Market review

Markets pushed back the US Federal Reserve’s first interest rate cut, amid consensus of a soft economic landing. This allowed most yields to trade around the recent ranges. Against this backdrop, the Australian bond market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell 0.30%.

Global moves continue to be a strong influence, as the debate over the strength of the cycle and policy easing rages. Bonds range traded, ending the month with yields higher.

The Reserve Bank of Australia (RBA) kept policy unchanged at 4.35% in February, as expected. Global moves continue to be a strong influence, as the debate over the strength of the cycle and policy easing rages. Australian three-year government bond yields ended the month 13 basis points (bps) higher at 3.70%, while 10-year government bond yields were 12bps higher at 4.14%.

Against the current cash target rate of 4.35%, three-month bank bills ended 1bp lower at 4.34%. Six-month bank bill yields ended 5bps higher at 4.48%.

There is more consistency around the global start of the major market easing cycles, with markets now looking at mid-year for rate cuts to commence. Europe is expected to be first off the blocks in June, with the US thereafter. To date, most cutting cycles are expected to be historically modest. Market pricing adjustments have been fewer in the local market, but there is more consensus on an Q3 kick-off, and a limited move.

Global inflation is falling, but proving to be stickier, just above central bank targets of ~2%. A surprise US CPI result triggered a peak in the bond sell-off mid-month. This was brought back by subsequent mixed data but highlights that the easy inflation moderation gains are behind us. The Australian monthly CPI was a little lower than expected, but steady rather than falling, at 3.4% yoy. The real side of the economy is slowing at the margins, and employment disappointed with the unemployment rate rising to 4.1%. There remain some distortions in the data, making the monthly noise higher than usual. The RBA recognise this, and at their meeting and subsequent public commentary highlighted they remain highly data dependent for now.

In risk markets, a consistent theme during Corporate Reporting Season was one of resilience and robust fundamentals, particularly for Investment Grade issuers. When combined with evidence of slowing inflation and expectations of an imminent rate cutting cycle, this catalysed an impressive credit rally as institutional investors including pension funds, insurers and annuity providers, sought to lock-in attractive yields from high-quality liquid assets. Easing financial conditions and a pick-up in M&A activity encouraged Corporates to bring forward issuance plans to meet investor demand, resulting in a raft of corporate bond supply.

The domestic market was extremely active with numerous issuers issuing bonds. Both financial and non-financial issuers were represented, and transactions spanned the capital structure. Notable transactions from financials issuers included Tier 2 bonds from NAB and Macquarie Bank, together with ASX Listed Hybrids from ANZ and Bendigo & Adelaide Bank. Notable transactions from non-financial issuers included senior bonds from Telstra, Perth Airport and neighbourhood convenience REIT Region Group. Transactions were well over-subscribed with investors showing increasing appetite to lend in longer tenors. Asset-backed markets were likewise busy.

The Australian iTraxx Index ended 5bps tighter at 63bps, while the Australian fixed and floating credit indices returned -0.04% and +0.51% respectively.

Market outlook

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 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 RBA released its new format Monetary Policy Statement, modestly downgrading their GDP forecasts, as well as their CPI expectations; but maintain there is a high degree of uncertainty. The data has backed up this uncertainty, with a high degree of volatility. Unemployment has risen to 4.1%, wages sit at 4.2% yoy, and the retail data has bounced a less than expected 1.1% mom.

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. 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 sound corporate fundamentals. As such, we 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 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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