Input complexity clouds Australian debt strategy outlook
KangaNews hosted its annual roundtable discussion for Australia’s leading bank fixed-income strategists in March amid a fast-changing world. While inflation, interest rates and geopolitical risk are on the rise, financial markets are not yet in crisis territory. The strategists agree Australia is in relatively sound financial shape as the world moves into a higher rates regime.
THE MACRO VIEW
O’Leary Despite the growing risks, Australian GDP is rising, fuelled by an increase in household spending. How have forecasts changed since the beginning of the year?
MASTERS Since late February, our economists have revised global forecasts down considering Russia’s invasion of Ukraine. Within Australia, though, our growth forecasts have barely changed since February.
Escalating geopolitical tensions have contributed to hikes in energy prices, causing supply issues. There is risk of an even higher inflation print next quarter than what was initially forecast. The market also expects Reserve Bank of Australia (RBA) tightening sooner, which impacts our bond yield forecasts. However, what goes on with US Treasuries has greater impact further out on the curve. In the past fortnight, we met our second half 2022 forecasts in March.
MCCOLOUGH We are similar with our bond forecasts – we have had 260 basis points for US 10-year yield for a while. There is upside risk to the forecast but there is more stability further out. When bonds peak relative to the timing of US Federal Reserve hikes will be significant.
Our Australian GDP forecast likewise remains similar, with 5.5 per cent forecast for 2022 led by consumer spending. Post-pandemic demand and high savings rates are driving this spending. Our unemployment rate forecast for year-end is now 3.8 per cent, revised down slightly from 3.9 per cent at the beginning of this year. The biggest shift is our terms of trade, which we had coming down to 3 per cent but is now at 8-9 per cent as Australia benefits from higher commodity prices.
We now have the RBA raising the cash target in June. We have brought some rate hikes forward for this year, with year- end cash at 1.25 per cent before we reach a terminal rate of 2 per cent by mid-2023. Overall, we are not seeing a major shift in market fundamentals due to geopolitical risks.
PLANK The nominal economy powers along but the growth- inflation relationship is slightly worse. We have revised real GDP figures down a little, reflecting the impact of higher prices on consumer behaviour.
Inflation figures are higher though, leaving the nominal economy strong. We think the RBA will eventually bring the cash rate into the 3 per cent area – which the market has now priced in, albeit much sooner than we anticipate.
We are close to considering whether rates are topping out in the US, which is particularly important for the long end of our curve. Our recently revised view is that the Fed will eventually go restrictive, similarly taking rates into the 3 per cent area. This has pushed up our US Treasury forecast and flattened the curve.
We debated intensely about US curve inversion and have it flat with optionality either way. What we are seeing in the US, as well as a flattering, is a shift up that feeds into our long end to some extent. We have revised up our terminal 10-year US bond forecast a touch, reflecting the higher neutral or end point for the Fed.
WHETTON We still have the first RBA rate hike in June and 1.25 per cent as the terminal or neutral rate. However, with the onset of war and greater inflationary pressures, our economists are slightly more flexible about the RBA going tighter.
A final cash rate of 1.75 per cent would be tight for us. We have lifted our bond and swap yield forecasts, though, and toward the end of the year we forecast the longer ends of the curves beginning to invert for the US and Australia as rate hikes come through.
Even with the terminal rate at 1.25-1.75 per cent, we think the economy will begin showing signs of consumer-side strain later this year, bringing further inversion.
O’Leary The US is currently experiencing a strengthening trend in wage growth, which we have not seen in Australia. Will this make a difference?
WHETTON Bargaining takes relatively longer in Australia because of the openness of the US labour market. In some ways we are better placed than the US, though more vulnerable in others.
While we prepare balance sheets well and have a large pool of savings, our debt-to-income and debt-to-GDP levels are high, which will present problems later. Cost-of-living pressure is not being offset by wage increases while in the US – with its tighter labour market – it is to a greater degree.
PLANK Structural rigidity is keeping wages softer here. Once wages increase, history suggests the RBA will need to go harder to slow down the labour market compared with the US. Just as wages were unresponsive to the RBA at low interest rate levels, I expect the RBA will have a harder job as rates increase.
