Why the RBA is likely to remain on hold for longer than it should

Interest Rates

The rate reversal is gaining momentum with the Fed on a “slower to lower” path if going lower at all. Fed members continue to talk up their pensive stance. 2-year treasuries have rebounded the strongest, trading now at 4.68%, a rise of nearly 60pts since January lows and 5pts last week. The US yield curve is resuming its reversing trend, the 2-10 year gap now at -0.44% from -0.34% 2 weeks ago.

Australian bond yields were essentially flat last week looking for data to get some direction. Australian rates will come under the same thematic as the US, that being the expected falls in inflation not materialising. The Australian yield curve remains inverted to 3 years and thereafter positive. 1-year rates are at 4.02% and 2 years at 3.82%, giving some guide as to market thoughts over these time frames. Both expectations not exactly bullish bonds.

Major Credit Markets

Global investment grade (IG) markets were stronger with CDS margins continuing their slowdown trend back to levels last seen in late 2021. Post the COVID market recovery, global IG credit traded sideways in a small band from September 2020 to January 2022. Current levels are just above this band. Credit yield demand is huge, IG issuance at a record YTD.

Strong Australian secondary credit markets were reflected in the demand for primary issues last week. Australian corporate bond supply did recover last year from its 2022 post-financial crisis with an annual issuance low of around A$6bn, to raise more than A$11bn, though this was well under the A$22bn record set in 2021. Last week Macquarie Bank issued AUD1.25bn of 10NC5 Tier 2 notes (rated BBB) at 3m BBSW + 1.95%. Rabobank (rated A+) issued AUD2.15bn in 3 and 5-year senior unsecured notes at 3m BBSW + 87 and 103bps. ASX (rated AA-) issued AUD375m of a 3-year senior note at 3m BBSW +93pts. Perth Airport (rated BBB) raised AUD700m of 3-year senior secured fixed rate notes at 5.60%, a margin of 1.47%.

High Yield Markets

The US high yield (HY) sector remains strong with good issuance signalling demand. The average HY spread is lower by 12bps YTD, underpinned by the strong equity market.

The ANZ hybrid was completed with a $1.7bn total issue size, an increase due to ANZ’s acquisition of Suncorp Bank. The margin was set at 2.90% with $900m in reinvestment, leaving $800m for the $3.2bn of new demand.

Despite the ANZ deal being completed, volumes remined light. The average major bank hybrid margin moved wider by 8pts to 2.473%. For the week wider spreads were seen in most Westpac issues, AN3PH and CBAPJ and in the non-majors short-term issues were sold: BENPG, BOQPE, MBLPC and SUNPG. Tighter spreads were evident in remaining CBA issues, NABPH and NABPH and in non-majors the longer-dated Macquarie and Suncorp issues.

Bendigo Bank in its results flagged a new hybrid issue to replace the upcoming June maturity BENPG issue.

Listed Hybrid Market

Hybrids – value relative to senior bonds and subordinated notes

At a top level, senior bond credit margins drive the credit profile for all of an issuer’s debt instruments in the capital structure, with changes magnified the further a security is down the ranking. However, lower ranking securities may reflect changes in sentiment first as they are more sensitive to incremental changes in risk. This is an interesting dynamic and warrants close attention.

This week, in order to make comparisons across the capital structure, we show trading margin histories for not only a hybrid security, but also a senior and subordinated bond from 1 issuer, CBA. For a valid comparison, the 3 securities are chosen with similar maturity dates (vital as credit margins naturally contract as maturity approaches).

The first chart shows the trading margins for the CBA January 2028 maturity senior bond, the CBA November 2027 subordinated note and the CBAPL hybrid, a June 2028 maturity. Note the changes in the margins over time. The senior and sub note margins are in gradual downtrend, expected given the maturity and hence risk shortens as time proceeds. The downtrend however is not smooth. Hybrids generally also tighten in margin over time (typically with less than 4 years to run), however hybrid margins show more variance week to week. This reflects 2 things: a hybrid’s sensitivity to senior and sub note margin changes as well as sensitivity to a range of equity factors; the general equity market, absolute bank share price levels and bank share price volatility. Further, as we have described many times, new hybrid issuance significantly impacts trading margins. Such disturbances can also occur in the sub note market, an example being the APRA comments in late 2022 regarding the appropriate margin for banks rolling issues.

