Last week was a big one for the history of Japanese monetary policy. If you did not notice this, you are forgiven. Getting any news on Japan – one of our largest trading partners – in Australia is apparently beyond the average attention span of any Australian journalist, so if you are expecting something about the droll subject of monetary policy then, please, do not hold your breath. The Bank of Japan (BOJ) is preparing to tighten monetary policy for the first time in 30 years. This is newsworthy!
The minutes from the October meeting of the BOJ – released on 6 November – stated that the BOJ would keep its key short-term interest rate unchanged at -0.1%, as widely expected. At the same time, the central bank redefined 1.0% as a loose “upper bound” rather than a rigid cap and scrapped a pledge to guard the level. Since July, the long-term interest rate has been capped at 1%, an increase over the previous cap of 0.5%. In a quarterly outlook report, the BOJ revised higher inflation forecasts for FY 2023 and 2024 to 2.8% from 1.3% and 1.2%, respectively, exceeding its 2% target.
It is clear to everyone outside the BOJ that it is failing to instigate monetary policy effectively. The BOJ has apparently and mistakenly decided to instigate monetary policy like a ninja in a stealth-like fashion. Obviously, the BOJ does not remember how inflation works, given it has been 30 years since it was last a problem. Monetary policy is a blunt instrument and needs to be rammed home with a hammer, not tickled with a feather. It may have quietly abandoned yield curve control, but it still does not understand the extent of the inflation problem in Japan.
Yen weakness is going to keep the economy stronger and inflation higher for longer.
Long bond rates rebounded after some early week falls with yields rising on reduced optimism that the Fed. Reserve would cut rates sooner than previously assumed in 2024 with the economy remaining resilient. Stronger employment data also moved short-term rates higher. For the week yields rose
3-6pts across the curve. The overall fall in rates over the past few weeks is now showing signs of halting.
Aust. rates also rose across most of the curve more so than the US, with 2-year rates up 12pts to 4.27% and 10-year bonds up by 9pts to 4.57%. The new RBA governor stated it plainly: the current stubborn inflation is now a self-induced phenomenon from government policies rather than a cause of global inflation (which in contrast to Aust. is falling). Hence from the governor herself who sets rates, the indication is that the cash rate may rise again. The market is now thinking about the possibility of a cash rate rise in Q1 2024 as well as pushing out forecasts as to the timing of interest rate cuts. This is all of course compounded by the new RBA board to commence in February and its economic leanings.
Major Credit Markets
It’s a bull market in credit. As time proceeds and predictions of doom economic scenarios recede, credit markets become increasingly more comfortable. Hence, we are entering a danger period, complacency breeds disaster. US IG spreads rallied strongly again with the US iTraxx hitting an 18-month low of 0.63%. US high-grade corporate bonds’ average spreads are 23bps tighter YTD. It’s a global phenomenon: the European iTraxx at 0.85% also an 18-month low.
Australian IG markets also hit recent margins lows, the local iTraxx now at 0.75%. Bank senior bonds rallied 1bps and sub note 1-3bps across the maturity curve, shorter-dated stronger. Issuance was active. Coles (BBB+) issued $600m of 7 and 10-year fixed rate bonds at 1.30 and 1.55%. UBS Australia (A+) raised $2bn in fixed and floating rate 3 and 5-year unsecured bonds at 1.25% and 1.45% margins respectively. CBA issued $1.5bn of a 1-year FRN at 3m BBSW + 0.47%.
High Yield Markets
The US high yield (HY) market rally continues with average HY spreads tightening 5bps to 3.90%. YTD HY spreads are at 89bps. Flows have been strong into HY funds in past weeks, November so far recording the highest monthly inflow volume YTD.
The hybrid market was firmer this week after the Westpac issue was finally announced and completed. The average major bank hybrid margin fell by 0.17% to 2.65%. CBA and Westpac hybrids were the main movers tighter in margin, especially CBAPG and WBCPI.
Westpac issued $1.75bn of a new hybrid including some $800m of reinvestment of WBCPIs (June 2024 maturity). This was a 7.8-year issue at a 3.10% margin. The issue was strongly oversubscribed with the final book at $3.45bn.
Listed Hybrid Market
Hybrid exposure – comparison of methods
Investors can gain hybrid exposures in various ways. Firstly, directly via a selected portfolio, either just in the major banks or including non-majors paying higher dividends such as those from Macquarie bank or regional banks. Secondly hybrid exposure can be gained via an ETF. Two exist, BHYB which is a major bank-only hybrid portfolio and HBRD, a general hybrid portfolio which can also hold other bank debt securities. Thirdly investors can hold exposure in more risk-averse funds which from time to time strategically invest in the hybrid market rather than 100% exposure as with BYHB.
The chart below shows the performance of various ASX hybrid investment methods. The chart commences in April 2021, the date the BHYB index listed. The comparison index is the Evans and Partners major bank hybrid index on a grossed basis. Two ETFs are shown, Betashares’ BHYB index which is 100% invested in major bank hybrids only, and Betashares’ HBRD which typically contains hybrids but can also hold other bank debt at the managers’ discretion. Each time series includes the value of dividends grossed up. The Evans index is adjusted for same costs as for the ETF.
The hybrid index outperforms both ETFs. Comparatively, the return since April 2021 for the major bank hybrid index was 10.4% (3.99% ann.), for BYHB 9.09% (3.50% ann.) and for HBRD (9.68% (3.72% ann.) The message is that the ETFs underperform the major bank index after costs. The better return for HBRD compared to BYHB highlights that active management and holding some non-major bank hybrids add some small value. Given the index in this comparison did even better, we infer that active management of simply a major bank portfolio could improve returns further. There are times not to hold hybrids – such as when margins get extremely tight and volatility in credit or equity markets increase. Investors are better off in a fund that can protect funds in better-ranking securities as well as being opportunistic in the hybrid market. Funds also typically have lower volatility than hybrid ETFs.
Forward Interest Indicators
Swap rates rise along with the general rise in bond yields described above.
- 10-year swap 4.85%
- 7-year swap 4.70%
- 5-year swap 4.59%
- 1-month BBSW 4.30%
Arculus Funds Management is an Australian asset manager of both public and private mandates.
They manage two retail public unit funds for DDH Graham:
- The Arculus Preferred Income Fund, formerly the DDH Preferred Income Fund
- The Arculus Fixed Income Fund, formerly the GCI Australian Capital Stable Fund
Platform Availability: BT Wrap / BT Panorama / Macquarie / Netwealth / Hub24 / Praemium / OneVue / Australian Money Markets / Ausmaq
- Market at a pivot point as inflation surge likely to return in March | Economic update - December 12, 2023
- Are we in the eye of the inflation storm? | Economic update - December 5, 2023
- The Bank of Japan doesn’t remember how inflation works | Economic update - November 28, 2023