Liz Harrison, Fixed Interest Analyst – ESG in the Janus Henderson Australian Fixed Interest team, provides her Australian economic analysis and market outlook.
Bond markets remained volatile in March. The recovery story picked up pace in the US market, backed by strong economic data, a rapid vaccine rollout, an expansion of the Biden stimulus package and a central bank that is willing to tolerate an inflation overshoot, whilst keeping interest rates at the lower bound. While Australia also showed promise of a strong recovery with some good economic data, the other contributing factors in the US opened a divergence between Australia and the US. Australian bond yields shifted lower (prices higher) over the month, while the US 10-year yield reached a 14-month intra-month high. Credit markets were relatively stable over the month. The Australian bond market recouped some of last month’s losses, with the Bloomberg AusBond Composite 0+ Yr Index ending March 0.80% higher.
While Australian economic data surprised to the upside in March, due to our lack of vaccine supply, snap lockdowns and hotspot border restrictions are still being relied upon to curb infections. This may ultimately widen the divergence between the US and Australian recovery story.
Yields at the shorter end of the yield curve drifted higher than the Reserve Bank of Australia’s (RBA) 0.10% cash rate and three-year government bond yield target. The three-year government bond edged slightly higher, ending the month at 0.11%.
Longer-dated government bond yields retraced off two-year highs reached in February. While domestic data was still robust, with indications of a strong labour market recovery, buoyant housing market and improvements to the fiscal position, the slower than expected vaccine roll out (disruptions in the international vaccine supply), floods, unwavering commitment from the RBA and record market moves in the month prior tempered the enthusiasm to push yields to new highs. The 10-year Australian government bond yield ended the month 13 basis points (bps) lower at 1.79%. The 30-year Australian government bond finished 15bps lower at 2.76%.
Australian fourth quarter 2020 GDP figures were released this month, with a stronger than expected lift in growth by 3.1%. The driver was a sharp rebound in production and a surge in commodity prices, particularly the price of iron ore. This flows into a significant improvement in the Australian Government budget, as tax receipts rose, coupled with lower than predicted expenditure.
Domestic employment figures were strong, with employment lifting by 88,000 in February, beating the consensus estimates of a rise of 30,000. The participation rate stayed at 66.1% in the month and hours worked returned to pre-pandemic levels. The unemployment rate dropped to 5.8% from 6.3% in the month prior.
Credit growth remained subdued in February, printing below expectations at 0.2% month on month (m/m), with investor credit disappointing. This was unsurprising given the current property boom as most of the credit growth came from the housing market, particularly owner-occupiers (+0.6% m/m). This coincides with a rise in residential building approvals up 21.6% m/m in February (consensus was for a 3.0% increase).
Money market rates remained very low given the 0.10% official cash rate and RBA forward guidance for an extended period of highly accommodative policy. Three-month bank bills ended the month slightly higher at 3.5bps, while six-month bank bills rose 6bps to 8bps.
During March, credit markets adjusted to the more volatile yield environment while absorbing a very busy period of primary issuance post-reporting season. Concerns that further bond yield rises might trigger credit spread widening saw a significant number of issuers access the primary market while yields and spreads were still low in outright terms. This bout of heavy primary supply saw credit spreads gently widen. In Australia, bank floating rate note (FRN) spreads rose by 3bps, while corporate credit spreads rose 12bps, which saw investment grade credit underperform. Higher yielding spread sectors like bank hybrids and subordinated notes remained relatively stable and returned between 0.3-0.5%. iTraxx Australia tightened 5bps adjusting for the roll, with the new index finishing at 64 reflecting more stable conditions in offshore risk markets versus the end of February.
Primary issuance came in all the colours of the rainbow during March. In financials, we saw senior issuance from offshore banks like Toronto Dominion, OCBC and MUFJ. Meanwhile, ANZ was the first major Australian bank to issue senior notes since January 2020 as they managed upcoming maturities by issuing 1-1.5 year notes. CBA decided to focus on capital instruments post-reporting, issuing Tier 2 bonds into the USD market and raising a new Tier 1 hybrid through the ASX listed market, which will take the mantle of the lowest margin major bank hybrid issued at a spread of 275bps. Corporate issuers were also busy, with issuance from REITs like Mirvac, Stockland, BWP Trust, ALE and Centuria, auto finance companies Mercedes Benz, Toyota, Nissan and Volkswagen. Meanwhile, a range of other sectors were also keen to lock in long term funding, with 10-year issuance from Verizon, Westconnex and Lend Lease which issued their second green bond into very strong demand. Not to be outdone, the securitised market was also busy with Resimac, Pepper, Defence Bank and Zip all taking advantage of significant current demand for RMBS and ABS floating rate securities, which still offer a yield advantage versus senior bank notes.
We expect the recovery story to continue to play out, noting cracks in achieving global synchronisation. The US looks set to steam ahead, with a further boost to the US economy from the Biden fiscal packages. The most recent announcements of an initial infrastructure package worth around US$2.25 trillion, followed by another worth more than US$1 trillion to be announced in April, cannot be underestimated. The 8-year roll out will not provide an immediate sugar hit to the economy, but instead a more measured and stable stimulus. Corporates will be the ones footing the bill, which will be paid for over 15 years by raising the corporate tax rate to 28% from 21% and increasing taxes on companies’ foreign earnings to 21% from 10.5%. While the tax increase is significant, the rate is still lower than the 35% it was prior to the Trump administration.
The uneven roll out of the vaccine is also likely to affect the recovery pathway in some countries. The US has now given first doses to 73.1% of its over 65 years population, while the UK has administered more than 30 million first round doses and 4 million second doses. This is directly translating into fewer deaths and the easing of restrictions. In contrast, the European growth rebound is likely to be hampered as a slow vaccine rollout on the continent dampens economic activity. Restrictions continue, with France announcing a four-week nationwide lockdown, while Italy is expected to extend its current lockdown. While Australian economic data surprised to the upside in March, due to our lack of vaccine supply, snap lockdowns and hotspot border restrictions are still being relied upon to curb infections. This may ultimately widen the divergence between the US and Australian recovery story.
The recent floods in NSW and QLD are likely to detract from GDP in the near term, as well as leading to sectorial imbalances (e.g. the insurance sector). Disruptions to coal production (as QLD’s primary coal producing region was impacted) and the loss of crop (and lowering of quality) for the agricultural sector will be the largest detractors. The RBA has forecasted a 0.5% hit to GDP growth in the March quarter as a result. However, over a longer time frame, the rebuilding process will provide a boost. Houses need to be repaired, cars and household contents replaced, and farms, businesses and public infrastructure will need to be restored.
It is unsurprising that the bond market unwound some of the violent sell-off from February as markets are known to overshoot. While we do expect the cyclical rebound and greater tolerance by central banks for inflation to run higher to keep the rates curve relatively steep, we are mindful of the market getting ahead of itself as the global road to recovery is not straightforward. A further tightening of monetary conditions through higher yields and currency strength should act as a drag on growth and require the RBA to keep monetary conditions accommodative. An expansion/extension of its quantitative easing program may be warranted to support medium-term growth prospects and support lower yields.
Views as at 31 March 2021.