Mutual Daily Mutterings
Quote of the day…
“The world is not going through a food crisis because of speculation – Chuck Norris simply had a larger breakfast than usual.”
“Won’t someone think of the children…and old folk?”
Overview…”RBA whips out the one wood…WHAMMY…”
- Moves: risk on… stocks ↑, bond yields ↓, curve ↓, credit spreads ↓, volatility ↓ and oil ↓….
- I’ll get to last night’s action in a second, but the big news for our market yesterday was the RBA hiking rates by +50 bps, a surprise to most, and only one or two market watchers picked it – golf clap. In it’s statement, there was a notable change in tone from the RBA, more hawkish, finally recognising that inflation is a problem that needs tackling head on. The bank will go hard again with future hikes if required…if the data warrants it…and in their opinion. The weight of money amongst market watchers on the next move is +50 bps in July, then another +25 bps in August. Amongst the big four and super-regionals, WBC is the only bank at this stage to push the hike through, raising their variable home loan rate by the full +50 bps.
- And on to last night…a late rally in US stocks saw the S&P 500 and other core indices post reasonably broad-based gains, with much of the rally coming in the last hour of trade. While it was broad-based, the move wasn’t all that convincing to me – it was a choppy session, with market players seemingly hesitant to add risk amid ongoing concerns around how aggressively monetary stimulus will be extracted from the system, and what the impact on growth will be. Bond yields were unchanged at the front end, but lower out the back on growth concerns, a bull flattening of the curve. Credit was well supported in primary and secondary offshore, while locally there appears to be a sniff of increased trading activity.
- Talking heads…”it does seem that the odds of a soft landing are reasonably good but it’s tough to manage. Navigating it into that narrow runway is challenging. The price of oil rising of course, will reduce aggregate demand, perhaps. And that will likely help bring it into that zone. But lots of other things have to happen.”
- The move in rates and yields following the RBA’s hike was painful for funds with meaningful exposure to duration. The Bloomberg AusBond ACGB index dusted -0.54% on the day, taking month to date returns to -1.2%, and -9.75% YTD. The worst YTD performance (to June 7th) on record. Semi’s were similarly hammered, with month to date returns of -1.20% and YTD returns of -9.75%. In the fixed credit space, the Bloomberg AusBond Credit (FXD) index is down -1.13% month to date and -7.31% YTD. Fixed rate markets continue to generate historically the worst performance on record. The floating rate note index on the other hand is flat month to date and only down -0.40% YTD.
The Long Story….
- Offshore Stocks – a choppy session as market players continue to ‘um’ and ‘ah’ over inflation risk, monetary policy response to said risk, and the growth impact of said policy response. US stocks were buoyed toward the end of the trading day by Target Corp. lowering its expectations around inflation, slightly. Pretty thin to be honest, and while market players might of latched onto it as a broad position, Discretionary (-0.4%) was the only sector not to advance overnight. Through the next reporting season, retailers are expected to warn that bloated inventories will take a few quarters to clean up and supply-chain disruptions will increase mark-down risk again. Within the S&P 500, 83% of stocks advanced, and as per above, only one sector failed to fire. Top of the pops was Energy (+3.1%), followed by Industrials (+1.4%) and Healthcare (+1.3%). For bang for buck, Tech (+1.2%) had the largest impact on the broader index.
- Talking heads…“the yield on the 10-year note fell back below 3.0%, so it seems like the stock market is very focused on the Treasury market this week. I’m not so sure that the 3.0% level is as important as the stock market does this week, but with no Fed speak this week and the CPI number not due out until Friday, we could see stocks whip around in both directions for a few days.”