MASTERS Award wages make up around 20 per cent of the wage price index and EBAs [enterprise bargaining agreements] are at 40 per cent. These typically move with a lag and it is probably a reason we have not yet seen a meaningful increase in wage growth. If wage increases begin flowing through, we will have embedded inflation expectations and wage expectations. Central banks are wary of this.
MCCOLOUGH We have the neutral cash rate at 1.75 per cent and our terminal rate is 25 basis points higher. Our neutral also factors in the debt servicing ratio, which is crucial to the whole monetary cycle. Per our calculations, 1.75 per cent puts us in the same position we were in immediately after the financial crisis with the debt servicing ratio. If rates rise to 2 per cent or 2.25 per cent, we will reach similar peaks to just prior to the last tightening cycle.
Through this cycle, we will learn how much calibrating we need, especially with offsetting factors like savings. We estimate around A$270 billion (US$201 billion) of excess savings because of the pandemic, which would otherwise have been spent. This provides a buffer. Australian borrowers are also two years ahead, on average, with their mortgage payments.
The interplay between these factors and rising rates is important. Are the first rate hikes functionally almost irrelevant and absorbable? It is obviously at the margin that really matters.
Of course, most of the savings have gone to a cohort of Australian households that can afford some hikes. But we have had a huge amount of pain coming through mortgage books when fixed rates start to run off. If a borrower fixed for two or three years in 2020 and rates considerably increase, they will have a huge jump in mortgage expenses.
PLANK The bulk of mortgage rate jumps occurring for fixedrate borrowers will be because of floating rates as the RBA hikes. It is not just because they are rolling off. For those that fixed in 2020, the current floating rate is still lower than the rate they fixed at – there is no cliff but rather a step down. The impact of rolling off will primarily – though not entirely – occur because the floating rate is going up. I think there is some double counting.
MCCOLOUGH This is more about 2023 than 2022, but the point makes sense.
PLANK Based on where floating rates are now, the average person who took out a mortgage in 2021 would see their rate rise by 30-40 basis points. This has been played up as a big issue, but I disagree – unless for some reason those people never expected rates to go up. Presumably they were not given mortgages on that basis, even so.
WHETTON We are concerned with the number of people who will experience some impact from expiring fixed rates. We recognise there is a massive pool of savings. However, it is not about the average borrower, but the 35 per cent who are quite stretched and have bought in the near term with a fixed rate that rolls off. We see the bulk of roll offs – 45 per cent – occurring between June and December 2023, amounting to around A$150 billion of loans maturing.
It is their ability to double the cost of the mortgage, and I agree that the cohort of people who have the money will not be too worried about mortgages going up. It may eat into repayment figures, but they can afford it. It is those who cannot that give us the lower neutral rating.
If we return to 2006 levels, we are in record territory of disposable incomes going to mortgages. This worries us in the context of how far the RBA can go, because such an outcome is very contractionary.
MASTERS The other notable factor in neutral and terminal levels is the term funding facility (TFF), which effectively represents a couple of rate hikes. This is another reason the RBA terminal rate will likely be lower than the Fed’s – but the market is not currently pricing this in.
Fed moves spark debate on Australian impacts
The US Federal Reserve has increased the cash rate for the first time since 2018 and has signalled further aggressive rate hikes as it battles inflation. While the move may not directly affect Reserve Bank of Australia (RBA) strategy, the Australian central bank will need to manage several indirect effects.
PLANK The articles written in the past few weeks about the Fed forcing the RBA’s hand forget the experience last cycle. During the last tightening cycle the Fed went from 0.25 per cent into the 2 per cent area while the RBA cut rates. There is no mechanical link between the central banks. The linkages are indirect rather than direct: they tell us something about inflation and, potentially, about the currency.
MASTERS It affects the yield curve, though. A more aggressive Fed means the Australian 10-year bond yield goes a lot higher than it normally would have.
MCCOLOUGH This would be an indirect impact. Turning to where markets have already moved, the RBA does not have as much work to do under such a scenario. Price action reflects commentary about the Fed forcing the RBA’s hand. It is certainly behaving this way at the moment, but I do not think it will have much impact on the RBA’s policy reaction function.
