Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Investor concerns shifted from fretting about inflation and the timing and speed of offshore central bank tightening, to calibrating the impacts of the rapidly spreading Omicron variant. There was some flattening in the yield curve, with shorter-dated yields higher and longer-dated yields mixed. Inflation expectations rose, while credit markets were supported. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index rose by 0.095% over December.
While the RBA has signalled that it will patiently wait for labour market tightening to lift wages growth above 3% and for core inflation to settle at around 2.5% on a sustainable basis, markets are more impatient... priced for a 0.75% cash rate by the end of 2022 and 1.25% by mid-2023."
Three-year government bond yields traded in a choppy 16 basis point (bps) range before ending the month 5bps higher at 0.91%. Intra month volatility reflected shifting views on the commencement of the next cash rate tightening cycle following offshore central bank and COVID-19 developments. Despite a late month rise, 10-year government bond yields ended 2bps lower at 1.67% as growth concerns rose.
The economy shrank by a less-than-expected 1.9% over the September quarter. As lockdowns were lifted, business surveys pointed to a strong rebound in activity over October/November, though the emergence of the Omicron variant saw December consumer confidence edge lower.
The labour market roared back to life surpassing market expectations, with 366,100 jobs added over November. The unemployment rate fell from 5.2% to 4.6%, while the participation rate climbed back up to an elevated 66.1%. Forward-looking labour demand indicators point to ongoing nearer-term strength.
Short-term money market rates edged higher on stronger activity readings and offshore central bank leads. Three-month bank bills ended the month 2bps higher at 7bps, while six-month bank bills ended 7bps higher at 21bps. Markets remain priced for nearer-term tightening despite Reserve Bank of Australia (RBA) guidance that a 2022 rate rise remained unlikely. Cash futures point to a 0.25% cash rate by around mid-2022 and 0.75% by the end of 2022.
In credit markets, sentiment was sensitive to Omicron news flow, which also coincided with reduced liquidity and conservative investor positioning ahead of the holiday season. While early findings are for lower severity as it relates to health outcomes, the sheer contagiousness of Omicron has resulted in mobility restrictions being reimposed globally, with associated negative impacts on economic activity expected going into the New Year.
To date, credit markets have largely shrugged off this new phase of the pandemic, alongside inflation and tapering/rate hike concerns, preferring to remain focused on solid fundamentals and a broad-based economic recovery. Amid elevated volatility, the Australian iTraxx Index initially widened, before closing the month 10bps tighter. Both domestic fixed and floating rate credit spreads widened 2bps respectively.
Primary market activity was muted (as is traditional for this time of year), with the only notable activity from banks issuing one-year floating rate notes. That said, we anticipate broader issuance to pick up early in the New Year, not least domestic banks as they return to normal issuance patterns with maturities looming, including hybrids due to be refinanced in Q1 2022.
Monetary normalisation is coming, with the first cab off the rank a decommissioning of remaining quantitative measures by mid next year. Conventional tightening is also coming, although with the last tightening cycle of a cumulative 1.75% between October 2009 and November 2010, memories of these may be foggy or even non-existent for younger cohorts.
While the RBA has signalled that it will patiently wait for labour market tightening to lift wages growth above 3% and for core inflation to settle at around 2.5% on a sustainable basis, markets are more impatient, emboldened by offshore central bank tightening where the recovery in the nominal side of their economies is more advanced than in Australia.
Markets are priced for a 0.75% cash rate by the end of 2022 and 1.25% by mid-2023. While we agree there will be some cash rate tightening (from accommodative to neutral settings), our view is that current market pricing for lift-off is too early. To get such an outcome, labour market conditions would need to tighten quickly over the first half of 2022 despite current Omicron headwinds. Not only would the unemployment rate have to fall to 4% or lower, but wages growth would have to overcome considerable inertia to quickly settle above a yearly 3% rate.
We have sympathy for the overall narrative but suspect more time will be needed for tightening labour market conditions to translate into higher wages. Instead, we look for the initial lift in the cash rate early in 2023 and for a 1% cash rate by the end of 2023. That said, we see the three-year government bond yield of 0.91% (at month end) as broadly fairly valued. At the longer end, we see the ten-year government bond yield at 1.67% (month end levels) as being modestly expensive with the recent rally eroding term premia at a time of heightened inflation risk.
If health systems can cope with the Omicron caseload, spread sectors are likely to remain well-supported, with corporate fundamentals continuing to benefit from the tailwinds of a cyclical recovery and cashed-up consumers. Though monetary conditions are set to normalise, it is worth bearing in mind that overall settings still remain accommodative and pro-cyclical. Given the many cross currents, we continue to remain very active and selective in the current environment. We favour cautious positioning in sub-sectors set to benefit from the country re-opening theme with authorities currently looking to live with the Omicron variant. We remain mindful and attentive to opportunities that may arise as markets react to the variability posed by pandemic conditions.
We continue to be attracted to semi-government securities, particularly those issued by NSW as it continues to come out of lockdown despite Omicron headwinds. Our inflation protection strategies continue to bear fruit, with breakeven inflation rates moving up towards the middle of the RBA’s 2-3% target band. We still see a role for some modest inflation protection given the risk of cyclical price pressures finding their way into both higher core inflation and inflation expectations.
Views as at 31 December 2021.