The markets were caught by a triple surprise last week. Firstly, the Treasury opted to issue less 10 and 30-year bonds and more 3-5 year bonds for its refinancing, then the ISM manufacturing and services PMI data was weaker, and finally the non-farm payrolls were weaker than expected. This brought about what looks very much like a short covering rally in the long end of the US curve with the US 5-year ending the week at an important resistance point (4.5% yield).
Australian 10-year bonds have now moved out to an 8bps premium to the US 10 year. If the RBA squibs a necessary interest rate increase on Tuesday this spread could blow out considerably with a rise in sovereign risk. This week’s RBA meeting is the first real test of the new Governor Bullock who has an education from the Fabián London School of Economics. She is already adopting a quiet approach, not making off-handed forecasts like her predecessor. However a failure to raise rates will need some quick-footed “yes but” commentary.
Major Credit Markets
US IG spreads traded tighter in line with the US equity rally. The spread contraction started late on Wednesday, continuing Thursday with the Fed rate pause and some flags that the Fed may be done rising. On Friday the weaker non-farm payrolls fuelled the rally resulting in a fall for the week in the US iTraxx of 0.12% to a 0.70% close.
Australian IG spreads also tightened over the week although major banks’ senior and sub note margins were steady. There is some concern however that the wholesale market may be under pressure in the weeks ahead with domestic and kangaroo issues avoiding the US market and instead coming to our domestic market. There is only so much new issuance the market can absorb!
High Yield Markets
For the same reasons, as IG credit markets as well as strong equity markets, US high yield (HY) rallied strongly last week with the average HY corporate spreads tightening by a large 0.38% to 4.15%. Monies are flowing out of the sector, however probably reflecting sentiment from the previous week.
The hybrid market tightened last week, modestly compared to other markets (see commentary next page). The average major bank hybrid margin is at 2.65% well up from 2.20% in late September.
Australian Unity announced, and priced, its fifth senior unsecured ASX traded bond. The 5-year bond will pay 2.50% over the 90-day BBSW, all cash. There was a rollover offered for AYUHC holders which matures in December 2024 and pays a 2.0% margin. AYUHD is still outstanding with a December 2026 maturity and was issued at a 2.15% margin. Both AYUHC and AYUHD consistently trade around a 2.0% margin.
Listed Hybrid Market
Hybrids lag the rally
As mentioned above, hybrid demand was only slightly stronger at week-end as a risk-on sentiment surfaced in all markets. The All Ords was up 2.2% for the week with most of that return in the last three days. Two of the three parameters that drive the hybrid market are market related, these being credit and equity markets. The third is hybrid IPO activity.
Regarding credit and equity markets, the three charts below summarise the quick risk-on. Chart one shows the Australian iTraxx which represents the investment grade credit market. Last week this index fell by 0.12% with most of that occurring in the last three days. The second and third charts show two equity market measures related to bank stocks. The first is an index of the major banks’ share prices. This index rose by 5.85% last week indicating strong major bank buying. Related is the volatility of major bank exchange traded options represented in the third chart by the 3-month implied volatility levels of option trading. As shown, the implied volatility of 3-month options fell sharply to a 12-month low.
The three measures in the charts are bullish for hybrid margins. If the risk-on sentiment persists, expect hybrids to rally. So far (although really only three days of risk-on) hybrids have only shown a small buy reaction. This is not unusual for hybrids: often a stable and moving risk trend needs to be in place before hybrids respond. Additionally given the flux of sentiment and markets in the past 12 months, the risk-on sentiment may be short-lived. Sometimes hybrid markets bide their time. The real driver of this rally is the US rate market. Equities responded to falling rates, so the long-term rate market is the one to watch.
Forward Interest Indicators
Swap rates fall along with comm. Gov. bond rates. Bank bills firm before RBA meeting.
