Market review

Doubts about the speed of central bank easing crept through in January, taking away some of the stellar December gains before staging a late month rally. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, rose 0.21%.

Doubts about the speed of central bank easing crept through in January, but bonds rallied late in the month. We see more easing by the Reserve Bank of Australia than the market is currently pricing.

The Reserve Bank of Australia (RBA) did not meet in January, and markets spent the month debating the merits of the starting point of the easing cycles. Global moves drove much of the Australian momentum, with US Federal Reserve (Fed) easing expectations being delayed. Australian three-year government bond yields ended the month 4 basis points (bps) lower at 3.57%, while 10-year government bond yields were 6bps higher at 4.01%.

Against the current cash target rate of 4.35%, three-month bank bills ended 1bp lower at 4.35%. Six-month bank bill yields ended 1bp lower at 4.43%.

Markets are still looking to the start of the easing cycle, but there has been a little less optimism globally about when it starts and by how much. The catalyst has been in the US, with some higher-than-expected inflation outcomes, amid a lower trend. There has also been pushback from central bank members, including the European Central Bank’s (ECB) Christine Lagarde, and Fed member Christopher Waller. The growing argument for a less contractionary policy stance is rising, but there is no catalyst for a near term move.

Local markets are pricing a less aggressive path for the RBA compared to global peers, but easing nonetheless. The quarterly CPI, late in January, showed inflation is running below the RBA’s forecast, ending the year at 4.1%yoy, while the trimmed mean finished at 4.2%. Services prices continue to run higher than goods, but tradeables inflation is dropping away. The labour market was also weak, while forward indicators of the labour market show signs of moderating. The late month inflation print brought expectations of RBA easing forward, precipitating a late month bond rally.

Risk markets consolidated gains from prior months with the ASX 200 reaching a new all-time high to end January. This positive sentiment resonated amongst credit markets where credit spreads were able to tighten further amidst the highest ever January supply of US investment grade corporate debt totalling close to US$200 billion. Australian primary markets also started with a bang with banks, state governments and supranational/agency issuers all printing large bond deals. This wave of supply was readily absorbed by investors less fearful of rising bond yields. ANZ set a new record for the largest order book size of over $8 billion for their senior bond deal during the month. The Australian iTraxx Index ended unchanged at 68bps while the Australian fixed and floating credit indices returned +0.44% and +0.41% respectively, modestly outperforming cash and government bonds.

Market outlook

Our base case is for the RBA to remain on hold at current rates before commencing an easing cycle in September 2024. We price a more modest than 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 earlier and 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. The Fed is anticipated to start easing in May, while the ECB starts easing in April.

The RBA will be buoyed by the lower-than-expected headline CPI print, while the weakening in the household consumer sector will lower forward inflation expectations. There are increasing signs of future labour market softness, while the December outcome itself was weak. We are forecasting a steady rise in the unemployment rate through 2024, which leads to more modest wages growth.

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 softening growth environment, our credit strategy remains skewed towards high-quality, investment grade issuers with resilient business models, solid earnings power and conservative balance sheets. We have been actively and selectively taking advantage of the attractive yields on offer in highly rated corporate bonds and structured credit, particularly in the primary markets where transactions have come with new issue concessions. While we believe that the cumulative impacts of restrictive financial conditions will become evident, we are mindful of a healthy starting point of above full employment and remain open-minded to a wider range of potential economic outcomes including those involving a soft-landing.

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 outstanding 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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