During November the market consensus shifted towards the FOMC and ECB remaining on hold throughout 2024. This reflects a forecast that inflation will continue to deflate while unemployment remains low, and the economy keeps growing but at a slow pace. This is the “Goldilocks” scenario. The alternative view is that inflation will begin to rise again shortly (February) once wages growth restores inflation-impacted household budgets.
Our view remains that in the US and Europe the “transitory factors” that drove inflation as these economies emerged from the pandemic lockdowns are now mostly depleted. If this proves correct inflation readings will stabilise at current levels which are above the central bank targets. In time these inflation numbers will be used to set wages, and this will embed inflation at a higher level than we have seen since 2010. In the US the preferred inflation measure of the US Federal Reserve – the core PCE price index – was steady in November at 3.5%. This level of core inflation will feed into wages growth and longer-term inflation readings; however, the Federal Reserve is likely to remain on hold because:
- The US labour market is softening at the margins.
- Wholesale and retail inventory levels remain near record levels.
- The USD remains strong relative to major trading partners.
- Broad money growth is now in negative territory.
- The Federal Reserve will continue to reduce the money supply over the next few years through its QT program.
Although the US economy is in a good position for the inflation battle it is still too early to claim a victory because:
- Money supply remains elevated after years of Modern Monetary Theory justified QE programs.
- Money velocity is now increasing for the first time in 25 years, and this will at least partly offset the decline in money growth.
- Fiscal expenditure remains at a very high level inconsistent with the current tight labour market conditions.
- The US government has retained the pandemic welfare payments, and these are supporting household consumption.
What this is likely to mean is that inflation remains elevated for longer than the bond market pricing indicates. This will see the US yield curve steepen to at least a neutral level (flat curve) over the next few months. The 2 to 10-year curve inversion has already, since August reduced from near 100bps to near 35bps. If the US Federal Reserve remains on hold throughout 2024 and in doing so anchors the short end of the yield curve, we are likely to see increased volatility in the 5 to 10-year part of the curve. There is a possibility that the US yield curve will steepen because:
- US fiscal expenditure is not under control and so requires increased treasury bond issuance to fund it.
- US corporates that issued 3-year and 5-year fixed rate bonds during the pandemic are now approaching refinancing points.
- The Federal Reserve with its QT program is letting its existing holdings mature and is no longer a buyer in the secondary market.
- Japanese investors are likely to prefer Yen-denominated bonds to US given the recent Yen weakness.
- China’s push to make the Renminbi a global trading currency will reduce demand for US bonds as China will hold its forex reserves in other denominations.
Although the Australian yield curve remains linked to changes in the US yield curve, we expect that Australian bonds will trade at a wider premium to the US curve in the months ahead. Our reasoning is as follows:
- Unlike the US and EU broad money growth is still in positive territory in Australia so stimulatory.
- Australian wages growth moved above 4% in the September quarter for the first time since 2009 and all indications are that successful wage negotiations are being done in the 4-5% range. Rising wages growth is in stark contrast to the EU and US where wages growth is elevated but declining. This level of wages growth in Australia is inconsistent with inflation returning to a 2.5% target level.
- Australian sovereign risk may rise significantly, and this will require a risk premium on all Australian-issued debt. This outcome will depend on factors like the formation of the new RBA interest-setting board and the rise in the Victorian State bond risk.
Long bond rates fell last week with several Fed members peppering the media with a range of views. It was Chairman Powell at the end of the week to set markets straight by sounding caution on the Fed’s interest rate outlook as data showed a continuing manufacturing slump. 10-year treasuries fell over the week by a large 0.26% to 4.208%. Short-term rates have been falling even faster, 2 years down by 0.34% to 4.54% as the yield curve normalises. US GDP increased at a 5.2% annualised rate last quarter, revised up from the previously reported 4.9%. However, when measured from the income side the economy grew at a 1.5% rate last quarter.
Aust. October inflation slowed more than expected sparking a bond rally. For October, CPI fell by 0.3% from September giving an annual rate of 4.90%, well below the expected 5.20%. Comm. gov, bond rates fell across the curve, the 2 years down by 0.11% to 4.166% and the 10 years down by 0.07% to 4.494%. Caution must be applied to a monthly number; the next quarterly number not due until next February.
Major Credit Markets
Investment grade (IG) markets paused their recent rally mid-week but resumed on Friday with the strong equity market and weaker US manufacturing and a slowing economy giving rise for rate rises to pause. Interestingly, monies are flowing out of IG funds, perhaps indicating profit takers after the recent strong rally.
Australian IG markets were also slightly stronger, the iTraxx index hitting 0.75%. Secondary buying was strong with major bank senior bonds tightening 1-4pts and sub notes very strong across the curve. Despite this, for November longer-dated sub notes (10 year to first call) were weaker rising over 12pts in margin. In contrast, issues with 5 years or less to first call have rallied 6 to 12pts with longer maturity issues best. Issuance was lighter with Westpac issuing a 1-year FRN at BBSW+ 0.47%. AMEO (Aust Energy Market Operator rated Moody’s Aa2) issued a 5-year fixed rate bond at 5.354%, a 1.05% margin.
High Yield Markets
US high yield (HY) markets continue to rally to 12-month lows. Most HY index margins fell significantly last week. Monies are now flowing back into HY funds. Contributing factors to the rally are a more stable view of the US economy, strong equity markets and a lack of new deals pushing buyers into the secondary market.
Hybrids continued to rally with strong equity and especially credit markets, as well as the dust settling on the recent Westpac issue. The major bank average hybrid margin fell by 11pts to 2.54%, well below the mid-November high of 2.93%. See the next page for what individual hybrids have moved.
The new Australian Unity senior bond commenced trading on light volume (only 350k on day 1) at a VWAP of $100.25 which is a margin of 2.48%. AYUHE is a 5-year senior bond paying a margin of 2.50% above the 90-day BBSW with a hard maturity date of 15 December 2028. Coupons are all cash no franking.
Listed Hybrid Market
Hybrids get their mojo back
As mentioned above, the average major hybrid margin contracted by 11pts last week. For November the average margin fell by 10pts to 2.54% but did hit a high of 2.93% mid-month as the Westpac IPO hit the market. From the high the margin is a huge 40pts lower now. Below we look at the contractions across the major bank hybrid curve since the mid-month high.
Mid-month the curve was almost flat, as shown by the red line. With two exceptions, there was only 40pts between the short and long end. No wonder that as the sector rallied the short end had more room to move down. The result was shorter-term margins falling some 80pts. At the long end, margins only fell 20pts, perhaps as the recent Westpac issue (7.8 years tenor) zapped long-term buying demand. Nevertheless, with a higher capital value sensitivity longer maturity hybrids may take longer to react fully. Expect the long end to get to at least a 2.80% from the 2.90%+ levels. Mid-curve margins fell some 30pts. Giving the curve developing a nice level of steepness (blue line).
Non majors were also strong across the curve, in particular BENPH, IAGPE, MQGPC and SUNPG, hence mixed across this sub sector.
Forward Interest Indicators
Swap rates fall along with the general fall in bond yields described above.
- 10-year swap 4.65%
- 7-year swap 4.49%
- 5-year swap 4.35%
- 1-month BBSW 4.30%
Arculus Funds Management is an Australian asset manager of both public and private mandates.
They manage two retail public unit funds for DDH Graham:
- The Arculus Preferred Income Fund, formerly the DDH Preferred Income Fund
- The Arculus Fixed Income Fund, formerly the GCI Australian Capital Stable Fund
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