currency has been remarkably stable since the violent sell off at the onset of the pandemic in March 2020 (that brought out forced selling of the Australian Treasuries to meet margin calls on the dollar and we saw for the first time since deregulation of the Australian currency a dysfunctional Australian Treasury bond market). There are several reasons why this stability may be challenged this year that include:
- The appointment of the new RBA interest rate setting Board reduces the central banks perceived and actual independence and this damages the markets faith in its ability to control inflation.
- The falling iron ore price should shortly begin to impact the Australian current account outcome. It should not impact Federal Budget forecasts as the Australian Treasury had absurdly low iron ore price forecast of US$55 tonne in last year’s budget, but it will mean that the actual tax revenue falls in the year ahead.
- The market does not believe that – in an election year – the RBA will have the stomach to raise rates even if inflation surprises to the upside and is in fact still predicting three interest rate cuts. If inflation begins to rise in Australia and the RBA does not increase rates, then the market will devalue the currency so watch the Aussie dollar not bond yields for the next signal on the direction of RBA policy.
Interest Rates
The last mile of taming inflation is lengthening. Stronger than expected US CPI and PPI readings for February bringing out the impact of rising fuel costs, further enhanced by a rising oil price last week, stoked fears of a later than expected easing cycle by the Fed. Other data showed a resilient economy which also gives reason for a pause. Treasuries jumped across the curve, 2 years up 0.25% to 4.50% and 10 years up 0.23% to 4.30%, just off 2024 highs.
Australian bond yields also rose across the curve by a consistent 0.15%. 10-year Comm. Gov bonds are now 4.16%, well under US 10 years. at 4.30%. This Aust.-US discount has been consistently growing since early December when Aust. rates were 0.20% above US rates.
Major Credit Markets
Despite the rise in bond yields on the back of sticky inflation and an equity market retreat, credit markets remain unruffled and close to lows. However, this may be a turning point or at least the end of the huge credit rally in the past 4 months.
The Australian credit market was also flat for the week. Issuance continues unabated with huge bids into bond IPOs. E.g. HSBC (rated A-) received $5.8bn of bids for the 2 tranches (fixed and floating) of a 10NC5 subordinated Tier 2 security, issuing a total of $1.5bn over both styles at a margin of 2.30%, with the deal initially indicated at a 2.50% level. ING Bank Aust (rated A) received over $3bn of bids for a 3-year senior bond with fixed and floating versions. A total of $1.25bn was raised at a 0.95% margin. NAB (rated AA-) issued $3.5bn of a 5-year senior bond in fixed and floating versions at a margin of 0.90%. Demand was $4.9bn with $3.5bn issued. Suncorp (rated A+) issued $1.25bn of 5-year senior bonds in fixed and floating tranches at a margin of 0.98%. This is 0.08% above comparable major bank senior bonds despite ANZ’s Suncorp takeover.
High Yield Markets
As for investment grade, despite the rise in bond yields and equity market retreat, US high yield (HY) markets remain unruffled and close to lows, with no net move in spreads over the week. Monies continue to flow into HY funds supporting credit margins.
Hybrids margins retreated after the previous weeks’ rally which in no small part was due to several major bank hybrids holding the franking component of dividends. The major bank average hybrid margin rose by 0.21% to 2.23% from an artificial low the week before of 2.02%. Selling is evident to fund the 3 new hybrid issues all settling over the next week.
CBA announced it will not roll over the CBAPH security which now will be repaid in late April. This is a strong positive for the sector: funds that may have looked to reinvest/invest into a new CBA hybrid will now prop the secondary market, not to mention the $1.59bn of redemption funds to hit the market at April-end.
Listed Hybrid Market
Hybrids – the long game
With the average major bank hybrid margin hitting lows we can look at a long data series to put this into context. The chart below shows the major bank average hybrid margin and the iTraxx index, a measure of the average Top 25 Australian corporate bonds’ average credit spreads. Right now, the average hybrid margin is at lows reached only three times before. This is not unexpected: the iTraxx index is also relatively low although not quite at the lows of 2018, early 2020 or mid-2021. Essentially, the average hybrid margin follows the iTraxx index. Hybrids can stay firm as long as credit remains strong. However, as has occurred many times in the past, large major bank issuance can upset the relationship.
Turning to Macquarie hybrid and longer-dated major bank hybrids, the second chart shows that whilst Macquarie hybrids are also at lows, long-dated hybrids are not. In fact, these are well off lows suggesting this is where the value in the sector is. If hybrid margins do widen then it will be more felt in the short to mid-dated part of the hybrid maturity curve, which we have noted previously is quite positively slope rather than the usual plateau after 5 years. Now that CBA is not to issue to replace CBAPH, the long end of the curve may be the place to be.
Forward Interest Indicators
Australian rates
Swap rates rise following bond yields higher.
Swap rates:
- 10-year swap 4.38%
- 7-year swap 4.23%
- 5-year swap 4.13%
- 1-month BBSW 4.30%