O’Leary With rising oil prices and inflation, some commentators have drawn links between the contemporary period and the 1970s. How accurate is such a parallel? Is the risk starting to transition to stagflation from inflation?
MCCOLOUGH We know where comparisons to the 1970s come from, given inflation concerns. However, the energy intensity of the Australian and other economies is less than it was then, especially given energy alternatives now.
Stagflation is not a one or two quarter phenomenon but a multiyear mindset where inflation expectations embed in the cost structures of business, leading to wage increases because of higher prices and then a self-fulfilling trend. One similarity is union support for considerable wage increases post-pandemic, but this is not enough to lead to embeddedness.
While the market is pricing inflation expectations higher, inflation is not out of control. Central banks have built enough credibility. Fed chair Jerome Powell’s response in late March repriced the front end of the curve, and the market’s response is rational given central banks maintain inflation-fighting credibility.
MASTERS There is a risk of stagflation. The market was more concerned prior to Powell speaking, though. While National Australia Bank certainly does not have stagflation as a forecast, it is a key risk based on market pricing. How do consumers deal with higher cash rates? How effective are higher cash rates at curbing inflation if it is driven by a high oil price and supply bottlenecks?
The Fed and the Bank of England (BoE) have also diverged recently. Admittedly the BoE is a little ahead on tightening but it is starting to pull back from very aggressive rhetoric on higher cash rates. I think the Reserve Bank of New Zealand (RBNZ) is worth watching. The RBNZ is going very aggressively and the housing market is really feeling it.
PLANK New Zealand has also ignored Australia’s experience with credit tightening. They were looking at a large fall in house prices simply due to the exogenous shock through the credit market. They are also now downplaying the risks and adding rate hikes. Circling back, though, talking about stagflation strikes me as strange when unemployment is at a 50-year low.
In the next couple of years we could have an unemployment rate that is too low and, to curb inflation, we need to drive unemployment up. Then we could have a period of rising unemployment with inflation still sticky. But I disagree with those calling this stagflation. Rather, it is a matter of exceeding full employment. There is a chance this occurs.
"While the market is pricing inflation expectations higher, inflation is not out of control. Central banks have built enough credibility. Fed chair Jerome Powell’s response repriced the front end of the curve, and the market’s response is rational given central banks maintain inflation-fighting credibility."
O’Leary It seems that COVID-19 has taken a back seat as the Ukrainian conflict intensifies. However, the pandemic is not over. How is this factoring into forecasting?
PLANK The problem with the pandemic is it is a 0-1 event. Traders can factor in a probability about bond value. When forecasting, we either forecast a pandemic or assume it does not happen; we cannot semi-price one in. From a forecasting perspective, most of the time the assumption is no pandemic and no lockdowns. From a trading recommendation perspective, one can factor it in as presenting a risk. For example, we would not do X until we see Y.
MASTERS It remains somewhat of a concern with supply issues – and the Russia-Ukraine conflict has exacerbated this with certain commodities. However, if demand shifts to services from goods as economies open, perhaps supply-chain issues from lockdowns will dissipate. Then the pandemic moves further into the past.
Sonnenschein How do you apply forecasting that is premised on events with a binary likelihood?
PLANK We were told the best health outcome for Australia was 50,000 deaths with numbers of sick people likely in the hundreds of thousands. We got two things wrong in March 2020. First, the initial forecast was premised on those health outcomes. Second, the government had flatly rejected a wage subsidy. Two days later it brought in one of the most generous packages globally.
We changed our forecast completely: we dropped our unemployment rate forecast to 7 per cent from 15 per cent. Economists have a 0-1 problem when forecasting interest rates – we assume no pandemic, but market pricing can.
Interest-rate levels are partly based on expectations of events that may or may not occur. We can reflect the pandemic risk to an extent in our interest rate forecast because of the fact some parts of the market price in a chance. Even in 2020, as things improved bond yields were still falling because the market remained worried about the possibility of something going horribly wrong.
O’Leary COVID-19 infections are rising in China and Shanghai has just gone into lockdown. Could this further exacerbate supply-chain problems?
MASTERS The risks are still around. The underlying question is when inflation peaks and comes off. We all thought US inflation would be peaking now, but then came the Russia- Ukraine conflict – which has likely extended higher inflation via commodity prices. Perhaps a lockdown in China or extended lockdown generally does a similar thing. In this sense the pandemic is still a factor.
