It was frustrating to see ANZ bank come out with a forecast that the RBA would cut rates in February. The rest of the banking sector seems to have withdrawn to the first cut now being in May when the new RBA interest setting board will be making the decision. Given the make-up of this new board, we don’t see any material changes in the way monetary policy is conducted in Australia, at least in the short term.
ANZ and a few others leapt upon the slightly weaker November monthly CPI data released in January to claim that if the RBA trimmed mean for the December quarter eased to just 0.5% (implying 2% annualised) then the RBA would cut rates by 25bps. ANZ has maintained this forecast despite:
The employment data in December showing a surge in employment. Employment growth was strong in December, up 56.3k to be 3.1% higher y/y. After showing no annual growth around the middle of 2024, growth in hours worked has recovered and ended 2024 up 3.2% y/y. The robust demand for labour has been met by an increase in supply – a function of both population growth and a 0.5ppt rise in the participation rate over 2024.
Putting all emotion and bias aside (something the bank economists cannot) we are compelled to point out the obvious here once again.
(1) Wages growth at 3.5% remains well above the 3% maximum the RBA, under Governor Lowe, repeatedly said was the level consistent with inflation being sustainably in the target band (we need to note here for the bank economists that the RBA target is now 2.5% and not the 2-3% zone). What is conveniently forgotten is that any level of wages growth is inflationary if it is not matched by an increase in labour productivity. The growth in employment, since the election of the Albanese government, has been in government services, health, and education. Most of the growth in these sectors has in fact been in administration and so labour productivity has fallen into marginal negative territory, but still, importantly, negative.
There is then a related issue played hard by our media and politicians with the narrative that there is a household budget crisis.
After a period of high inflation (as we have seen since the pandemic) those on fixed incomes have been impacted but what is overlooked is that in many government sectors (including Police, Fire, and Health) wages growth at a state level has not kept pace with inflation. It is then in households, where income is government sourced, that there is a budget crisis. This might seem like an odd outcome, and it can be partly explained by the disastrous financial position of the state of Victoria, but in all states (even WA) the governments have been giving a higher priority to their big spending plans. In time, however, we will and must see a catchup in wages growth for these government employed people. This is already underway with strike action by train drivers in NSW, police in Victoria, and nurses everywhere. Over the next 12 months, we expect then to see a surge in government related wages growth that will trigger a surge in inflation because the government employment growth has surged over the past 10 years. Apparently, someone worked out that it no longer takes 2 people to change a light bulb, but it now safely requires 50!
(2) The RBA has a dual mandate of price stability and full employment. With the unemployment level at 4% and the RBA’s estimate of full employment being 4.75%, the RBA should not be relaxing monetary policy. Until unemployment begins to rise the RBA can keep rates on hold. Added to this is the fact that Australia has unemployment at 4% after a huge period of net immigration and with labour participation at a record level. There is no room, on the basis of Phillips Curve Theory, to be cutting rates anytime soon.
Economists at ANZ bank broke ranks with the other major banks in January with a theory that the slightly weaker core and trimmed mean inflation readings in November will give the RBA room to cut rates in February, because they see the RBA as some sort of benevolent entity or that it is not actually politically independent at all.
The Trimmed Mean estimate for November was 3.2%yr compared to 3.5%yr in October while the excluding volatile items & holiday travel index came in at 2.8%yr compared to 2.4%yr in October. This fall was entirely due to the electricity subsidies at both Federal and State level moving from the headline CPI reading into the slower core and trimmed mean readings. The RBA will look through these subsidies to inflation rising when they expire. The RBA has repeatedly said this but apparently the ANZ economists were not listening?
In fact, electricity prices surged 22% in November due to the return to a single monthly instalment of the 2024/25 Commonwealth Energy Bill Relief Fund (EBRF) rebate for households in SA, Tasmania, NT, and ACT, and for most households in NSW and Victoria.
Differences in the roll out schedule of the 2024/25 EBRF rebates meant that households in these states received catch up payments (two instalments) in October. The first instalments of 2024/25 Commonwealth and State rebates in Western Australia were also used up in November. Households in Western Australia will receive their second instalments of both Commonwealth and State rebates in the March quarter 2025. When all these rebates expire (conveniently post the Federal and WA state elections) energy costs at a household level and more importantly at a business level will surge. The price of energy with a short lag impacts the prices of all goods and services. Energy is fundamental to our way of life, our prosperity and our survival. Its provision needs to be controlled by adults.
