Market review

The decision by the Bank of Japan (BOJ) to lift its 10-year government bond yield curve control target from 0.25% to 0.5% roiled global bond markets. Australian government bond yields initially moved lower on signs that growth was slowing, before rapidly rising following the BOJ move. Flaring volatility saw risk appetite wane, with equity markets weaker and credit markets mixed. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 2.06%.

By mid-2023, almost a year after the first tightening, we expect to see more definitive signs of the economy responding to monetary policy’s long and variable lags.

The Reserve Bank of Australia (RBA) lifted the cash rate by a widely expected 0.25% increment in early December, taking the cash rate to 3.1%. While noting monetary policy was not on a pre-set path, the RBA signalled that further tightening was likely over the period ahead, with the interval and size of moves to be guided by incoming data and the RBA’s assessment of the labour market and inflation outlook.

Australian yields initially fell as markets saw the prospect of a 0.50% move in the US cash rate as signalling that the tightening cycle was slowing. While the US Federal Reserve (Fed) lifted the Fed funds rate by the expected 0.50%, forward guidance remained hawkish and halted the fall in yields. Thereafter, yields lifted dramatically before Christmas when the BOJ unexpectedly adjusted its yield curve control settings.

At the shorter end of the yield curve, the three-year government bond yield fell to as low as 3.01%, before ending the month 34 basis points (bps) higher at 3.50%. Further out along the curve, 10- and 30-year government bond yields declined to 3.30% and 3.59%, before ending at 4.05% and 4.34%.

On the data front, the 0.6% lift in economic growth over the September quarter affirmed the signal from activity-based measures that growth remained solid but was moderating going into year-end. Business conditions eased further in the November NAB Business Survey but remained at elevated levels though there was some further easing in forward orders and business confidence.

Labour market conditions remained tight, with employment lifting by a stronger than expected 64,000 in November. The participation rate climbed back to an historically high 66.8%, which left the unemployment rate unchanged at 3.4%. Consumer sentiment remains depressed, with cost of living pressures and tightening monetary conditions taking their toll.

Volatility returned to the short-term money market as markets reassessed the outlook for monetary policy. Three- and six-month bank bill yields lifted by 17.5bps and 20.5bps to end the month at 3.26% and 3.77%. In terms of the tightening cycle, markets are looking for the cash rate to peak close to 4.0% in late 2023.

In credit markets, investors await further feedback as companies move into early 2023 reporting season. Cognisant of the impacts of tightening policy, slower growth will be unevenly distributed and disproportionately felt across sub-sector credit fundamentals. The grip of macro settings on corporate earnings outlooks and employment intentions will be closely scrutinised by central bankers and investors alike.

Primary markets moved into ‘holiday mode’, with Suncorp-Metway issuing a new five-year note early in December which was well received. The waning supply of new issuance allowed domestic spreads to firm and deliver some healthy excess returns from elevated spread levels via income advantage. The Australian iTraxx Index closed largely unchanged at 91bps along with floating rate spreads, while fixed rate credit spreads rallied up to 8bps as swap yields tightened to government bonds. Australian fixed and floating credit indices returned -0.62% and +0.34% respectively, with benefits of credit excess returns offset by the rise in broader bond yields for the fixed rate market.

We anticipate Q1 2023 new issuance will resume strongly, with Australian banks looking to navigate their term funding facility refinancing early in the year. The strong level of income coming through from high quality credit securities provides investors some return buffer for likely concessions into primary supply.

Market outlook

The move by the BOJ threw a curve ball at markets and resulted in higher yields at the longer end of the curve. The rally in yields across the yield curve in early December proved to be premature given the hawkish stance of central banks and no signs of a definitive softening in labour markets or gap down in inflation. However, the rally was a harbinger of what to expect once markets look through the final phase of the tightening cycle.

Our base case has the RBA tightening by 0.25% in February and then pausing before delivering a late tightening cycle 0.25% “inflation insurance” move in May. This would take the cash rate to a moderately restrictive 3.6%, making the current tightening cycle the largest and fastest in the monetary policy inflation targeting era.

By mid-2023, almost a year after the first tightening, we expect to see more definitive signs of the economy responding to monetary policy’s long and variable lags. The overall profile for growth over 2023 is one of deceleration rather than outright recession. That said, the risks are tilted to the latter given the uncertain paths for the Ukrainian War, energy prices and offshore central bank tightening.

While we do not see the conditions in place for monetary easing in 2023, the window opens for the RBA to take its foot off the monetary brakes over 2024 provided core inflation eases in response to a period of sub trend growth. After pricing in a cash rate peak closer to our profile in early December, market pricing has pivoted back to a 4% cash rate peak later in 2023 and 4.4% long-run cash rate (using the 8-year rate 2-years forward as a proxy). In our view such a cash rate is more in line with a cyclical peak rather than the ‘new’ long-run normal cash rate. Accordingly, we see the recent lift in yields as beginning to restore value.

In navigating the environment ahead, investors should be on the lookout for improved compensation for risk as monetary policy tightens further. 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 have 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 believe this is a process that will occur in due course as earnings outlooks weaken.

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.

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