Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Renewed central bank inflation-fighting resolve, and a preparedness to bear the costs of tighter monetary conditions, pushed global and domestic yields higher. Equity and credit markets gave back earlier gains following a hawkish Jackson Hole speech made by US Federal Reserve (Fed) Chair Powell. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 2.54%, unwinding some of July’s 3.36% gain.
With demand still strong in the Australian economy, we look for the RBA to lift the cash rate by 50bps in September to 2.35%, just below estimates of the neutral cash rate.
The Reserve Bank of Australia (RBA) lifted the cash rate by another widely expected 0.5% increment in early August to 1.85%. After troughing early in the month, yields surged higher on the pivot to more hawkish central bank commentary and strong activity data. At the shorter end, the three-year government bond yield rose 55 basis points (bps) to end the month at 3.21%. Further out along the curve, 10- and 30-year government bond yields ended 54bps and 39bps higher at 3.60% and 3.82%.
On the data front, the divergence between falling consumer sentiment and strong activity levels continued. While consumer sentiment fell towards Pandemic lows on rising cost of living pressures, actual spending remained solid with retail sales lifting 1.3% in July and 1.4% in real terms over the June quarter.
Business conditions remained robust, with the July NAB Business Survey recording well above average levels of business conditions and capacity utilisation. Price pressures were evident while demand for labour remained strong.
Also read: What Will It Take To Create A Vibrant And Accessible Bond Market?
The labour market took a breather in July with school holiday timing and high rates of illness muddying the waters. The number of jobs fell by 40,900, although a sharp fall in the participation rate meant that the unemployment nudged lower to 3.5%. While RBA liaison pointed to rising labour costs, these were yet to show up in the June quarter Wage Price Index. Wages rose by 0.7% over the quarter and 2.6% over the year.
Short-term money market yields continued to rise as markets discounted further tightening. The three-month bank bill yield ended the month 34bps higher at 2.46%, while six-month bank bills ended 22bps higher at 3.01%. In terms of the tightening cycle, markets increased the quantum of tightening with a 3.2% cash rate priced by year end and 3.85% in mid-2023.Earnings season both on and offshore concluded with corporates in aggregate performing reasonably against low expectations. In the Australian investment grade market, issuer balance sheets were healthy, albeit management teams remained cautious in their outlook statements.
Early signs of moderating inflation increased hopes of a dovish pivot by central banks, supporting sentiment and sustaining a weeks-long risk rally throughout most of August. These hopes were dashed by an unequivocally hawkish speech from the Fed Chair at the Jackson Hole symposium towards the end of the month, causing a sell-off in risk markets. The Australian iTraxx Index closed 2bps tighter at 109 bps, while the Australian fixed and floating credit indices returned -1.42% and 0.35% respectively.
Market outlook
Central bank inflation fighting narratives have become more urgent and hawkish. At his Jackson Hole speech, Fed Chair Powell noted that the costs of bringing inflation down rise the more entrenched it becomes. To avoid higher inflation expectations becoming entrenched, the Fed signalled that it would take policy settings to as restrictive levels as needed, for as long as is needed.
Given Fed signalling, we think the odds are tilted towards a 75bps move at the September FOMC meeting and for a 3.85% peak in the US cash rate in mid-2024. Such a rapid move from ultra-accommodative to restrictive settings runs the risk of pushing the US economy into recession.
With demand still strong in the Australian economy, we look for the RBA to lift the cash rate by 50bps in September to 2.35%, just below estimates of the neutral cash rate. With much of the heavy lifting done, the RBA is likely to shift to ‘business as usual’ 25bps tightening increments thereafter and we look for the cash rate to peak at 3.1% by late 2022/early 2023 and hold at that level until early 2024. Such a profile has the RBA feathering the monetary brakes attempting to engineer a soft landing that sees inflation gradually fall back to the top of the RBA’s 2% to 3% target band.
Market pricing is more aggressive, building in a 3.85% cash rate mid-2023. Reflective of the sell-off in yields mid-June, markets do not see this as a cyclical high, but the prevailing cash rate for the rest of the decade.
This seems implausible to us as it assumes that one of the biggest and fastest tightening cycles in the current inflation targeting era results in a neutral or terminal cash rate around 150bps above the RBA’s estimate of 2.5%. Accordingly, we see value emerging during periods where aggressive tightening is priced in without regard to the economy’s response to restrictive monetary settings.
Commitment to tackle high inflation through tightening in global liquidity will continue to generate volatility in credit markets. To navigate the environment ahead investors should command improved compensation for risk. We observe that the repricing across different pockets of credit and risk premia have not been simultaneous, providing outperformance opportunities through active rotation.
Attractive yields on high quality credit spreads has seen demand return from defensive income investors. In our view the more illiquid, structured, and levered sectors of the market are yet to adequately reprice. We anticipate that as conditions tighten further, global spreads will suffer decompression where high quality liquid credit outperforms lower quality as compensation for default risk and illiquidity needs to increase. We continue to favour being positioned up in quality and seniority in capital structures leaving powder dry for when compensation for investors escalates.
Views as at 31 August 2022.