A simple method to gain insight as to the appropriate level of hybrid margins relative to senior bonds and sub notes is to examine the ratio of hybrid margins to each. Such ratios should be stable over time, however as the second chart shows they are clearly not, often due to idiosyncratic factors (as mentioned above, mainly liquidity) but also trading lags and leads. What the correct ratio should be is subjective just as what the correct credit margin should be for a debt security at any point in time. The chart also shows the average for each ratio (lighter straight lines). Right now relative to senior bonds, this CBA hybrid is at fair value whereas it is slightly cheap relative to the CBA sub note.

For completeness, the ratio of this CBA sub note to senior bond margin is also shown. Note its downward slope, showing that the market has gradually over 2023 rerated what is the appropriate CBA sub note margin relative to CBA senior bonds.

Fund managers who understand these pricing comparisons, and who are monitoring day to day the relative pricing as well as each securities liquidity, can add significant value by switching between the three types and trading the lags and leads.

Source: Refinitiv, Arculus

Forward Interest Indicators

Australian rates

Swap rates are closely tracking long bond yield changes.

Swap rates:

  • 10-year swap 4.38%
  • 7-year swap 4.25%
  • 5-year swap 4.15%
  • 1-month BBSW 4.30%
Source: Refinitiv

Macro View

  • Last week’s stronger than expected increase in wages growth, in the December quarter, was largely ignored by the bond market and considered immaterial to the outlook for inflation. The market is wrong.
  • In an Australian context, where we have a central bank that strongly believes in the Phillips Curve Theory – a belief that the government with changes to fiscal policy can control the unemployment and price outcomes – we can see in the chart below that higher inflation in the future is a certainty. Unemployment is below the full employment level of unemployment – 4.25% – while labour participation is near a record level and wages growth is accelerating.
Source: LSEG Datastream

Wages growth has been increasing faster than consumer prices since the March quarter of 2023. These wage increases were the normal lagged response to the increase of inflation over the preceding 9 months. Much has been made by some commentators about the anecdotal signs of weakness in household spending. It is normal that after an inflationary breakout caused by an external shock – like the oil price surge in the 1970s and the pandemic lockdowns – household budgets adjust to the loss of purchasing power by cutting back discretionary spending. What is also normal then in every economic cycle is that once the lagging increases in wages arrive into the household budgets spending resumes.

The loss of spending power due to inflation has brought a sharp decline in the savings ratio and consumer confidence. Somewhat remarkably retail sales – in aggregate – remains strong. To date neither inflation or the interest rate increases have dented household spending.

Source: LSEG Datastream

Even though the economics of the Phillips Curve Theory strongly suggests inflation will begin to rise again shortly the RBA is likely to remain on hold for longer than it should for 2 reasons:

  1. The RBA pays a lot of attention to the Household Savings Ratio. Throughout the pandemic Governor Lowe mentioned after every meeting that the economy would recover because household savings were high. Now they were only high due to fiscal measures taken by the federal government and not because of careful management by households of their budgets, but the RBA is likely to watch for the wages increases impact on the savings ratio before tightening again;
  2. The second reason is that the RBA has an absurd hope that labour productivity in Australia will increase such that the wages growth impact on inflation is offset. While it is true in the US that wages growth up until 2019 did not translate into inflation due to a rise in labour productivity, that has not been the case in Australia. Here the historical pattern has been a poor correlation between low unemployment and wages growth (due to the size of the welfare state here), but a strong correlation between wages growth and inflation outcomes. After the most recent RBA meeting Governor Bullock very clearly stated that “the outlook for wages growth was consistent with the inflation outlook on the assumption that productivity growth increases to the long run average”. What the RBA hopes is that wages growth can be at 3.5% and the inflation target of 2.5% still be achieved provided that there is annual productivity growth of 1%. This maths is simplistic, but applying it to the current level of wages growth at 4.2% the RBA would need annual productivity growth to be much higher than the historical average in order for inflation to continue to decline. Frankly, we don’t see much chance of any productivity growth before or after the new IR laws come into effect in the second half of 2024.

The Treasury Secretary, Steven Kennedy, recently told the senate estimates committee that “there has been no evidence of a wage price spiral emerging and no evidence of a change in inflation expectations”. First, inflationary expectations are a coincident not a predictive indicator. They explain changes in inflation only in hindsight. Secondly, it is too early, due to the natural lags between unemployment, wages growth, labour productivity and final prices to be seeing evidence of a wage price spiral, but Phillips Curve Theory would predict it is inevitable. Inflation will be higher a year from now than it is today.