Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
An earlier than expected pivot to a more hawkish stance by the US Federal Reserve (Fed) and strong domestic economic data saw a bringing forward of tightening expectations lift shorter-dated yields. Meanwhile, longer-dated yields fell as inflation expectations were wound back. Risk appetite held up as prospective tightening was not seen as derailing activity. Equity markets were generally firmer and credit markets remained well supported. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, ended June 0.69% higher, but was 0.84% lower over the year, even after allowing for February’s 3.58% fall.
Just as the economy was roaring and markets began to bring forward tightening, the latest round of lockdowns are a reminder that a post pandemic world is still some time away."
Volatility returned to the shorter end of the yield curve as cash tightening expectations were brought forward following stronger economic data and Federal Open Market Committee (FOMC) members building in the start of a US tightening cycle by the end of 2023. The yield on the November 2024 government bond rose to as high as 0.47% on the expectations shift, before ending the month 13 basis points (bps) higher at 0.41%.
The signalling by the Fed that monetary policy could be normalised after the COVID-19 shock reduced term risk at the longer end of the yield curve. The 10-year government bond yield ended 18bps lower at 1.53%, while the 30-year government bond ended 36bps lower at 2.28%. Inflation expectations shifted lower, with the 10-year breakeven inflation rate falling 12bps to 2.06%.
Partial demand indicators showed the economy was on a tear before the latest round of rolling state lockdowns. The economy expanded by 1.8% over the March quarter to join the labour market in lifting to at least pre-COVID-19 levels. Business surveys point to another quarter of strong growth in the June quarter with activity, confidence, forward orders and labour demand at high levels. Consumer sentiment slipped in June from historically high levels following Victorian lockdowns and further near-term falls can be expected as more states experience lockdowns.
The labour market roared back after taking a breather in April. The number of jobs rose by a higher than expected 115,200, with most of the lift coming from full time jobs. The participation rate lifted to a very high 66.2% while the unemployment rate fell from 5.5% to 5.1%, the lowest rate since December 2019. Forward labour demand indicators remain strong and recent rapid improvement was a major factor in tightening expectations being brought forward.
Short-term money market rates remained very low given the 0.10% official cash rate and Reserve Bank of Australia (RBA) forward guidance for an extended period of highly accommodative policy. Three-month bank bills ended the month 0.5bps lower at 3bps, while six-month bank bills ended 2bps lower at 6bps. Further out, markets began to build in monetary tightening towards the end of 2022, with the November 2022 30-day interbank cash rate future contract ending the month at 0.30%.
Domestic credit markets appeared to take major city lockdowns and increased volatility in bond yields in their stride. Buoyed by the economic recovery and increasing system liquidity as final Term Funding Facility (TFF) borrowings were drawn by the banks, credit spreads tightened 4bps providing a modest boost to returns. S&P’s upgrade of Australia’s AAA rating outlook to stable, combined with their favourable commentary around Australia’s banking industry country risk assessment (“BICRA”) provided fundamental support across bank capital notes, with the listed hybrid market posting a stellar month, returning 1.0%.
There was a flurry of primary market activity early in the month prior to financial year end. ANZ attracted strong demand for their new hybrid (ANZPI) priced attractively at a spread of 300bps, however they chose to issue offshore in Sterling for their Tier 2 needs. Macquarie saw the vacuum left behind and tapped strong local demand for Tier 2 notes at a reasonable spread of 155bps. Elsewhere corporates were also active, with Charter Hall Long WALE REIT and Australian Gas Infrastructure Finance returning to the market, while Lendlease International Towers Sydney Trust (Barangaroo Towers) issued an inaugural 9-year bond at a spread of 140bps.
Positive ESG impact issuance continued to pick up, the highlight being Wesfarmers issuing a Sustainability-Linked Bond (SLB), the first of its kind into the Australian market. This is a new style of security, whereby the coupon of the security is linked to future performance of the company in meeting contractual sustainability targets. In this case Wesfarmers chose two environment targets related to reducing their firm-wide Scope 1 and 2 greenhouse gas emissions. Should they not deliver on their future targets by the end of 2025 the coupons on the bonds will increase by a maximum of 25bps for the remaining term of the securities. The Canadian Pension Plan Investment Board (CPPIB) also issued their first public Australian dollar bond, which is backed by their Green Bond framework and provided investors a healthy 0.5% additional spread above government bonds from a AAA rated issuer.
It was often quipped pre-COVID-19 that monetary policy was more art than science. The renewed bout of rolling lockdowns, which began with Victoria, highlight the uncertain pandemic path ahead. Just as the economy was roaring and markets began to bring forward tightening, the latest round of lockdowns are a reminder that a post pandemic world is still some time away.
The RBA will be well aware of the art needed to balance recent economic strength and labour market improvement against the potential hit to momentum from the latest breakout of the more contagious ‘Delta’ variant.
We do not expect the RBA to follow the Fed’s hawkish policy pivot at its monetary policy review meeting in early July. The broad messaging is likely to remain that accommodative policy settings will be needed until the tightening trifecta conditions have been met. These are: i) an unemployment rate close to 4%, ii) wages growth of at least 3% and iii) actual inflation at 2% or above on a sustainable basis.
In a nod to stronger labour market conditions, we don’t see the RBA extending its 3-year yield target from the April 2024 bond to the November 2024 bond. Our base case has the first tightening in H1 2024, with a tightening cycle that takes policy from easy to neutral, not easy to tight which markets had priced in when yields spiked in late February.
While recent strength tilts the balance of risks towards an earlier lift off, market pricing for a tightening cycle beginning in late 2022 seems premature and implicitly assumes that the tightening trifecta conditions will be met. The wages condition will be difficult to meet given that RBA liaison finds many companies adopting a “wait and ration” approach rather than adding to their cost base by paying higher wages.
To meet the tightening trifecta conditions, the RBA will most likely need to renew its current bond purchase program which ends in September. We suspect they will commit to another six-month tranche of buying before moving to a more frequent and data dependent approach from March 2022. Against this complex backdrop we see the 10-year government bond yield of 1.52% at the time of writing as being mildly expensive.
Spread sectors are likely to remain well-supported, with corporates in particular, benefiting from the tail winds of a cyclical recovery and persistent accommodative policy settings. Nevertheless, with the spread cushion for investors within pockets of credit having narrowed substantially, we remain very active and selective in this environment. While the market searches for any yield advantage, we remain discriminate, avoiding lower quality borrowers. The need for inflation protection has diminished, with breakeven inflation rates moving back into the lower end of the RBA’s 2% to 3% target band.
Views as at 30 June 2021.