Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Higher than expected inflation in the United States saw the Federal Reserve (Fed) respond with an outsized tightening and preparedness to push the US economy into recession to quell inflation if needed. The Reserve Bank of Australia (RBA) moved in a similar fashion and against this backdrop, yields surged higher across the curve. Risk appetite fell on rising recession risks with equity and credit markets significantly weaker. The Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, remained in bear market territory falling by 1.48% over the month and 10.51% over the financial year.
The shift in central bank reaction functions, following May’s US blockbuster Consumer Price Index (CPI) result was profound and left the narrative of a temporary inflation spike that would resolve itself post-COVID-19 lockdowns in tatters.
The RBA lifted the cash rate by a larger than expected 0.5% in early June, dispelling earlier signalling that ‘business as usual’ 0.25% moves lay ahead. Yields rose ahead of the RBA board meeting but the largest lift in yields came mid-month following US inflation data and the Fed’s 75 basis points (bps) lift in the US cash rate. Three and ten-year government bond yields rose to as high as 3.69%, and 4.20% before ending the month 27.5bps and 31bps higher at 3.12% and 3.66%. Further out along the curve, 30-year government bond yields finished 16.5bps higher at 3.84%.
The rationale for the larger cash rate move was that the current amount of accommodation was inconsistent with the strength and resilience the RBA was observing in the economy. Real gross domestic product (GDP) rose by 0.8% over the March quarter and by an above trend of 3.3% over the year.
Partial demand indicators pointed to ongoing strength in the June quarter with strong business conditions recorded over April/May in the NAB Business Survey. That said, cost of living pressures and expectations of higher interest rates were beginning to show up with sharply falling levels of consumer confidence over May/June and easing property prices.
Labour market conditions remained buoyant with strong gains in employment and labour force participation in May, with the unemployment rate holding at an historically low 3.9%. On the wages front, the Fair Work Commission announced a 5.2% lift in the national minimum wage sparking concerns of wage/price spiral risks.
Short-term money market yields continued to rise, reflecting the shift by central banks to more front-end load tightening cycles. The three-month bank bill yield ended the month 64bps higher at 1.81%, while six-month bank bills ended 75bps higher at 2.67%. In terms of the tightening cycle, markets are looking for a 3.10% cash rate by year end and around 3.75% by mid-2023.
Hawkish central banks and fears that tightening financial conditions could trigger a recession-roiled credit markets. The Australian iTraxx Index widened sharply, closing the month 35bps wider at 130bps. The Australian fixed rate credit market returned -1.34%, negatively influenced by rising bond yields and spreads, while floating rate credit recovered slightly from the weight of bank supply in May to post a positive 0.05% return as primary issuance was largely absent.
Domestic primary activity was limited to financials, with corporates remaining on the side-lines. Notable transactions included two ASX listed hybrid Additional Tier 1 transactions from NAB and Westpac, two weeks apart. Callable at 7.5 years and 6.25 years, these transactions were priced at margins of 3.15% and 3.40% over bank bill swap rate (BBSW) respectively, reflecting increasingly challenging market conditions as the month progressed. Also in the hybrid space, Macquarie Group launched and is currently marketing another Additional Tier 1 transaction with a 7.25 year call date at an anticipated margin of 3.70-3.90% over BBSW.
The securitisation primary market remained active, with a number of issuers printing transactions. Of note, NAB returned to the market, issuing its first residential mortgage-backed securities (RMBS) transaction since 2018. The $1.5b transaction incorporated a green tranche, and senior AAA notes were priced at 1 month BBSW + 1.20%.
The shift in central bank reaction functions, following May’s US blockbuster Consumer Price Index (CPI) result was profound and left the narrative of a temporary inflation spike that would resolve itself post-COVID-19 lockdowns in tatters. There appears to be a growing acknowledgement that price pressures are coming from the demand side as well, turbo charged by re-opening and massive fiscal easing.
Monetary policy can’t directly solve supply side problems caused by lockdowns, war, bad weather, or sanctions, but it can play a role in managing the demand side of the economy via changes in monetary conditions.
With risks rising of higher cyclical inflation becoming entrenched, the Fed moved to front-end load policy tightening, signalling a lift in the US cash rate to 3.4% by the end of 2022, peaking at 3.8% by the end of 2023. While the Fed’s preference is to engineer a soft landing, Fed rhetoric is very hawkish with Powell indicating that the Fed was prepared to put the US economy into recession to anchor inflation and inflation expectations if necessary.
The RBA has joined the central bank pivot to more front-end loaded tightening with the Governor signalling that accommodative conditions were no longer required and to expect further tightening. By how much and the impact of higher rates on the economy remains an open question.
At one stage markets were discounting a 3.6% cash rate by December, lifting to 4.2% by mid-2023 and averaging at around that level over the next decade. This seems implausible to us as it assumes one of the biggest and fastest tightening cycles in the current inflation targeting era results in a 4.2% neutral or terminal cash rate. The RBA’s estimate is 2.5% and ours is not that dissimilar. In our view, a cash rate of 4.2% would represent a cyclical peak and enough to cause a slowdown significant enough to trigger the next easing cycle.
While market pricing has pulled back somewhat, markets are still factoring in a 3.1% cash rate by December and 3.75% by mid-2023 and averaging just under 4% over the next decade.
Our base case view is for the cash rate to lift by 50bps at the July and August meetings before tightening increments return to ‘business as usual’ 25bps increments. We look for the cash rate to lift to 2.6% by December and peak at 2.85% in H1 2023. Such a level is on the tight side of neutral and we look for the RBA to hold that level till mid-2024, before modestly easing as the extended period of tighter policy sees growth slow and inflation head back into the target band.
Accordingly, we see some value emerging in the mid part of the yield curve as market pricing does not see the Australian economy responding to an extended period of tight monetary policy. While we remain agnostic on the longer end of the yield curve, we are mindful that term compensation is improving and that there is ultimately scope for capital gain if central banks overdo tightening and trigger a recession.
Uncertainty about the durability of the current expansion and cyclical cost pressures are likely to contribute to ongoing volatility in credit markets. These periods can provide opportunities when spread widening is more than fundamentals. We remain active and selective, favouring relative value within sub-sectors, whilst being judicious on overall credit beta. Recent spread widening has allowed us to access high quality names at attractive levels.
Views as at 1 July 2022.