The 3 big surprises from last week that

There were 3 surprises last week:

ISM manufacturing PMI moving above 50.
The 308,000 increase in non-farm payrolls in March.
The equity market’s reaction to the non-farm payrolls data.

Firstly, the US ISM manufacturing PMI was not only much higher at 50.3, than the 48.3 expected for March, it was the first reading above 50 in 16 months. This is significant because an ISM manufacturing reading above 50 is an indication of a manufacturing expansion in 6-9 months’ time (not in the March quarter of 20204 as misinterpreted by so many). Perhaps more importantly this indicates that a manufacturing expansion may arrive:

After many interest rate increases.
While inflation remains above the Federal Reserve target.
With unemployment at 3.8% and well below the measure of full employment (4.5%).
After a prolonged period of wages growth well above the level consistent with inflation falling back to 2% sustainably.

Secondly, on Friday night the non-farm payrolls reading of an increase of 308,000 in March was significantly above the market’s expectations of a 200,000 increase. Perhaps even more significantly the private sector increased employment by 263,000. It needs to be remembered here that the actual changes in employment lag the decision making at an enterprise level by 6-9 months so this surge in private sector employment relates to decisions made as far back as July last year. It is then worth noting that the ISM PMI manufacturing index did spike higher in September only fall heavily in October and November so we may yet some weaker employment data in April and May before another surge in the second half of the year (just in time for the Presidential election).

The third surprise last week was then the equity market’s reaction to the very strong employment data. The data does pretty much crush any hope of a cut in interest rates this year so the Dow and S&P may well struggle with their leadership dominated by interest rate-sensitive companies. The leadership of the US equity market is incredibly narrow at the moment, so there is no room for anything to go wrong.

Then there is the growing market consensus that the US is about to experience a period of stagflation. Our view is that it is too early to be considering a US economic contraction, but inflation remains a livewire. The Federal Reserve view (and we are all guessing here) is that now that it has achieved negative monetary growth it can afford to be patient. We and the market consensus expect that even if the core PCE price index begins moving higher in the months ahead, the Federal Reserve will remain on hold for 2 reasons:

It is worried about financial stability given the smaller banks exposure to the commercial real estate sector.
It is a Presidential election year.

So we believe that with the Federal Reserve anchoring the short end of the curve at 5.25% the markets will force the rest of the curve to steepen for 3 reasons:

The economy will remain robust, and inflation will begin to rise again.
The US Treasury is already having to issue $80bn of new debt each month and with the power of compounding this is only going to increase. If the US 5 year and 10-year Treasury bond yields moves back above 5% again then financing US government debt may prove challenging.
The US dollar may shortly begin to lose its role as the global reserve currency. Slowly but surely the Chinese-initiated axis against the USD is growing stronger. At this stage we are only including in this anti-US axis China, emerging economies with strong trade links to China and of course Russia, but China with its fixed exchange rate has a powerful weapon in its arsenal – devaluation. Central Command in Beijing can overnight order a new lower Renminbi trading range, and it can afford to do it because it has retained strong FOREC reserves and is currently suffering disinflation.

When a country, like China, has a fixed exchange rate it needs to hold foreign exchange reserves, principally in USDs. These USDs are then held as USD Treasury bonds. If, and it is a big “if”, the USD loses its mantra as the “global reserve currency”, then China and all other countries with a fixed exchange rate regime are no longer going to be as big a holder of US bonds before.

All of this has momentum, even urgency, right now because the Japanese Yen has fallen and remains under pressure to fall further. The weak Yen is making Japan-based manufacturing once again competitive after 30 years of stagnation and Chinese domination. If the Yen falls through the support points it is currently testing – despite the assertations of support from the BOJ (that we don’t believe) – then China may react.

