The audacity of Governor Powell, who has now cut rates by 50 basis points just prior to the election and 25 basis points as promised just after the election, was laid bare (naked really) last week when he said that the Fed is in no rush to cut rates.
“The economy is not sending any signals that we need to be in a hurry to lower rates,” Powell said in prepared remarks for an event at the Dallas regional Chamber of Commerce last Thursday.
He pointed out that the US economy recorded 3% real GDP growth in 2023 and 2.5% in 2024. He did not point out that this growth has been supported by consumption at the Federal and State government levels. The Democrats through the poorly named ‘Inflation Reduction Act’ and actually have increased fiscal spending from pandemic induced levels. Much like Australia governments (State and Federal) spending, this fiscal expansion at a time of full employment is feeding a wage price spiral.
He also noted that consumers have been spending at an elevated pace supported by wages growth and strong household balance sheets. He did not point out Labour Productivity rose from June 2022 to June 2023 coinciding with the period in which inflation was falling rapidly or that last quarter wages growth began to increase and labour productivity to fall. If this pattern continues then cost push inflation will commence.
He also noted that business investment has accelerated over the past year. Rising business investment is a key indicator of future economic growth. It is also a necessary condition before we see labour productivity growth.
He unfortunately went one step too far when he claimed that inflation would continue to decline to the target 2% without a recession or meaningful increase in unemployment. Powell may be right in the very near term that CPI touches 2% but it will not stay there given the current robust outlook for the US economy. We doubt inflation as measured by the CPI will continue to decline any further because wholesale prices have begun to rise again. The IMF at the APEC conference has also highlighted this risk.
Last week it was reported that the US CPI monthly reading was 0.2% for October. It has been now at 0.2% for the past four months at a headline level.
Core CPI excluding food and energy was 0.3% last month the same rate as the previous two months. The annual headline CPI rate actually accelerated in October to 2.6% from 2.4% in September. The following chart is an effective way of explaining the path that inflation has taken in the US. The peak just above 9% in June 2022 was result of the global supply chain disruption and the subsequent decline into June 2023 was due to supply change being fully restored. This was the transitory impact from the pandemic. The fall of inflation from June 2022 to June 2023 had nothing to do with monetary policy.
Since June 2023 as noted by Governor Powell, last week, the US economy has remained robust, and inflation has stopped declining and stabilised above the Federal Reserve’s target of 2%. The longer that inflation remains above 2% the more embedded inflation becomes because workers wage levels need to compensate them for the increase in the cost of living.
It is hard to take the Federal Reserve approach to Monetary Policy as truly independent anymore given the pre-election 50bps rate cut that now looks reckless. Powell did not mention the Trump policies – at all – in his speech as if he just hopes Trump will not keep his policy promises. We, unfortunately, must live in the real world where we have to take the implications of the Trump tariffs seriously. Our view remains that we will see higher inflation in the US over the next 12 months. How much higher is the real question.
Interest Rates
Although US 10-year bond yields rose from 4.31% to a high of 4.50% last week the market appears to be reluctant to push either the 5-year or the 10-year much higher in the short term. 10-year treasuries finished at 4.44%. Last week the market ignored the hawkish Powell comments as well as a slew of positive economic growth data releases. Chief amongst these was the stronger than expected retail sales increase of 0.3% last month that pushed the annual rate to a robust 2.8%.
Australian bond yields rose broadly in line with the US yield curve last week however with a difference. Australian short-term rates rose more than the US and longer dated less. The better-than-expected employment data and wages growth of 3.5%, pushed expectations of a rate cut back, with 2026 perhaps being the first cut? The Banks that have been calling for a rate cut now for …. well forever really, have been forced to the realisation that the RBA does not need to cut rates when the economy is operating at or beyond full employment.
Major Credit Markets
US investment grade (IG) markets were slightly weaker with large issuance satisfying demand and forcing secondary spreads out a few points. Further, monies flowed out of IG funds adding to the weakness. Investors now that the election is out of the way and some euphoria about the meaning for the economy is passing, investors are trying to rationalise paying historically tight spreads.
Australian credit markets were strong. It was a busy week for issuance. As expected, ANZ came with a Senior bond offer last week with a 3-year that priced at 67bps ($350m). The Port of Melbourne $450m Senior done at +128bp over swap was done quickly by NAB and WBC while the ING $300m senior 5-year done at +80bps was a surprise given the fact that NAB only a week earlier has a issued a 5-year +82bp (NAB AA-, ING A). QBE came with a 12NC7 year Tier 2 at +180bps for $250m but it was the CBA 15NC10-year done at the incredibly tight +165bps that shocked seasoned investors. There is a now large mispricing of risk at T2 levels that does not reflect the risk relative to Senior or the expected supply over the next 12 months.
High Yield Markets
US high yield (HY) markets retreated after a huge post-election rally, the tailwinds of which are now fading. As with IG above, given spreads are historically very tight, is there rationale for further tightening?
Hybrid margins rallied back after going against the global trend of tightening credit margins the week before. The average major bank hybrid margin fell by 0.08% to 1.86%. WBCPH dominated trading with close to 330,000 units trading hands as investors looked to move out of shorter dated issues (see next page).
Dividend season is coming again with next week being the best buying opportunity, as by December 12th nearly all bank hybrids, including all Macquarie and major banks, will be quoted ex-dividend. Recall last quarter as we reported, in what was then a strong market, many hybrids held the franking component, pulling trading margins in by some 0.10% across the sector.
Listed Hybrid Market
Hybrids; changes in the curve.
Last week saw volume trading in shorter dated hybrids which appeared to be driven by selling, given margins moved much wider. This is shown in the chart of blue dots (most recent) well above the red dots from the week prior. The trend lines summarise the moves. Longer dated hybrids were slightly lower. Mid-curve this was slightly more pronounced, issues like CBAPK, WBCPK and ANZPI performing well. Compared to a few weeks ago, the latest curve (blue summary line) is now more traditionally shaped, that is, a positive slope leveling out after five years.
Forward Interest Indicators
Australian rates
Swap rates rise slightly with bond rates but day to day volatility reduced.
Swap rates:
- 10-year swap 4.56%
- 7-year swap 4.41%
- 5-year swap 4.30%
- 1-month BBSW 4.31%
