Firstly, apologies for not including the risks of a UK budget related bond market meltdown in our list of geopolitical risks a few weeks ago.
This risk is now a clear and present danger for the bond markets.
The UK budget announced last Wednesday represents a seminal shift in the way a Western democratic government exercises domestic economic power. Gone is the pretence that the UK Labour Party has any respect for private enterprise, private wealth aspiration or in fact private asset ownership. Much like the way the Australian ALP has entrenched its power at a State level in Victoria and QLD (previously), the UK Labour Party without any shame for breaking their electioneering promises not to raise taxes “on working people” are going to massively increase public debt and taxation and spend it on a massive increase in the public sector.
There will be growth in GDP but almost entirely from the government sector so labour productivity will collapse.
For us, the most frightening statement in the entire budget was this:
“Investment rule: to reduce net financial debt (public sector net financial liabilities) as a proportion of GDP. This rule keeps debt on a sustainable path while allowing the step change needed in investment, by capturing not just the debt that government owes, but also financial assets that are expected to generate future returns.”
This translates into Chinese state owned enterprises (SOE’s) styled government corporations that replace private enterprise in the supply of goods and services, but worse still the re-definition of net public debt will allow them to put a value on these SOE’s such that it is deducted from pubic debt (also not clear, but probable, that the SOE’s will also have balance sheet debt not included in public debt (as it is here in Australia. NBN anyone?)).
The markets reacted with a sharp fall in the Pound and a rise in bond yields but perhaps given proximity of the US Elections the real action has been delayed for the time being. It is hard to see how the markets would not treat this budget much the same way they treated the Truss budget in 2022. This is an inflationary budget.
Interest Rates
We have just had a dramatic shift in the bond market with 2-year yields rising from 4.04% to 4.22% over the past two weeks even though US 3-month bills yields have fallen from 4.64% to 4.51% over the same period. The market remains confident that the Federal Reserve will cut rates by 25bps at both the Nov & Dec meetings, but the bond market is now worried about inflation returning in 2025. Fridays bond action, with yields initially falling after the weaker than expected payrolls data, only to surge to close much higher, is revealing. The US 10-year yield closed at 4.40% and is now 80 bps higher than its mid Sept close at 3.60%.
The long end of the curve continues to track the US yield curve while the 2 to 5-year. area has now flattened. Despite media and bank economists still proclaiming that an interest rate cut will occur in February, the market is now forecasting higher rates 12 months ahead. Given the strength of the employment market, an RBA cut so close to the next Federal election would look political. To date Governor Bullock has sounded non-political.
Major Credit Markets
US investment grade (IG) Corporate bond spreads tightened as weak U.S. job growth data gave markets reason to increase bets for a rate cut from the Federal Reserve. Credit indexes fell by small margins. Issuance volume for October was a 3-year. monthly high.
Australian credit markets were also steady with some wait and see until the US election. October was a strong month for bank Tier 2 sub notes, with 5-year issues in about 0.17%. With the recent rise in long bond rates, buyers of bank Tier 2 sub notes are preferring fixed rate versions over floating rate. As a result, fixed rate 5-year sub notes rallied about 0.30% in October. It was a light week of issuance into the end of the month. AMP Group returned to the market with a $200m Senior bond offer that began at +235, tightened into an issue margin of +210 and then is being traded in the secondary at +196bps. AMP Group is rated by S&P at BBB. The Police Bank (BBB+) issued $75m Senior at +115bps on Friday. Hard to see how the market can price these two issuers this far apart.
High Yield Markets
US high yield (HY) markets remain strong across all rating categories. October issuance was an October high for the past three years. Average spreads are as follows with the YTD spread contraction: “BB” 1.78%, -0.24%, “B” 2.85% – 0.56%, “CCC” 7.66% – 0.94%. The “BBB” to “BB” spread is 0.73%, steady YTD.
Hybrids strength remained given there is no likely primary issues before year end. The average major bank hybrid margin is now just below 1.80%. Volumes were at average levels with the new MQGPG dominating turnover with nearly $9m traded. The hybrid margin curve has also flattened. The gap between all issues and longer dated is now under 0.20% whereas for most of 2024 the gap has been 0.30-0.40%.
Listed Hybrid Market
Hybrids – returns accelerate
As described in recent weeks, hybrids have performed well in past months, fuelled by the scarcity factor as a result of investors fearing the APRA review will halt further issuance. The Evans and Partners hybrid index returned 0.73% including franking in October. Specifically major banks returned 0.75% and non-major banks (regional banks, Insurers and Macquarie bank/group) returned 0.68%. YTD the majors have returned 7.83% and non-majors 7.22%. Typically, the non-majors outperform due to higher dividend rates, however in the past two months demand has been more evident in the major banks given the APRA review concentrates on them and Macquarie. The first chart shows the monthly returns for the majors and non-major since Covid. In the past three years, major banks hybrids including franking have returned 8.21% p.a. whereas non-majors returned 8.88%. This 0.67% gap is a reliable estimate of the risk premium attributed to the non-majors. Intuitively this is slightly higher than the IPO margin premium in past years.
Looking at this longer term, the second chart shows the index performances for major and non-major hybrids since 2012. Major banks have returned 5.90% including franking, non-majors 7.10% since this time. This 1.20% return premium for the non-majors is great than the 3-year. period above. This may reflect that since 2012 hybrid margins have been wider than the past three years. Note from the chart the linear return line and the acceleration from this line for each category since late 2023. Returns for hybrids, both major and non-major hybrids, have increased p.a. over this time. This is summed up by the average major bank hybrid margin level – it was 2.70% in October 2023 whereas now it is 1.80%.
Forward Interest Indicators
Swap rates rise with bond rates, long rate moves above bill rates.
Swap rates:
- 10-year swap 4.47%
- 7-year swap 4.31%
- 5-year swap 4.18%
- 1-month BBSW 4.31%
