The inflation genie’s out of its bottle – what will get it back in?

There has been a lot written about last week’s CPI reading in Australia, so we won’t rehash it here. The following articles cover it well:

Remarkably there are still a number of market commentators and economists claiming that inflation is still declining. Those that are calling for the RBA to increase rates, however, will be disappointed. As we outlined last week even if the RBA had the political courage to increase rates, we have an RBA governor and deputy governor, Hauser, that don’t truly, deeply believe that inflation is a monetary phenomenon. Hauser’s attempt to dismiss last week’s CPI reading as inconsequential would have embarrassed a high school economics student.

So, in an election year, we have governments increasing fiscal expenditure when the economy is operating beyond full employment and an RBA that won’t tighten monetary policy. This means higher inflation because the transitory pandemic factors are now exhausted, and we now face cost push inflation. The only question is – despite the shallow attempt to manipulate the inflation outcome with energy subsidies by state and federal effectively governments – how high will inflation be in the December quarter? and then how much higher will it be at the end of 2025 and how much higher again will it be in 2026? and… so it progresses. The inflation genie’s out of its bottle and now only a sharp economic shock, internal or external, will get it back in its bottle.

Interest Rates

US 5 and 10-year yields rose over the past week on increased supply, certainly, but also the weakness in Japanese bonds. The Yen too is beginning to weigh on the global bond market. There may also have been some repricing, by the market, of the odds of a Trump win post the debate and what his raft of policies might mean for the bond markets.
2-year treasuries were slightly higher in yield whereas the 10-year was up 0.135% to 4.39%.

Wednesday’s dramatic jump in bond yields reflected the market realisation that Australia now has cost push inflation and more importantly, it has seen that the energy rebates in Tasmania did not have a sustained impact on the CPI reading. The Australian 10-year is now trading a slight premium to the US 10-year, and we see a risk that this will widen out further in the months ahead. Commonwealth Gov. bond rates were higher across the curve by 0.06 to 0.16%.

Major Credit Markets

Credit markets were steady last week after some volatility in prior weeks. US and European Investment Grade (IG) credit indices were slightly tighter as investors absorbed data that showed US inflation was flat in May but in line with expectations. IG mutual funds are still attracting investor funds.

Australian credit markets were quiet despite a rise in interest rate volatility. The run into the end of the Financial Year saw little issuance except for a Bendigo Bank 1-year floating rate senior bond at BBSW+ 0.60%. John Deere Financial (rated A+) raised A$450m from a 5-year MTN 5.097% 2029 fixed rate bond at a margin of 1.0%. Pioneer Credit raised $55.5m of a 4.5-year unrated and subordinated bond at BBSW+10.50%.

High Yield Markets

US High Yield (HY) spreads were slightly wider over the week with the weakness concentrated in the CCC sub sector. “B” and “BB” rated issues actually rallied slightly. Year-To-Date, “CCC” rated bonds are wider by 0.93% whereas YTD “BB” is tighter by 0.16% and “B” by 0.49%. Interestingly, the investment grade to HY average margin difference is basically square YTD.

Hybrid margins fell over the week by 0.15%, the average major bank hybrid margins now at 2.16%, not too far from the recent low of 2.00% in mid-May just prior to the NAB issue. Most major bank hybrids were stronger except for shorter-dated issues such as AN3PH and CBAPG. In the middle of the curve CBAPI, AN3PI and WBCPL all performed strongly. Outside the major banks, nearly all other issues also performed well with the exception of BENPH and CGFPC. Issues potentially due for reinvestment such as the short-term BOQPE and MQGPC also saw strong demand. 

High Yield Market

Hybrids – amount on issue

Major bank hybrid issuance is active with all major banks issuing each year and sometimes more than 1 issue in a 12-month period. The chart below shows issuance since 2011 when the Basel III hybrids were first issued. It took a good five years for the issuance to reach a stable level, although there were several old-style issues still in place up to 2015, however these did not equal the volume gap. Since 2017 the total on issue has been about $32 billion with an increase in 2024 now to $35 billon. Prior to 2024 the steady state was simply achieved by replacement issues at the first optional repayment date, these typically of roughly the same size. However, in April 2024 CBA did not replace the CBAPG issue. Conversely NAB issued out of cycle, although only $1 billion, however it was the second NAB issue in 8 months. CBA has not issued since May 2023. A pending APRA paper re hybrid structure may be to blame.

For completeness the second chart shows the issue margin from the securities in chart 1 vs the average hybrid margin at the time, noting that the average margin typically represents about a 5-year maturity whereas new issues are usually 6-7 years in expected length. As shown, the issue margin closely tracks the average margin. New issues are set vs market trading margins at the time.

Forward Interest Indicators

Australian rates

Swap rates jump with the rise in Australian bond rates this week.

Swap rates:

  • 10-year swap 4.56%
  • 7-year swap 4.46%
  • 5-year swap 4.39%
  • 1-month BBSW 4.31%