In the chart above the data is quarterly not monthly. At the end of the September quarter inflation by all measures was still declining in Australia due to falling durable goods prices, subsidies and a rise in the AUD after the Federal Reserve cut rates by 50 bps. Quarterly data is more reliable because different price changes occur at different intervals during a quarter (e.g. insurance). Using monthly data, we are already seeing a pickup in headline CPI, and this tends to lead the trimmed mean with a lag of about 90 days. So, we expect that if headline CPI is again higher in December, then it will keep rising once ALL the electricity subsidies expire and stronger wages growth feeds into higher prices.
There is another big, big reason the RBA will not be cutting rates anytime soon and that is the weakening currency. A weaker currency increases the price of imports and Australia, with its tiny manufacturing base, has little capacity for import substitution. A change in the currency has a high correlation with inflation outcomes.
Interest Rates
The benchmark curve has been trading in lockstep with the US curve over January so far at a 15bp discount. We would argue very strongly that ahead of an imminent Federal Election a raft of irresponsible spending promises increases the risk that the Aussie 10-year moves back to trading at a big premium to the US 10-year. In June 2022 after the ALP was elected the A10yr-US10yr spread blew out to 75bps. We expect that a Federal Election will be called this week for late February, not April as the market is expecting. The lame duck RBA will not cut rates as some bank economists predict.
Major Credit Markets
US investment grade (IG) markets weakened with the overall rise in equity and rates volatility pre the inflation print. Subsequently credit indices have retracted the mid-January rises, especially the US.
In Australian credit the year started in the first week of January at a hectic pace – not seen for many years. Supply and demand have been solid so far, however, experienced players can attest that the market can reach a saturation point rapidly. Hence investor vigilance is required. The signs we are then looking for are reduced order books that inhibit the issuer’s ability to tighten guidance, soft post-issue performance and elevated levels of switch flow in and around pricing that allude to diminished cash piles. Perhaps most telling would be sustained ambivalence from core investor groups – and in recent times, this has been Asian real money. To re-iterate, we have not seen any evidence of this to date, but whilst the primary taps remain on, we expect some gyrations in investor appetite in the coming weeks.
High Yield Markets
US high yield markets have outperformed IG markets in recent weeks, not exhibiting the mid-January margin spike of IG and underpinned by healthy issuance and the flow of good economic news, which is a large driver of HY returns given companies issuing HY debt are typically more economically sensitive.
As 2025 starts the hybrid market has started slowly with spreads moving wider on gradually improving volume, albeit still under average daily levels. Margin tights were observed on December 31, with the average major bank hybrid margin at 1.80%, however since 2024 end the average margin has moved in a 0.22% range, closing at 1.94% last week. This is a large range and reflects lighter volumes. Margin moves in some hybrids have been larger than the average. The curve has widening slightly at the long end but quite substantially at the short to mid-section.
Listed Hybrid Market
Hybrids in 2025
2025 begins in the shadow of the recent APRA guidelines released early December and previously discussed. However, underneath the surface, the APRA ruling will have a broad impact as 2025 proceeds, mainly from investor behaviour. Alternatives are now being marketed assuming investors are to leave the hybrid sector. This is pre-mature.
Hybrid margins will still be influenced as usual by equity and credit markets. Despite some volatility a week ago, credit and equity markets are strong, underpinning hybrid pricing. We have often cited a third major pricing factor, liquidity. The major impact of the APRA changes will be to reduce issuance and hence the volume of available stock. This will be increasingly felt as time proceeds as hybrids are redeemed and not replaced. We are at the beginning of a long run-off, as shown in the chart below, which shows the cumulative sector size for bank hybrids and the run-off. No meaningful sector size reduction occurs until late 2027.
Right now, it is way too early to be looking for alternatives when current hybrid yields are still attractive. However, this may may change in March if ANZ and / or CBA do not rollover their upcoming maturities totalling $2.3 billion, AN3PH (March) and CBAPG (April) respectively. Much of that $2.3bn will first look to the hybrid market for replacement. This will keep the market well bid. Even if these issues are rolled, there is no new net issuance.
APRA provides world leading banking oversight with the aim of a stable banking sector. We may criticise APRA’s recent bank balance sheet changes regarding hybrids, but the review drives home the point of a vigilant regulator. Paradoxically this makes hybrid investing safer, despite the regulator removing this asset class due to their concerns about hybrid investor risks.
Forward Interest Indicators
Australian rates
Large swap-rates rise in line with global bond rates.
Swap rates:
- 10-year swap 4.51%
- 7-year swap 4.351%
- 5-year swap 4.22%
- 1-month BBSW 4.32%