MCCOLOUGH I do not see it hitting global growth too much. The lockdowns so far have been short. I think the Shanghai lockdown is the first time we have considered it from a growth perspective. Overall, we are not concerned.
PLANK The experience with Omicron is authorities give up as it spreads further. There is a chance that an explosion of Omicron cases accelerates China’s transition to living with COVID-19. The hit on supply chains may be short lived but there is still some uncertainty around COVID-19 in China that is different from Australia, the US and Europe.
WHETTON It will affect supply chains and delay when inflation peaks. However, China continues issuing local government bonds to finance infrastructure projects. These can somewhat offset weakness in the economy. China has been easing anyway, yet the world has turned its attention toward the US and Europe, and the reflation story. In the background, China will bubble along and its impact on Australia will be positive as it continues buying Australian hard commodities.
Sonnenschein Is the federal election factoring into the outlook?
MCCOLOUGH Economic management will always be a discussion point, though this is not the previous “debt and deficit disaster” era. This has ballooned four times larger since the government came in and there are not enough black and white policy differences to shape the growth path of the economy.
WHETTON The only concern is adding fuel to the fire of an already hot economy. If one tries to fix cost of living issues simply by giving people more money, it will just add to the cost of living by pushing prices higher. Either side is likely to do this, though – which is one risk. Debt and deficits are perhaps conveniently forgotten by the current government. The market is shrugging it off as the amount of government debt we have is not a big deal to the cost of money in Australia.
O’Leary How likely is a slowdown in the housing market and what is the probability we will see some macroprudential measures aimed at housing?
MCCOLOUGH We expect a fall of 10-15 per cent over the next year. We may have seen a few macroprudential measures under a different economic and geopolitical scenario, though they are not in our current forecast.
PLANK We all predict house prices will fall; the difference is the degree. Despite having the highest cash-rate forecast, we likely have the smallest fall in house prices. The sector will be affected and we anticipate prices falling later this year or next, but overall being resilient.
Looking back to the 2000s, rates went up considerably and so did house prices. If the wage price index is in the forecast 4 per cent area, a strong disposable income backdrop emerges considering average wages are probably growing at 5 per cent alongside tax cuts in 2024.
When the RBA reaches the neutral rate, it is likely to pause for six or 12 months. I can see the housing market getting a second leg in 2024.
WHETTON We expect more pressure on the household sector because of our lower neutral view. We do not have a big drop in prices and forecast an 8 per cent housing fall next year, taking us back to where we were a few months ago. This brings us back to our previous discussion on the rationale for rate cuts. My guess is a very substantial, ongoing fall in house prices with a household sector in some trouble.
This is not a central scenario but a tail risk. I do not foresee macroprudential measures. However, we should note about 20 per cent of mortgage stock was written over the last year and there is a large cohort of lending that is at six times or greater income multiple. If measures are introduced, they would likely affect nonbanks and not banks.
Even then, nonbanks are such a small part of the lending pool. On the other side, I do not envisage a loosening in conditions either – because it would likely be the wrong end of the cycle.
O’Leary In crises past, the Australian bond market – high-grade and credit – would likely have seized up for a while. But the market has shown resiliency this year, at least in new issuance flow. Why is this?
PLANK I would not say crisis but a shift in macro conditions. We have seen big moves in macroeconomic conditions leading to dramatic repricing of the curve. The flow-on effect to credit and spread markets has been there, but markets have not seized up. Markets have functioned well, doing what they should. Spreads have widened to some extent.
MCCOLOUGH Credit spreads were widening before tanks rolled into Ukraine in anticipation of policy tightening in 2022, so the recent repricing is more a product of fundamental reasons. Financial crises have been solved before. We know how
WHETTON Here we are at the end of another quarter and end of financial year in Japan. Normally we would see a big squeeze in dollars, which has not happened because of swap lines and the resilience of financial markets to adapt and learn without relying on last-minute funding.
Australian swap spreads moved considerably at the end of 2021. Credit spreads widened, but they had been extremely low. However, we cannot look at this in isolation. Spreads have been narrow for a while, and suddenly they are a bit challenged and wider. There are no dramatic moves and there is no crisis.