- 10-year swap 4.96%
- 7-year swap 4.80%
- 5-year swap 4.67%
- 1-month BBSW 4.19%
We have a quiet week ahead with little data of any importance. The focus will be on the RBA interest rate decision on Tuesday. The market now expects that after the recent inflation and retail sales data the RBA will reluctantly raise rates by 25bps because inflation is unlikely to decline to its 2.5% target in a “reasonable time frame”.
Australian retail sales – core CPI and RBA trimmed mean
- The speech by the Federal Reserve Governor Powell, following the decision to leave rates unchanged at the November meeting, needs to be taken with more than a pinch of salt. The confidence implied in the speech that growth will not maintain the September quarter pace of 4.9% was based on the same list of factors used by the Federal Reserve since June to predict that US growth would moderate just enough to see inflation ease back to the Federal Reserve target of 2.5% (Goldilocks). It must be remembered then that the Federal Reserve failed to predict the strong consumer-led 4.9% surge in GDP growth in the September quarter.
- Since June we have forecast that the Federal Reserve would not be forced to raise official rates again until its preferred inflation measure – core PCE price index – begins to rise again. The Federal Reserve has to contend with a balancing act between maintaining official rates just high enough to ease growth to a slower pace while still conducting QT in the background.
- Broad money growth is now contracting. This is important because it means that the Federal Reserve does not need to raise rates again in this cycle, but can patiently wait for the economy to slow and create excess supply that will gradually reduce prices.
For those that understand Monetary Theory this is an important chart. The most basic monetary theory equation is:
It is important to understand then that monetary growth and money velocity are on one side of this equation. Velocity has been in decline since 2000 because banks have shifted to just residential house lending, and this has reduced the money multiplier effect.
One of the problems we currently face in making predictions using Monetary Theory is that it has been distorted by the Keynesian Modern Monetary Theory approach to Monetary Policy, since the GFC. The QE policy was effectively financing the fiscal expansion since 2009.
There are 3 important points to note here:
- Although Monetary Growth is now slowing, this is after excessive QE over the past 10 years has increased the money base to its highest level in history. This did not result in inflation because the US was exporting inflation to China and money velocity was falling during this same period. Post pandemic we are likely to see global supply chains less reliant on China and so effectively importing inflation back into the US. The rise in money velocity may be enough to offset the fall in money supply growth, such that inflation is able to keep increasing (V increases while M falls = Increase P for the same level of Q).
- Now that the Federal Reserve has to taper QE in order to control inflation, it cannot finance the fiscal deficit with bond buying (QE) and instead, this supply will need to be absorbed by the market. What this will mean is, that while the central banks may leave rates on hold now for the rest of the cycle, the curve will steepen because of increased bond issuance connected with the ever-expanding fiscal deficit and the Federal Reserve, as the largest buyer of these bonds, is no longer in the market.
- Despite all the interest rate increases to date, consumers are still able to fund household spending for two reasons. Firstly, wages growth is still tracking well above where it was pre-pandemic and will remain strong with ongoing levels of low unemployment. Secondly the increased level of welfare instigated in the pandemic has now been reduced back to pre-pandemic levels. Such a high level of welfare reduces the household’s dependence on employment and will make the Phillips curve theory redundant. This may mean that we continue to see rising inflation even with rising unemployment.
The bond market reacted to a smaller increase than expected in non-farm payrolls on Friday night in much the same way it overreacted to the stronger than expected increase in payrolls last month. Given the lagging nature of payrolls decisions and the impact of the recent auto workers strikes it is perhaps more instructive to use an average over the 2 months of 223,000. This is still a much stronger average level of growth in payrolls than the market, the Federal Reserve and most economists expected. It is a clear sign that higher rates are not yet slowing labour demand. The problem for the Federal Reserve, that wants to be patient, is that unemployment is still below the full employment level of 4% (NAIRU), wages growth is still well above historical levels consistent with the 2.5% inflation target, and now the core PCE price index is beginning to rise.