In Australia the release of the monthly CPI data upset the bond market that had been hypnotised by the relentless beat of the banks, media, and government messaging that inflation would keep declining. Although no one expects inflation to decline, or rise for the matter, in a linear manner, many in the market did the maths on the RBA achieving its inflation objective in “a reasonable time frame” and rightly concluded that inflation is unlikely to meet its 4.8% year-end forecast given it is at 5.4% in the September quarter and more importantly core inflation is running now at 5.2%.
It must be noted here the importance of returning inflation to the target level in a “reasonable time”. This is emphasised by all central banks because the longer inflation remains above the target the greater the probability of it becoming entrenched through wages growth increasing in line with the inflation rate. Right here, right now, we have wages agreements being signed across the economy in the 4-5% range or worse still at 13% over three years – 4.33%. This means that wages growth is being locked in for the next 3 years at a rate well above the 3% maximum the RBA has stated many times is consistent with the 2-3% inflation target zone.
Although we expect the RBA to increase rates in November by 25bps, this is something that should have been done in July or August, but as we predicted the new RBA Governor has patiently waited for her new updated stationery to arrive. The real risk here is that the RBA, after this rate rise, is then on “hold” until the February meeting where the interest rate decisions will be made by the new RBA interest setting board which will be populated with 6 external “monetary policy experts”. If pushed, we would struggle to name 6 Australian-sourced “monetary theory experts” but there are vast numbers of people who think they are “monetary policy experts”. When the composition of this new board is announced the market will judge the degree to which the RBA is really still “independent”. If the RBA is judged to be no longer independent the market will adjust Australia’s sovereign risk and this will mean either higher bond rates or a lower currency or more likely, a combination of the two.
The bond market reacted to the inflation data with yields moving up across the curve.
Several pieces of data last week confirmed that the bond bulls (long duration fans) need to be sent out to the woodshed. It is the only humane way to treat them as they were miserable even before the strong data showed how robust the US economy remains. In summary last week:
- GDP growth in the September quarter 4.9% pa.
- GDP price index 3.5% versus 2.4% expected.
- Goods trade balance improved from -$93bn to -85.7bn.
- Real consumer spending QOQ 4% versus the 0.7% expected.
You can still hear them wailing that the economy is only stronger than expected because business investment, employment, and consumer spending were stronger. Well yes, the components of a strong, sustainable economic outlook are ALWAYS increased business investment, increasing employment, and then this enables increased consumer spending! The consumer is spending today because of stronger employment today. Employment is stronger because of increased business investment.
Actually, the more frightening piece of data for the sloth of perma-economic bears was the US durables goods data. The market had expected a 1.1% increase but received a month-on-month increase of 4.7%. When this is combined with the uptick in the ISM PMI data a picture forms of the manufacturing sector beginning to expand again.
A mixed week for bond rates as they see-sawed on strong macro factors, geopolitical issues and grappling with the huge US deficit that needs to be financed. US 10-year bond yields haven’t pushed through the key 5% level. 10-year treasuries closed at 4.84% down 0.068% for the week. 2-year treasuries also fell however still finished above 5% at 5.01%. The 2 to10-year yield curve has flattened dramatically, from -1.08% at June end to -0.16% now. The flattening of the curve is because a recession looks less likely. The Fed interest rate decision this week should then be to increase rates. The flattened curve is telling the Fed that the US economic outlook is improving and the key inflation indicator for the Fed – the core PCE prices index – has stopped falling and begun to rise.
The Australian 10-year continues to rise and at one stage was above the US 10-year rate, closing at 4.814%. A stronger-than-expected CPI has increased expectations of an RBA rate rise on 7 Nov.
Major Credit Markets
Investment grade (IG) corporate bond spreads were flat as positive corporate earnings and economic data boosted investors’ optimism against the effect of high rates. Demonstrating this is that IG issuance is a decade low as companies decide not to finance at the post-GFC high in yields despite tight credit spreads.
Australian IG margins were slightly tighter overall. However, major bank senior bonds widened across the maturity curve by 2bps and sub notes by 3-6pts with shorter-term issues showing the widest move. Local issuance was also light with Bank of Australia (rated BBB) issuing $225m of a 3-year floating rate bond at BBSW + 1.50%. Port of Brisbane (BBB) issued $200m of a 7-year fixed rate senior secured bond at a yield of 6.392%, a margin of 1.65%.
Forward Interest Indicators
Swap rates continued to rise with long-term bonds. Bank bills also rose in anticipation of a 0.25% RBA cash rate rise on 7 Nov.
- 10-year swap 5.10%
- 7-year swap 4.93%
- 5-year swap 4.79%
- 1-month BBSW 4.15%
High Yield Markets
US high yield (HY) continues to weaken with default rate rises in these lesser credits. Issuance is also at lows as companies grapple with the absolute higher level of rates.
After a steady week prior, hybrid spreads widened last week with the average major bank hybrid margin up 0.05% to 2.71%. Volumes pick up after falling in mid-Oct but are still 10% below average. Weakness was mainly felt at the long end of the curve with NABPI, CBAPM, CBAPK and WBCPK margins all rising 5-7 pts.
NBI Global High Yield listed fund (ASX:NBI) announced it will delist the fund in order to close the trading price discount to NTA. No mechanics have been released however the process will be gradual and take 12 months of drip-fed redemption allowances to allow bonds to be orderly liquidated if required. NBI is looking to maintain the fund as a typical unit trust.
Listed Hybrid Market
Hybrid dividend rates are reset each 3 months according to the margin rate (set at IPO) plus the 3m bank bill rate (the bank bill rate trades at a slight premium to the RBA cash rate). Cash rates have been increased in the past 18 months by the RBA to combat inflation. This is based on the broad notion that higher rates reduce the public spending and hence less demand for goods will curtail rising prices and thus inflation. Rising rates may be hard on the hip pocket but are good for hybrids as they increase the hybrid dividend rate. The RBA cash rate has been steady at 4.10% since July. However, given this week’s higher-than-expected CPI reading, it is likely the RBA will increase the cash rate again, most probably by 0.25% at their next meeting on 7 November. The yield of Bank bills has already risen to 4.30% in anticipation.
The chart shows the rising RBA cash rate and how this has translated to hybrid yields, represented by the average hybrid margin plus the 3m bank bill rate. Note however that a new higher dividend comes into place on the date the current period dividend is paid. Hybrid yields on average are now returning 7% (including franking). This is close to a high for this cycle and indeed a high since 2012. Longer-dated hybrids with margins near 3% are now yielding well over 7%.
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