The absence of Russia’s roughly US$600 billion of liquidity, which went into the market daily, has not created problems. The Australian market is also somewhat removed. Of course we are part of the same system but overall it is showing good resilience and working functionally.
O’Leary The closure of the CLF (committed liquidity facility) does not seem to have had a major impact on the liquidity available to bank issuers. Is this surprising?
PLANK We knew the TFF was ending and that after a two-year absence the banks would return. This absence, combined with banks being highly rated, meant everyone thought there would be some upward pressure on spreads. It has happened a little sooner, exacerbated to an extent by geopolitical concerns, though we knew it was coming. The CLF was always temporary and we have seen pricing adjust quite smoothly, if a little earlier than some forecasts.
MCCOLOUGH I would have been surprised if it had a major impact.
MASTERS The bigger issue for bank issuance would be if deposits started to run off given the banks have benefited from a massive increase in deposits. I view the TFF maturity as more of an issue than the CLF.
WHETTON Over the last 18 months, there has been a big drop in government bonds held by ADIs [authorised deposit-taking institutions] because of the RBA’s bond purchase programme. It is just a question of whether the mix of government and semigovernment bonds held by banks changes. The big picture does not: everyone knows the CLF is going.
MASTERS What is more interesting recently has been how well bid semi-government floating-rate notes have been. This may be partly due to the CLF closure.
PLANK The CLF has helped the states cap their spreads.
O’Leary Supranational, sovereign and agency (SSA) and local high-grade borrowers issued a lot in Q1. We have also had opportunities for Kangaroo issuance into Australia. Are these dynamics likely to continue?
WHETTON On SSAs, it is clear over the last few years that supply has dramatically shifted from the 10-year to the two-, three- and occasionally five-year areas, meaning a different buyer base. The basis is higher now as the Australian banks go back offshore.
There was substantial SSA issuance in January and February, in line with normal conditions though certainly well above recent years. The absolute volume of SSA issuance will be higher, but the nature of SSAs and their investor base has changed. International demand will not be the same while yields are higher and the Japanese have stepped away from the 10-year life insurance product over the past decade.
Issuance has really changed in tenor and investor basis. The basis will provide opportunities for issuers to come into the market, but if it is too expensive for Australian banks to go offshore they will issue domestically.
O’Leary Are environmental, social and governance (ESG) factors playing a greater role in cost of funds or liquidity in SSA bonds?
WHETTON Premia have not moved much. There was some movement in global sovereign markets toward the end of last year, including Germany and the UK. It is a conversation domestically, but low down the list. Our main issues are macro and the rates outlook generally.
Investors are typically finding niche pockets, whether through SSAs or, in the case of New Zealand, Housing New Zealand to be enough to fill their mandates. There do not seem to be many significant changes with mandates toward owning more.
MASTERS The size of a greenium is somewhat of a guess. I do not think the sovereign curve is being affected in its pricing yet. I know papers have been written on currency impacts for countries with massive climate risk and how this feeds through. In Australia, at least, it is still very much a growing market and we only have a couple of semis issuing into the space. They are well supported, but so are their benchmark issues.
MCCOLOUGH Over time it will evolve into a sustainability-linked bond curve. All boards are going in this direction and medium-term state government priorities are too. Eventually, greeniums will not matter if the whole curve has sustainability embedded within it.
Sonnenschein We recently saw a prominent Australian fixed income investor exit the sector and, in doing so, deliver a prediction about the death of bonds and their replacement with distributed ledger technology and central bank tokens. How much credence do strategists give this prediction?
WHETTON Around 85 basis points fell off within a couple of days of those comments. I do not think there will be a death of bonds because they are the only way many sovereigns raise money – this will not be done via tokens. No bonds makes no sense. They are an investment class, a liquid asset class and a fungible store of value that is recognised and regulated. I see more risk in cryptocurrency being regulated to the point where it becomes unviable for many investors.
PLANK With bonds, investors want to be able to exit. The reason credit markets are less liquid than government bond markets is because of their specialised nature. If an investor wants an asset that is fungible and easy to trade, the answer is not crypto.
MCCOLOUGH Imagine if we did not have the bond market during the financial crisis and the pandemic.
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