Interest Rates

The past week was actually a little dull for the bond markets with only small movements. The drama was in the equity markets that rallied on a combination of seasonal reporting risk having passed and an assumption that the last US nonfarm payrolls report was an anomaly and not a definitive recession signal. The fall in Bond yields stops with rates steady after expected CPI prints, showing a slight contraction. Mid-week better economic data erased much of the economic doom from two weeks ago and hence rates have recovered some of the recent falls, especially 2 yr. treasuries, now back over 4%. The yield curve has re-inverted from its flirt with flatness, 10 yr treasuries now at 3.88%

Investors and traders may be bracing for new issuance from the Australian States with T Corp due to roll a bond and the never-ending story of rising Victorian debt maintaining the growth in bond supply. Australian rates fell across the curve as the market flipped to a “rate steady” mode rather than rate rises. 10 yr. comm gov bonds fell 0.15% to 3.925%.

Major Credit Markets

Investment grade (IG) bond spreads continued to recover with US IG issuance strong and buying demand focused on the absolute high level of rates as yield falls are expected. Both the US and European IG iTraxx indexes are now back at levels prior to the rate volatility two weeks ago.

Floating rate credit margins remain well bid with much of the recent action across the FXD coupon curve where a skew to better selling has seen FXD bonds underperform their FRN counterparts. Macquarie and Regional bank spreads are holding in well but flows remain light, whilst Suncorp bank continues to field decent two way across the domestic real money community. Australian investment grade credit margins also recovered although not quite as strongly as in the US. The market took advantage of better conditions to issue strongly: CBA raised $4.35bn in a triple tranche senior bond sale. BNP issued $1bn of a 10NC5 Tier 2 sub note in fixed and FRN formats all at a 2.15% margin. Macquarie issue $1.25bn of a 10.5NC5.5 Tier 2 sub note also in fixed and FRN stye at a 1.85% margin.

High Yield Markets

High yield markets also continue to recover although not as quickly as IG markets. Despite this, outright yields on fixed rate HY bonds are at recent lows, a combination somewhat tighter spreads but also the absolute lower level of rates. HY issuance is currently strong, in somewhat of a make-up for previous lighter weeks given market volatility. Secondary volumes are well elevated over 2023 levels. However, HY funds are seeing significant money outflows.

Hybrid margins fell slightly over the week as the recent market volatility abated and especially with equity markets resuming an upward path. Of the major banks, NAB and Westpac hybrids were all strong as well as medium to long dated CBA hybrids. In contrast ANZ hybrids were weaker. In the non-majors AMP, Bendigo and IAG hybrids were stronger, whereas Macquarie and Suncorp mixed.

Listed Hybrid Market

Hybrids – value relative to senior bonds and subordinated notes

As mentioned above, last week CBA issued a huge 3 yr. senior bond issue. Three-year and five-year floating-rate notes were issued at 3m BBSW+ 70bp and 87bps respectively. Also, a five-year fixed-rate tranche was issued at 87bps above swap. Hence it is timely to make comparisons across the CBA capital structure. Below we show trading margin histories for a CBA senior bond, a CBA subordinated bond and a CBA hybrid, all 3 with similar maturity dates.

The first chart shows the trading margins for the CBA January 2028 maturity senior bond, the CBA November 2027 subordinated note and the CBAPL hybrid, a June 2028 maturity. Note the changes in the margins over time. The senior and sub note margins are in gradual downtrend, expected given the maturity and hence risk shortens as time proceeds. The downtrend however is not smooth. Hybrids generally also tighten in margin over time (typically with less than 4 years to run), however hybrid margins show more variance week to week. This reflects 2 things: a hybrid’s sensitivity to senior and sub note margin changes as well as sensitivity to a range of equity factors; the general equity market, absolute bank share price levels and bank share price volatility. Further, as we have described many times, new hybrid issuance significantly impacts trading margins.

A simple method to gain insight as to the appropriate level of hybrid margins relative to senior bonds and sub notes is to examine the ratio of hybrid margins to each. Such ratios should be stable over time, however as the second chart shows they are clearly not, often due to idiosyncratic factors (as mentioned above, mainly liquidity) but also trading lags and leads. What the correct ratio should be is subjective just as what the correct credit margin should be for a debt security at any point in time. The chart also shows the average for each ratio (lighter straight lines). Right now relative to senior bonds, this CBA hybrid is slightly expensive relative to senior bonds whereas it is fair value relative to the CBA sub note. Fund managers who understand these pricing comparisons, and who are monitoring day to day the relative pricing as well as each securities liquidity, can add significant value by switching between the three types and trading the lags and leads.