Some have described last week’s US bond sell off as a “bondcano”. We would prefer to be little less dramatic given that this is something we have forecast for some months now. The key underlying pressures are:
- A strong underlying economy led by services activity that has resulted in a strong labour market.
- Core inflation remaining well above target with a rising risk of feeding into wages growth.
- Energy costs rising.
These are all characteristics that can be identified in most, if not all, developed economies over the past 6 months.
In a US context we then need to add:
- The Treasury supply-demand imbalance caused by the debt ceiling standoff that has been accentuated by Biden-led Democrat spending increases at a time when the economy is operating beyond full employment.
- The huge open position in US Treasury futures that has the potential to destabilise the treasury market.
Increased US Treasury supply is putting pressure on all global bond markets. The US Treasury has a heavy program of bond issuance over the next few months to maintain the government funding requirement and has still not yet restored the $550bn balance to the General Account of the Treasury that was run down during the debt ceiling negotiation period earlier this year. The rising tide of US Treasury issuance may at some point result in higher Treasury bond volatility. One measure of US Treasury bond volatility is the Move index.
US Treasury bond volatility needs to be monitored very closely at the moment. The Bank of England, the Bank of International Settlement and the Federal Reserve have all recently highlighted that the short interest in Treasury futures has risen well above the level it reached in early 2020. The rise in short interest has occurred because hedge funds are deploying a strategy called the “Basis Trade” whereby they buy a US Treasury at one price (e.g., $100), sell it in the futures market at a higher price (e.g., $100.50) and leverage this difference by also using the bought bond to borrow (e.g., $98) and again recycle this into the “Basis Trade”. Hedge funds deploy this strategy ahead of downturn points in the economy where interest rates begin to fall and demand for fixed rate government bonds rises and causes the margin between the actual, and futures price to contract. The problem the regulators are worried about is that if margins actually widen (don’t contract) in line with increased Treasury market volatility, then unwinding the “Basis Trade” will make the bond market dysfunctional in a similar way it did in March 2020, and briefly in 2008 after the Lehman’s collapse. This is something that the Federal Reserve at the recent Jackson Hole Symposium considered with a paper written by Darrell Duffie, “Resilience redux in the US Treasury market”, Graduate School of Business, Stanford University, 13 August 2023.
Finally, we continue to monitor the Italian bond market, as one of the known risks to global bond stability, in the months ahead. Last week the spread between Italian and German 10-year yields quietly slipped over the 200bps cap imposed by the ECB. The market may be only just beginning to test the ECB resolve here.
Interest Rates
US treasuries soar higher again, the 10-year up 0.21% to a new cycle high of 4.793%. Global bond markets have begun the transition from expecting central banks to be driving interest rate outcomes, to a market-driven interest rate outcome. This is evident in the steepening of the fixed curves in most developed economies with the central banks patiently anchoring the short end while the market reacts to the stronger growth and higher inflation for longer outlook. Both the US 2-5 year and US 5-10 spreads are flattening.
Australian gov. bond rates didn’t follow the US rises as strongly with the 10-year Comm. gov bond rate rising by 0.05% to 4.564%. Offshore investors are now seeing a rise in Australian sovereign risk on the back of the RBA structure being less independent, maverick inflationary IR laws, and a dysfunctional gov. senate, all reflected by wider swap spreads and a lower AUD. The US-AUD 10-year gap widened to -0.22%, a 6-month low.
Major Credit Markets
Investment grade credit spreads soared on the back of fears the “bondcano” will disrupt economies, create higher funding costs, and be a weak environment for the large fiscal funding due in the US in the next 18 months. The perceived strong US growth number late in the week gives more reason for the Fed to increase rates. The US iTraxx rose by 0.02% to 0.753%, the European iTraxx by 0.09% to 0.99%.
The Australian iTraxx rose by 0.10% to 0.97%, a 2-month high and well above early September lows of 0.76%. Major bank senior margins were steady despite ongoing issuance by Kangaroos. The recent steepening of the US curve has increased the swap rates, making the US market an unattractive proposition for Australian issuers. We expect then to see an increase in the volume of Kangaroo issues here, and Australian banks to upsize planned issuers in the months ahead. As a result, senior bank spreads should widen next month.
Forward Interest Indicators
Australian rates
- The gap between bill rates and swap rates continues to widen.
- Swap rates:
- 10-year swap 4.85%
- 7-year swap 4.67%
- 5-year swap 4.49%
- 1-month BBSW 4.05%
High Yield Markets
US high yield (HY) markets were quite weak with the average HY spread moving wider by 0.32%. However, this level is still well below April levels. US BBB spreads also moved wider by 0.08%.
Hybrids had a poor week, finally responding to the weak equity market and as described above, weak credit markets. The average major bank hybrid margin rose by 0.27% to 2.52%. After a light volume start to the week with public holidays, volumes were 20% above average as buyers looked for size bids. Nearly all major bank and non-major bank hybrid margins rose for the week. Weakest were the ANZ and Westpac issues: AN3PH, WBCPI and WBCPH each some 0.50% or more in margin, weaker. NAB hybrids fared comparatively well with NABPJ in fact steady. In the non-majors, Macquarie hybrids were weakest and SUNPG, it rising some 1% in margin. Bendigo, BOQ, AMP and Challenger issues were all slightly softer.
Listed Hybrid Market
Margin changes
As hybrid margins move wider over recent weeks, as described above, examination of the major bank margin curve allows identification as to whether individual moves are relatively warranted. The chart below shows the curve on 21 September and Friday, 6 October. Individual hybrids are identified from the 6 October curve (blue dots), the corresponding 21 September levels directly below (red dots). As shown, most widening has occurred at the short end, where for 2024 maturity issues, the margin rise is about 0.70%. Of these, AN3PG will be offering close to a 6% p.a. yield for 6 months’ exposure. From mid-2026 on, the selling has not been as evident. In some cases, such as NABPH, WBCPK, and NABPI, margins as basically steady. At the long end of the curve, the recent 2023 issues are quite stable, with only CBAPM and NABPJ showing a slight widening.