- S&P 500 relative strength indicators…
- Local Stocks – the larger than expected rate hike from the RBA sucked the jam right out of the market’s donut. The ASX 200 was down -0.9% leading moments before the rate hike announcement, but then plunged like an anvil at 2:30pm, dropping another -0.8% in minutes. At day’s end the index was down -1.5%, with 86% of stocks retreating and now sector able to advance. Tech (-3.0%), REITS (-2.9%), and Discretionary (-2.3%) were the worst of the worst in a straight-line sense, but it was Financials (-2.3%) that did all the damage. Major banks were harshly dealt with. NAB (-3.3%) was the worst of the big four on the day, followed by CBA (-2.6%), WBC (-2.1%) and ANZ (-1.5%). Futures are up a touch (+0.6%)
- Markets have assessed that rising interest rates are initially beneficial to bank earnings and margins. However, over the medium-term rising interest rates are seen to be detrimental to bank asset quality, all other things being equal, which is probably what drove sentiment yesterday. A bit too soon really. While rising intertest rates generally do contribute to deteriorating asset quality metrics, and rising impairment costs, it can take time and the starting point in this instance is one of strength. So, realistically we’re just likely to see a normalisation toward long run average impairment costs, which has historically been around 0.43% of total lending (big four average across the majors since 1991), or 0.24% in the post GFC world. The average across the four majors is currently around 0.12% (FY’21), which represents 30-year lows…so, they can really only go one way. It is worth noting that correlation between impairment costs or charge offs and cash rates or BBSW rates is relatively modest at ~30% (1991 to 2021).
- And before the everyone panics around the bank’s credit quality after reading the usual post rate hike hyperbole coming out of the click-bait media, bank credit quality today is stronger than it was when the last rate hike cycle kicked off, which was September 2009. Last time charge-offs were higher to begin with (0.36% vs 0.12%) and provisioning for loan losses much lower at ~100% vs ~300% as at FY’21. Also, banks are holding much more capital now vs then, with CET1 at ~12.50% vs 8.00%, and total capital ratio of ~19.00% vs 11.50%. It’s also worth mentioning, with regard to the following chart, charge offs during the prior recession, in the early 1990’s were driven largely by commercial exposures, not housing. Bank exposures to this space is materially less now vs then.
- The impact on variable rate mortgages from change in rates is somewhat meaningful, especially within the prevailing inflationary back drop. For a $500,000 mortgage, a +50 bp rate hike equates to an additional $208.33 per month in interest payments, equal to your average weekly beer-money allocation I’m thinking. If you live in Sydney, where the average mortgage is double this at $1,000,000, then obviously you double the interest payment amount, so $416.67.
- Major bank charge offs vs interest rates – charge offs assumed to post GFC mean revert…
- Offshore credit – another active session…and the tone in primary markets continue to improve as eight issuers priced US$8.2bn. Borrowers paid 7 bps in new issue concessions (vs 11 bps YTD average) on order books that were 3.9 times oversubscribed (vs 2.8x YTD average). While order book attrition was elevated with demand dropping 30% from peak to final, it’s not unexpected given the aggressive pricing levels. Investors continue to grab higher-quality, longer duration paper amid a deluge of financial institution supply that’s dominated the year. For reference, some of the longer dated books have been 10x – 11x oversubscribed
- Offshore credit indices vs A$ spreads…cumulative YTD spread change…
Source: Bloomberg, Mutual Limited
- Local Credit – trader’s take on the RBA rate hike…”a hawkish surprise from the RBA (+50bps) with the likelihood that this translates into renewed pressure on credit spreads. Swap EFP’s close the day sharply wider (+4 – 6 bps) with Semis replicating the magnitude of the move. The impact on Corporates and SSA remains harder to gauge, but very early indications are that corporate spreads will underperform and SSA will outperform. We have reason to contest these moves (indeed we think that the opposite will transpire) but for now, we will report the flow as we see it.”
- Despite trader’s trepidation around the impact on spreads, the rate hike seemed to have a muted impact on major bank senior on the day. In fact, major bank senior spreads inched lower out the back of the curve with 5-year paper now sub-100 bps (at +99 bps), or -1 bps on the day. Elsewhere along the curve, 3-year paper is +1 bp wider at +88 bps, while the rest of the curve is unchanged. Traders are noting continued, albeit light, buying out the back of the curve, while a 3-year mandate announcement (Singaporean bank, DBS) weighed on the belly (3-year) of the curve. In the tier 2 space, spreads reversed course against recent tightening trends, edging +1 – 3 bps wider, reflecting generic move wider in spreads following the RBA’s decision. An ANZ tier 2 deal remains a possibility, which would likely exert some widening pressure on spreads, all other things being equal.
