The markets, at both a bond and currency level, are now forecasting that the RBA has fallen behind the curve with its interest rate moves. The RBA is now expected to increase rates by 25bps at the November meeting and then remain on hold until the February meeting, when a new RBA interest setting board is expected to ignore the inflation risk and outcomes in much the same way it did in the late 1980s. This also signals that we no longer have an independent RBA. The following chart shows this change in market price relative to other economies. The Australian 2 year has risen by more over the past week than others
Over the past six months, the readers of our Weekly and Monthly updates will be able to acknowledge that we have consistently forecast that inflation and higher rates will occur, and that accordingly, duration should be minimised. As an Absolute Return manager, we are not biased to either fixed or floating rate bonds because we can alter duration, unlike fixed rate or credit fund managers.
Arculus Funds Management (formerly GCI Australia) first pointed out, since the midst of the pandemic lockdowns, that an inflationary breakout would occur for the first time since the 1980s. Inflation is something not understood by many economists (anymore) and even fewer market strategists, and apparently, disgracefully, by no asset managers that have been advocating for investors to increase duration by purchasing fixed duration bonds since 2022. They were wrong then, they are wrong now, and they may well be very wrong over the next 12 months given the underlying economic strength in the US, Australia, and perhaps even the global economy (notwithstanding we have now raised Europe – inclusive of the UK – to a high risk of suffering a material economic contraction within the next 12 months). It is flabbergasting that, given the potential capital loss on a long duration bond holding, investors don’t retain a tight stop loss when they have been gambling that the economy will magically still grow, and at the same time inflation will conveniently fall to the central bank target Goldilocks is a fairytale! Apparently, asset class advisors are recommending adding a little duration risk, with long duration bond positions, in order to offset the risk of a fall in equity prices. This is a fool’s errand, much the same way it was in 2008. Over the short and medium-term period, only quality advice will provide investors with the right timing to switch duration because at key turning points TIMING makes all the difference to long-term returns. Picking the right time to make investment changes is the entire purpose of economic study. Time, not timing, in the market is a convenient theory for those that cannot understand or make the economic timing decisions.
It is then quite odd that those that promote time rather than timing are currently promoting Alternative Asset class investments that are useful for investors only because they seek to reduce the impact of short-term equity market sell offs. They are making a huge timing call! If the Australian economy suffers its first economic contraction since the last recession in 1992, there is a high likelihood that due to the extreme levels of household debt, the economic contraction will resemble a depression in God helps us all! All Alternative Asset class investments carry a higher degree of economic risk due to the size of the underlying businesses in which they invest, and a much lower degree of transparency on the underlying investments as well has very little liquidity.
Quite recently we have highlighted 3 known risks to the global bond market:
- A breach of the ECB maximum German/Italian 10-year bond spread of 200bps;
- Japan abandoning yield curve control and tightening monetary policy;
- US bond volatility forcing the spread between actual and futures pricing of Treasury bonds wider. This leads to the selling of the record level of hedge fund positions taken out to gamble on this spread contracting it and when an economic contraction This has been termed the collapse of the US basis trade in papers published by the Fed Reserve, BOE and ECB.
The accelerated sell off in global bonds over the past week has, at its foundation, the inconvenient truth that the economy is not contracting and that inflation will shortly begin to rise again – perhaps even to new highs. It must be STRESSED – right here, right now – that the known risks we have highlighted are actually unfolding and that this may well result in the global bond market becoming dysfunctional, resulting in bond yields “overshooting” to the upside. Let’s then review these known risks…
Japan has not yet begun tightening monetary policy. Much like the asset manager that has been conditioned by recent history to buy long duration bonds after a 200bps increase in official rates, the BOJ and much of the Japanese financial establishment have forgotten how inflation actually occurs, how it destroys economic prosperity, and much like a virus, how difficult it is to As the following chart displays, Japan now has an actual inflation problem that requires an actual monetary policy response. The BOJ may not understand monetary theory and, if this is true, then it should not have employed excess monetary supply (let’s face it very unsuccessfully since 1994) to maintain economic stability, but having done so, they must also now recognise the inflationary potential of having excess money supply chasing prices higher. The main and obvious risk to inflation is the weak Yen –inflation will be higher in Japan!
