Market review

Bond markets continued to range trade, buffeted by thoughts of a soft landing and adjustments on the start of the next phase of the cycle. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 1.12%.

The economy continues to inch towards the easing cycle, and the Reserve Bank of Australia will slowly build the case to take their foot off the policy tightening pedal.

As central banks remain highly data dependent, bond yields swayed according to the news flow. Monthly end to end yields were lower, but intra-month there was no consistent trend. Australian three-year government bond yields ended the month 9 basis points (bps) lower at 3.62%, while 10-year government bond yields were 17bps lower at 3.96%.

Against the current cash target rate of 4.35%, three-month bank bills ended unchanged at 3.43%. Six-month bank bill yields ended 2bps higher at 4.50%.

Global economic data continues to be volatile, as the aftereffects of the pandemic flow through, the lagged impact of the hiking cycle works through the system, and at the margins, major global thematics play out. These factors escalate the degree of difficulty for market pricing in the next phase of the economic cycle. This has been reflected in the lack of sustained trend in yields through the month.

The initial catalyst lower was a subdued outlook for the Chinese economy, with no big-ticket surge in spending at the annual national congress. This came up against a higher-than-expected US Consumer Price Index (CPI) outcome, dampening expectations for an early start to US Federal Reserve rate cutting. The bond rallied into month end, however, recognised that the major central banks will begin to ease policy in 2024, no matter the actual starting month. The Swiss National Bank kicked that process off, with a surprise cut. On the other side of the scale, bond markets are watching any asset allocation implications for the first Bank of Japan interest rate hike in 16 years.

The Reserve Bank of Australia (RBA) monitors these forces closely, as well as the progress of the domestic economy. They kept policy unchanged, as expected, at 4.35%. We believe that the statement highlighted the essential first step ahead of any interest rate cuts later in the year, by moving to a neutral bias, rather than a hiking bias. The RBA are no longer “ruling anything in or out” from here.

With GDP having moderated at an annual rate of 1.50% year on year (yoy), a very weak consumer and trend moderation in the headline CPI, it would be hard to push for a hike or a cut at this juncture. The monthly CPI came in at 3.40%, still below the official quarterly series, and while progress has stalled, it sits well below the peaks. The labour market is being monitored in a broad sense by the RBA, rather than the headline unemployment number, which dropped lower to 3.70% in February, due in part to seasonal adjustment factors. In short, the economy continues to inch towards the easing cycle, and the RBA will slowly build the case to take their foot off the policy tightening pedal.

Buoyed by broadly positive economic data demonstrating economic and consumer resilience, market expectations for “Soft” or even “No-Landing” scenarios continued to strengthen. In a complete reversal versus this time last year, easy financial conditions globally encouraged a swathe of corporates to access primary markets to issue bonds. Investors eager to lock-in attractive all-in yields ahead of an anticipated rate-cutting cycle, looked past historically expensive risk premia and lapped up new issuance pushing credit spreads even tighter.

In the domestic credit market, similar themes played out. Primary markets kept up high activity levels as financials and non-financial corporates issued new bonds. The securitised market was like-wise busy. Notable transactions included A- rated real estate investment trust Stockland issuing $400m of 10.5-year senior unsecured fixed rate bonds at an attractive yield of 6.15%, while regulated electricity utilities Victoria Power Networks (rated A-) and Ausgrid (rated BBB) issued $450m of five-year and $575m of seven-year senior unsecured fixed rate bonds at yields of 5.06% and 5.41% respectively. Lastly, global consumer packaged goods behemoth Nestle issued $1.2 billion of inaugural bonds across five- and 10-year tenors at yields of 4.60% and 5.25% respectively. Rated AA-, these bonds added welcome high-quality diversity to the Australian Investment Grade bond market.

Adjusted for the semi-annual roll, the Australian iTraxx Index ended 5bps tighter at 64bps, while the Australian fixed and floating credit indices returned +0.90% and +0.50% respectively.

Market outlook

The global economy remains soft but not in recession, and the US economy is holding up better than most expected. In this environment, the Australian economy is arguably underperforming. The household sector is anticipated to remain soft in the first half, before picking up later in the year. The investment cycle is mature, and expected to pull back in the second half, while government spending will assume its typical counter cycle role. Given this, we forecast 2024 GDP at a weak 1.3%yoy. We also see inflation moving back to target later in the year, ahead of the RBA’s own estimate. Key uncertainties remain population growth, housing, and fiscal policy. We believe that population growth will moderate, and housing and labour markets move back into balance over time. There is also a keen eye on fiscal policy heading into budget season.

Our base case is for the RBA to remain on hold at current rates before commencing an easing cycle in August 2024. We price a more modest than historically average easing cycle, of around 175bps, spread over 12 months. We see the risks skewed to the downside, with a rising probability that the RBA may have to move slightly faster than our base case. In this scenario, the RBA starts moving in August 2024, with a total of 250bps of cuts, to below neutral interest rates over the following year.

We see the very near-term RBA pricing as relatively in-line with expectations. However, the expectation of policy rates held above neutral over a period of years continues to underestimate the cyclical risks. We currently consider the Australian yield curve as under-valued at points in the curve. We hold a long duration position and look to add to it on any worsening of the economic outlook.

In recognition of the complex macroeconomic environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. While acknowledging that credit spreads in general have tightened considerably, all-in yields particularly in low/no default-risk Investment Grade credit remain highly attractive. We have been actively and selectively taking advantage of these yields in highly-rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions. Further, backed by fundamental research and experience, we also continue to identify pockets of opportunity where perceived risks have been overly discounted into the valuations of what would traditionally be considered stable and sustainable credits. In such instances, a strong case can be made for capital gains over-and-above already attractive cash yields, setting up for attractive risk-adjusted returns for patient investors with a medium term investment horizon. We continue to judiciously seek out, create and access such opportunities, while simultaneously preserving significant capacity to take advantage of opportunities arising through future market dislocations.

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