What needs to happen for rates to be cut

On the face of it the US CPI result that showed a monthly decline (-0.1%) and the year-on-year rate falling to 3% was very good news. The market’s reaction, however, was muted by the following issues:

The market was already forecasting a decline to 3.1% following a fall in the PPI in May (flows into CPI with a short lag).
The fall in gas and oil prices in March/April was expected to put significant downwards pressure on inflation in the June quarter. The 3.8% fall in the gasoline index in June was the biggest contributor to the decline in the CPI.
Shelter costs, airline fares and used car prices all declined simultaneously last month for the first time since the pandemic. Used car prices are now down over 8% this past year (1.5% last month alone) and are unlikely to keep falling. Equally, airlines fares should stabilise after declining when the post-pandemic capacity was added and in future will be driven by wage costs. Last month’s 5% decline in airfares is not repeatable. The focus then is on shelter costs which have been expected to fall for some time. This sticky type of inflation needs to keep falling if inflation is going to sustainably reach 2%.
The PPI data that came out on Friday night showed both an increase of wholesale prices last month and the May decline revised upwards to a flat reading. Year on year producer inflation increased to 2.6% the highest reading since March 2023. The decline in goods prices the PPI showed is good news for the June PCE data, but as it was entirely due to the 5.8% fall in gasoline prices the market should look forward to higher gasoline prices in the months ahead now that the oil price is rising again.
While US employment growth remains robust the US Federal Reserve should leave rates on hold so we don’t expect a rate cut at the July or August meetings, but September remains a live option.

Interest Rates

Yields fell across the curve last week after a better-than-expected US CPI reading. The move was accentuated at the short end of the curve where 2-year yields fell from 4.62% to 4.46%. At the long end the 10-year yield fell from 4.27% to 4.19%. The curve has flattened with the 2 to 10-year spread now at 27bps, however, most of the flattening occurred in June when it contracted in from 52bps. It is the fall in the 5-year yield from 4.22% to 4.11% that best shows the market’s confidence that the FOMC will cut rates at the August meeting. Such a move would be seen as highly political so close to the election but may be unavoidable.

The rally in the bond market was more subdued than in the US with the 2-year yield falling from 4.21% to 4.17% and the key 10-year yield from 4.37% to 4.33%. This will be due to the expectation that the RBA will raise rates later this year reflected by the rally in the AUD. The 4-year bond yield is the key indicator, its yield fell only from 4.11% to 4.05% last week. The Aust. benchmark curve maintained its slight premium.

Major Credit Markets

Investment Grade (IG) credit markets were steady with the expectation of rate cuts giving credit buyers confidence despite historically tight spreads. The flow of money has however reversed with cash flowing out of IG Mutual funds.

Australian credit markets were also strong especially at weekend after the US CPI reported. Major bank senior bonds were steady whereas bank sub notes were firmer especially at the shorter end of the curve. Offshore issuers were active. Rabobank Australia (rated A+) issued $1.25bn of floating and fixed rate 5-year notes at a margin of 0.98%, giving the fixed rate tranche a yield of 5.09%. Banco Santander (rated A-) raised $600m in fixed and floating 10NC5 Tier 2 sub notes at a margin of 5.25%, giving the fixed version a yield of 6.444%. ANZ raised US$2bn of 3-year senior bonds at T+0.50% in fixed and floating rate versions.

High Yield Markets

US High Yield (HY) spreads were slightly wider again over the week with mixed moves amongst the sub sectors: Automotive, Healthcare and Telecom have been strong whereas Consumer Products, Transportation and especially Media have been quite weak. If equity markets are any guide to HY, the Russell 2000 index jumped 6% last week in a rally indicating comfort with US SME. Perhaps this is a catch up to the HY markets, which are at highs.

Hybrid margins rallied over the week, the major bank average hybrid margin falling by 0.07% to 2.07%. The rally was across the major bank margin curve, only CBAPI widening in spread; however, it was well below the curve last week and hence is simply moving back to the pack. The non-majors were mixed. Bendigo issues and 2 Macquarie issues were weaker. In this rally since early June, shorter-dated hybrids have rallied more strongly than longer dated, resulting in a steepening of the margin curve.

Listed Hybrid Markets

Hybrids – BOQ not to repay BOQPE at the first optional cash date?

The terms of the Bank of Queensland Capital Notes issue in November 2017 have a mandatory conversion date of 15 August 2026. Unlike the recent hybrid issues which have multiple optional cash repayment dates, there is one optional redemption date of 15 August 2024 for BOQPE. As is assumed for most hybrids, the first optional redemption date is a de facto redemption date. In order for the bank to use the optional date, the bank must give holders between 15-50 business days note. We are currently nearing the 15-day cut off, this being Thursday, 25 July. The bank may provide a notice before then; however, most banks provide a notice early in such a period. Now we’re one for exercising an option late, but what make this curious is that typically the notice is accompanied by a replacement issue. Recent bank hybrid issues have required 3.5-4 weeks minimum to get the paperwork done, hence a new issue announcement would be expected early this week at the latest. In the case of no call and no replacement, BOQPE will continue to 15 August 2026. In this case the 3.40% margin will result in some repricing of the current security. Currently at $101.49, the margin to August 2026 is 3.81%, well above a new issue pricing. Hence a non-call for BOQPE would be a price jump to $102.50+, which would be a margin of 3.20%, appropriate for a 2-year BOQ hybrid.
The chart below shows the non-major bank hybrids including the BOQ issues. BOQPE as circled is well above the pack, and hence as mentioned above, a maturity extension would result in a large margin fall and this price jump. On the other hand, if a new issue is announced and hence a reinvestment offer, the margin required would be north of 3% given the current BENPI and IAGPF margins levels.