The US strikes on Iran’s nuclear facilities on Sunday will no doubt impact markets on Monday, but it could have been worse. The US has targeted only the 3 main uranium enrichment facilities and perhaps forestalled Israel targeting Iran’s oil production and shipping infrastructure.
Macro Commentary
One of the less obvious byproducts of the Israel conflict is the possibility of much higher oil prices and real supply shortages for China. China has been a consistent and large buyer of sanctioned Iranian crude oil for a very long time. Iran has also been then dependent on buying consumer goods from China. It has been a mutually beneficial relationship even if the Iranians are left with only one dancing partner.
China does not want the situation to escalate any further because of its dependency on cheap sanctioned Iranian oil and it has opposed US led sanctions. Since last September China has increased and been stockpiling Iranian oil in a clear sign that Iran was much closer to the nuclear bomb capacity than would be tolerated by Israel, US, Europe and even the UN and China knew it. Just four weeks ago the UN applied new sanctions that were related to its nuclear enrichment.
The real problem for China will come if Israel realises how important this trade is to China and destroys the Iranian shipping terminals. Just an indication of interest in doing this would force the CCP to pressure the Iranian regime to surrender. This was perhaps what Trump was hoping for by delaying military action for up to two weeks.
We do not share Fitch Ratings optimistic opinion that a loss of Iranian oil could be replaced by increased output from other OPEC partners. If Iranian exports are impeded for 90 days or one inventory cycle, then we expect the oil price to first spike well over $100 a barrel before there is a supply response from OPEC. Supply responds to the price signal in an efficiently functioning market.
A higher oil price even for a short period of time is important because:
- It will hit China growth that is spluttering
- It will boost US CPI ratings because oil in the US quickly feeds into about 30% of the CPI basket
A spike in the oil price may already be redundant for a higher inflation forecast. Back in 2020 the PPI Industrial Gases component began to surge higher in October 2020 and the oil price two months later. There was then a lag to March 2021 before these prices rises fed into US inflation. Now we are once again faced with industrial gas prices surging and the oil price also rising. A sharp increase in inflation must naturally follow.
Interest Rates
US interest rates were essentially unchanged in a week dominated by the Federal Reserve meeting. As expected, the Fed held cash rates steady, with officials signalling a wait-and-see approach in the coming months to gauge whether recent tariff impositions will place upward pressure on inflation. The Fed noted that economic growth is likely to slow, with tighter financial conditions and waning fiscal support expected to weigh on activity. While the overall stance remains data-dependent, members were divided on the need for rate cuts. Some officials, speaking after the meeting, pointed to only moderate recent price increases and signs of a softening labour market. Ultimately, the market remains focused on how reactive the Fed is willing to be – but acting too quickly on short-term data fluctuations risks undermining broader policy credibility. US 10 yr treasuries fell by 0.04% to 4.377%. Rates will fall on Monday given the Iran strike.
Australian bonds were also slightly down in yield on little news flow – only slightly softer employment data, although employment growth is stable. The comm. gov. 10 yr bond rate fell by 0.04% to 4.204%.
Major Credit Markets
US Investment grade (IG) credit remained steady with good inflow into IG funds providing support. The average IG margin is 0.88% with the tightest sub sectors being retail and consumer at 0.65% ad 0.72% respectively. The widest sector in IG is media at a margin of 1.13%.
With much focus on inflation, inflation linked bonds (ILB’s) give a market’s view on the future level of the CPI. After the US CPI last week, breakeven inflation levels have risen, the 5yr. up from 2.42% to 2.50%, the 10 yr up by a similar amount but at a lower level of 2.385%. Australian 5- and 10-year ILB breakevens are both the same near 2.0%.
Australian credit markets were softer last week with the iTraxx index moving wider by 0.07% to 0.79% despite US credit being steady and European credit only slightly higher. There was no real reason for the softness except for lack of investor demand. The market is pricing an 80% chance of a 0.25% RBA rate cut on the 8th of July
High Yield Markets
Global High Yield (HY) markets are still finding support despite the large fall in HY credit spreads over the past month from mid-April highs. Default rates have overall risen in past months for HY yield; however, this has been to just above the long-term average rate and hence not causing alarm. Further according to Bloomberg and Goldman Sachs, the median debt to company tangible assets ratio is below one for HY issuers. Thus, the debt levels of HY companies, on average, are below the value of tangible assets.
Hybrid markets were steady over the week despite an increase in volumes, concentrated in Westpac hybrids given all have just gone “ex-dividend”.
Nufarm ordinary shares rebounded over the week 7.14% to close at $2.40, well off the recent low of$2.08 in early June. This provided support for NFNG, up 1.89% for the week to $88.75. The yield from this price is 9.01%.
Listed Hybrid Market
Hybrids -curves of individual major banks.
In recent weeks, we’ve commented on CBA’s strong equity performance and the relationship between its hybrid securities and CBA senior and subordinated debt spreads. Below, we present the individual hybrid margin curves for each of the major banks.
Notably, Westpac hybrids are pricing below those of the other three majors, although part of this apparent premium may be attributable to lingering effects of franking mispricing following the recent ex-dividend date. Nonetheless, there is a relative value trade opportunity in switching from WBCPL or WBCPK into CBAPL or CBAPK, offering a meaningful yield pick-up.
The NAB and CBA hybrid curves are broadly aligned, whereas the ANZ hybrid curve sits slightly higher and is fully forward-sloping-a contrast to NAB and CBA, where the longest-dated hybrids trade at tighter margins relative to their respective bank’s mid-dated hybrids.
There continues to be ample scope for relative value positioning within the hybrid market, particularly by identifying divergences in margin structures and mispricings between similarly rated instruments across the majors.
Forward Interest Indicators
Australian Rates
Swap-rates drift off in line with bond rates.
Swap rates:
– 10-year swap 4.09%
– 7-year swap 3.88%
– 5-year swap 3.63%
– 1-month BBSW 3.71
