Economy – The Communication We Had to Have
Markets and the economy are now at highly disconnected levels. Economic data appears set to keel over and substantially moderate to those levels being borne out in market pricing across many verticals, from credit to inflation. For example, US and Australian 5yr forward 5yr Breakeven Inflation (BEI) rates have been falling in response to central bank hawkishness. This is our preferred measure of medium- term inflation expectations. The US 5yr/5yr is now back to 2.08 per cent from 2.55 per cent. Consequently, this is now almost back to the FOMC target of 2 per cent. To date, the FOMC has made significant inroads based on this measure, balancing the delicate trade-off between growth and inflation. Despite this, the challenge of delivering medium-term growth is yet to play out, and the degree of error is still large.
The potential unmooring of this measure, which threatened the efficacy of policy, has now started to moderate in response to the significant step up in communication. Central bankers had flip-flopped on their communication at the onset of the current inflation and have now started to gain traction within a disbelieving market. Central bankers appear to be steadily progressing with the current narrative that all will be done to contain inflation. Recent communication has been decisive, with this episode versus those prior appearing more responsive to the clear targets that underpin inflation targeting regimes. We now expect this to filter into actual outcomes in the second half of 2023. The inflation target and the communication around it have been significant short-term policy achievements. However, we reiterate that we still need to see actual outcomes move from expectations to realised inflation levels.
In Australia, we have dropped from 2.30 per cent two months ago to 1.65 per cent currently, which is now 85bps below the RBA target mid-point of 2.5 per cent. The context of this move is significant in light of the current inflation level and forecast CPI 1 to 2 years out – estimated to reach 7 per cent by December of 2022 and taper down to 3.1 per cent by December 2023. The BEI market in Australia is now pricing a substantial policy error from the RBA. Sensitivity to actual policy/communication is overwhelmingly different from that experienced in prior high inflationary episodes. The more public broadcasting of central bank inflation targets and the constant media influence could be playing a decisive role.
Australian real yields have now moved dramatically higher versus the US, with this being at all-time wides. The inconsistency here is that markets are pricing a dramatic policy tightening by the RBA, yet this would only make sense if inflation remained stubbornly high. We now see significant distortion and disparity across inflation markets, a theme we expect to extract value from in the coming months.
Markets – Choosing Your Poison
Throughout June, corporate spreads went wider across high yield and investment grade, reaching year- to-date highs in Europe and the US. Levels remain consistent with those reached during April 2020, the most volatile period of the pandemic. Interest rates were higher across most G7 economies, with the Fed raising the target for the fed funds rate by 75bps to 1.50-1.75 per cent during its June meeting instead of the anticipated 50bps. Chair Powell points to a capacity-constrained economy that can withstand tighter monetary policy. Furthermore, we expect further increases of similar magnitude for July, hoping that rapid interest rate hikes will bring inflation back to the 2% target. As expected, on Tuesday and in its third consecutive hike, the RBA lifted the cash rate 50bp to 1.35 per cent. Domestic energy supply is amidst one of the most severe supply shortages that we have seen, contributing to continued supply-side challenges and elevated inflation, now reaching 5.1 per cent (highest since 2001), this has further lifted expectations of another 50bp rate hike in August and further hikes in months to follow. Cross market volatility started the month at lower levels with the VIX reaching close to yearly highs, subsequently reverting to lower levels of 28.7 per cent in the US and the Australian VIX finishing at 19.1 per cent.
Inflation-linked bonds and real yields moved higher over the month, with the US 10-year real yield increasing 47bps to close the month at 0.66 per cent. There was significant capital structure volatility experienced throughout June. Senior EUR financials widened 31.2bps, our preferred proxy for senior preferred. European high yield widened significantly by 142.4bps with elevated at-the-money (atm) volatility of 64 per cent. European Investment grade (IG) widened by 31bps with elevated atm volatility of 66 per cent. AUS ITRX widened 35.4bps. Similarly, in the US, investment grade widened by 22bps with elevated atm volatility of 65 per cent. US high yield widened significantly to 579bp (up 118bp) with atm volatility of 61 per cent. EUR Financials SUB widened 61bps. Across bond ETFs, IBOXX (Corporate Investment Grade) and HYG (Corporate High Yield) closed down by -3.8 per cent and -7.4 per cent.
Australian government bond yields were higher over the month: the 3-year yield increased 27.6bps (from 2.84 per cent to 3.11 per cent), and the 10-year yield increased 30.9bps (from 3.35 per cent to 3.66 per cent), exceeding 8-year highs at 4.07 per cent mid-June. The US yield curve flattened, with the 2-year yield increasing by 40bps (from 2.56 per cent to 2.96 per cent), and the 10-year yield increasing by 17bps (from 2.85 per cent to 3.02 per cent). The 10-year breached the 2018-high of 3.15 per cent during June (month high of 3.48 per cent), and slipped below the 2.9% mark, a level not seen throughout the month. Weak economic data fueled concerns of a US economic recession, namely signs of a slowdown in consumer spending. Increased uncertainty in global yield curves played out throughout June, oscillating with significant volatility as markets digested the inflation/growth outlook. In Australia, interest rate volatility in the 1-year part of the curve increased to 116.5bps (20.8bps), 3- year finished at 135.4bps (up 20.5bps), and 10-year was 128.9bps (up 18.8bps). Similarly, in the United States, interest rate volatility reached year highs (171.2bps) in mid-June. In the 1-year part of the curve, volatility finished at 160.3bps (up 30.5bps), 3Y was 150.2bps (up 23.8bps), and 10Y was 122.5bps (up 9.8bps).