The ECB Italian/German 10-year bond yield spread has been trading above the 200bps cap for some time. At some point in the near future the hedge funds and other investors will conclude that the ECB will won’t be able to defend the 200bp cap and Italian yields will explode This then has implications for the Italian economy, the Euro and the survival of the common currency theory much like the Greek crisis in 2012. We have been warning of this risk for 6 months now.
Clearly, the US basis trade is already beginning to It will take some time in an ordinary market to reduce the Treasury market futures open positions to historic levels. There is a risk that this un-widening of the basis trade will become disorderly. In October the US yield curve has moved significantly. Brace, brace, brace!!!
US 10-year bond yields are now threatening the key 5% level. During the week the 10-year yield reached 4.99% before closing at 4.92% after a late Friday rally. Investors now need to brace for stronger US growth after higher than expected retail sales reported last week provided a further signal that the US economy remains robust. If the “transitory” factors are now exhausted, then we may see higher oil prices begin to drive headline inflation higher.
The Australian 10-year continues to trade a discount to the US 10-year. This is ridiculous when the Australian governments, at every level, act only in their self- interest and without any concern for the wealth, prosperity, and ultimately the survival of our democracy. If correct risk pricing eventuates then we may see a surge in Australian long bond rates, which would in turn wreak havoc on the Australian economy and risk assets. The new RBA Governor flagged that more needs to be done to control inflation. This may be a hint that the cash rate may be increased at the next meeting on 7 Nov.
Major Credit Markets
Margins expanded last week due to the combination of a fall in equity prices and the prospect of a broad war in the Middle East. There is also the inevitable risk that, with rates staying higher for longer, many corporate issuers will face higher interest rate costs when their bonds issued during the pandemic reach maturity and are rolled at the current higher rates. The US iTraxx widened by 0.04% to 0.813% and the European iTraxx by 0.057% to 1.04%
Australian Investment grade margins widened last week. The 5-year iTraxx index reached 97, a level not seen for some time. The rise in the US/Aust swap rate is expected to see Australian bond margins widen as domestic and Kangaroo issuers switch their capital needs to the raisings in the Australian market. Already we have seen, last week, QBE repay a US issue and raise $330m at +255bps Tier 2 in the Australian market. CBA issued $1.25bn of a 10NC5.
Forward Interest Indicators
- Swap rates jumped along with long-term bonds with some pull back on
- Swap rates:
- 10-year swap 98%
- 7-year swap 81%
- 5-year swap 65%
- 1-month BBSW 08%
High Yield Markets
US high yields (HY) were quite weak after some recovery the week Monies continuing to flow out of HY funds. HY and junk bond ETFs lost over 1.5% last week in price.
Hybrid spreads steadied last week after significant rises in the weeks before. Volumes have been well below Bank share prices have been weak. An index of the major 4 banks fell 2.27% last week. If this trend continues hybrid margins will resume rising.
Despite a relatively steady average margin, there were some large changes for individual issues: AN3PG, AN3PH, CBAPL and WBCPH all contracted in margin, whereas CBAPH, CBAPG, NABPH and WBCPI all had margins In the non-majors there were larger changes: BENPG, BOQPE, and SUNPG were particularly weak, CGFPD and MQGPD the only issues with tighter margins.
Listed Hybrid Market
The hybrid market has been weak since mid-September for several reasons: firstly the general rise in volatility driven by soaring long bond rates and secondly by a general rise in credit The chart shows the recent rise in the major bank average hybrid margin. Note the see-saw pattern in the last 6 months. As we have previously described, liquidity is a major pricing factor on hybrids, demonstrated when large new major bank hybrids are announced. As indicated, the rise in March was due to a new ANZ offer, the rise in late May due to CBA and in late August due to NAB. Other factors such as credit and equity markets do come into play but for most of 2023 these markets have been relatively calm, until now. The current rise is quite stark and quite similar to that when the 3 abovementioned issues were announced. Hence it may be premature to ascribe the current rise just to market volatility. As discussed in previous weeks, the new APRA hybrid review may bring forward bank hybrid issuance before the rules change. Perhaps the current margin rise foreshadows issuance to come in the short term.
Also shown is the trading margin of CBAPL, note how it is quite variable and follows the general market trend as shown by the average margin A trading margin is derived from the daily price. Once a hybrid is issued its margin varies according to the factors mentioned above.