- The benefit of rate hikes for floating rate funds is they reset the benchmark against which FRN coupons are set. For example, just under half of the Mutual Income Fund’s FRN holdings will see their coupon’s reset higher through June, and with yesterday’s move higher, that just adds to the income flow for the fund going forward. Specifically, just under half of the fund’s coupons will increase by +100 bps on average. And if markets watchers are right, then we’ll see another +75 – 100 bps of coupon uplift, at least, by the end of Q3. If spreads remain range bound, as we expect they will, it’s a positive performance outlook for FRN funds.
- Major bank 5-year vs Bloomberg AusBond Credit FRN Index…
Source: Bloomberg, Mutual Limited
- Bonds & Rates – well that was fun! I baulked on my original +40 bps rate hike call yesterday morning after re-reading the RBA’s previous meeting minutes, opting instead for a expecting a more leisurely +25 bps rate hike. Instead, the RBA came out all guns blazing, kind of, and hiked rates by +50 bps to 0.85%, the second meeting in a row where the board has surprised (vs consensus) to the high side and the largest rate hike in ~20 years. I should have stuck with my initial instinct…as they say, your first instinct is usually the right one.
- From the RBA’s statement…“today’s increase in interest rates by the Board is a further step in the withdrawal of the extraordinary monetary support that was put in place to help the Australian economy during the pandemic. The resilience of the economy and the higher inflation mean that this extraordinary support is no longer needed. Given the current inflation pressures in the economy, and the still very low level of interest rates, the Board decided to move by 50 basis points today. The Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead.”
- Of the 32 strategists that provide Bloomberg with rate calls, only one (Goldman Sachs) had tabled a +50 bp rate hike. Everyone else was at +25 bps or +40 bps. Given the hike was outside consensus expectations, market reaction was quite frisky. The 90-day bank bill rate spiked +27 bps to 1.50%, while three-year ACGB yields were up +15 bps to 3.135% and ten-year yields hit 3.565% (+7.5 bps).
- The RBA’s statement suggests the board is willing to break out the one wood again if requiredand hike by +50 bps further going forward, especially over the near term, a view shared by some in the market who are now forecasting another +50 bp hike in July and +25 bps in August, or vice versa in some instances. There is possibility for more hikes given the board seems comfortable with the strength and resilience of the economy to stand on its own two feet without the still extraordinary monetary support in the system. Perhaps another +75 – 100 bps of hikes over coming months, in one sequence or another, followed by a pause, perhaps September-October, to assess progress and impact of hikes. If going to plan, then another +25 – 50 bps in November-December, taking cash to around 2.00% by Christmas, which is at the bottom of neutral rate estimates (2.0% – 2.5%). Given the apparent shift to a more aggressive near-term hiking cycle, some market watchers have begun factoring rate cuts (yes, cuts), through the second half of 2023.
- The terminal rate is still estimated around 2.0% – 3.0% across most market watchers, which is well inside the near ~4.0% levels implied in option pricing. Given uncertainty around the path of inflation, and risk of overshoot (vs the RBA’s peak expectation of 6.0% in Q3) is elevated, which means risk of terminal cash rates actually hitting prevailing option pricing cannot be ignored.
- Offshore moves overnight were focused arounds the back end on growth concerns, which if the tone flows through to local markets will see a reversal of yesterday’s rate hike driven moves, to some degree. Talking heads…”much of the mispricing we see is in the bond market right now — the 10-year Treasury yield just keeps going up, even though the economy’s slowing. Eventually it’s going to be an anchor of slower growth that pulls down yields. And that’s actually where we’re seeing the best opportunity to kind of exploit.” I tend to agree with this narrative and once again see opportunities out the back of the curve with 10-year yields anywhere north of 3.50% (closed at 3.565%).
- RBA rate hike cycle – market expectations…
Source: Bloomberg, Mutual Limited
- A$ Fixed Income Markets…
- Macro – “above-average inflation and below-average growth fears spurred the World Bank to further cut its 2022 forecast. The global economy will eke out 2.9% growth, the lender said, compared with a January prediction of 4.1% and April’s 3.2% estimate. “Even if a global recession is averted, the pain of stagflation could persist for several years,” President David Malpass said. It’s set to hit low- and middle-income nations hardest, he warned, saying 60% of the world’s 75 poorest countries are already in or at risk of debt distress.” (Bloomberg)
Source: Bloomberg, Mutual Limited
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Scott Rundell, Chief Investment Officer
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