–  FEBRUARY 2022 INSIGHTS BY THE CURVE TEAM –

Summary

RBA Recap

  • The RBA ended their QE Program, in sync with other central banks.
  • Whilst inflation is at the forefront of the RBA’s policy, they are willing to be patient with the cash rate.

Markets Recap

  • Term Deposit and NCD rates are trending up. Bank appetite and increased reference rates are the main drivers.
  • The yield curve is steepening and offering reward for duration.

Investing Considerations

  • Increasing duration of investments will provide investors with the greatest return.
  • Take advantage of the slope of the curve.

Economic Summary

  • The economy is still recovering from Omicron, with business confidence down. Yet the broader outlook is positive.

RBA Recap

Policy Decision:

The RBA elected to cease its quantitative easing programme at their February meeting as was widely expected. In explaining the decision the RBA indicated it no longer needs to preserve the currency through this tool, as most other central banks have already ceased their QE programmes.

After implementing 5 emergency tools during the onset of the pandemic, (TFF, YCC, forward guidance and the accommodative cash rate), all that remains is the record low cash rate. Despite facing serious criticism that inflation and wage growth are accelerating through the economy, the cash rate has been left unchanged at 0.10%.

The Q4 inflation print was released in January with core inflation accelerating to 2.60% YoY (Trimmed Mean). The RBA finally updated their inflation forecast, which they had previously not released to the market. The central scenario now states that inflation will be 3.10% by the end of 2022, before subsiding to 2.75% in 2023.

Whilst inflation is heavily debated, Phillip Lowe provided rationale behind his lack of immediate concern for the latest figures. For the past 7 years, Lowe has been criticised for inflation not falling within the desired target. Many suggested he should have done more when inflation was low to support aggregate demand.

However, this time around, inflation has been heavily driven by supply chain pressure rather than an increase in aggregate demand. This is the key reason that he cites in not rushing to lift the cash rate. The rhetoric behind the inflation target is it needing to be “sustainably within the 2-3% range”, and that the RBA is “prepared to be patient” before adjudicating this. GDP has been forecasted for 4.0% this year, before slowing to 2.0% for 2023.

Unemployment is expected to decline to 3.75% and remain stable at this level to the end of the forecasted period. A low, sustained, unemployment rate is unchartered territory for the Australian economy. We have little data on how the economy will perform and what to expect in this situation. However, this is welcomed by Lowe.

Uncertainties continue to dominate the economic forecasts, largely due to Omicron. The central scenario is centred around a steady recovery, and incorporates the uncertainty associated with the pandemic.

The upside scenario hinges on stronger consumption on the back of Omicron fading into the background sooner rather than later. Consumers have placed themselves into voluntary lockdown, despite not having restrictions forced on them, and consumption is not as strong as expected as a result. If this mentality is to drastically change, the upside scenario sees unemployment expected to fall to 3.00%. Inflation will peak at 3.75% in 2023, as supply chains will suffer from increased pressure due to increased consumption.

On the downside, if consumers continue to be risk averse, or if Covid causes further disruptions, unemployment is seen as rising to 4.5-5.0% and inflation remaining within the 2.0-2.5% range until the end of 2023.

Despite the RBA’s latest update, the market is still expecting the RBA to lift the cash rate sooner than later. Economists too are still slating the first move for the second half of 2022. When questioned on a rate cut this year, Lowe said that it was plausible but unlikely. The RBA is expected to look through a core inflation number which will breech the 3% mark this year and instead focus on the medium term. They want to give wages a chance to do the heavy lifting on keeping core inflation in the target band as supply chain disruptions ease. While the RBA’s initial expectations of leaving the cash rate on hold until early 2024 are now a distant memory, any action this calendar year still seems unlikely.

Markets Recap

Term Deposit Rates Trending Upwards

Term deposit rates are heading higher as an increase in the demand for money from banks comes at a time of rising reference rates. Volatility has surfaced as banks compete with one another for funding.

ADIs have heightened their demand for money, as the $188 billion of TFF drawdowns is scheduled to be repaid in a years’ time. As retail deposits have soared during the pandemic, most have been left in at call accounts leaving banks with a lack of term within their liability books. The increased demand for money saw banks leapfrogging each other for funding, paying elevated rates, and creating volatility within the market. Due to the dynamic nature of funding requirements, rates will remain volatile moving forward.

Reference rates have increased over the past two months, adding more upside pressure to deposit rates. For example, 3-month BBSW often set at 0.02% in the middle of last year. Today, BBSW was 0.07%.

Further out the curve the move has been more dramatic. Coming off a low of 0.02%, 6-month BBSW has increased to 0.24%. As the reference rates continue to increase, term deposit rates will continue to rise. Meanwhile the 1 year swap launched from a low of 0.03% to be sitting at 0.60% at the time of writing.

In the longer tenors, such as 1 year, reference rates are far more volatile, and can move several basis points in one day. Term deposit rates have moved according to reference rates, and placed further upward momentum on rates.

NCD Rates Steady

The acute funding pressure in the institutional space from December eased as we entered the new year. While margins remain off their lows seen during the third quarter last year, they have failed to continue rising further alongside term deposit rates for now. Increased demand for money saw more investors deploy cash balances into short end markets.

As with the shape of the term deposit curve, investors who have the capacity to take advantage of longer tenors are being rewarded. The jump in the 1 year swap rate has seen a number of issuers offer rates in excess of 0.80% and in many cases presenting better value than term deposits of a similar tenor.

Bond Yields Are Rising

2022 has started with large issuance of new fixed and floating rate bonds. Issuance increased as banks lengthen their maturity profile past TFF and take advantage of historically cheap funding. CBA issued the single largest line in Australian history, with a $3.1billion 5-year FRN and a $900 million 5-year fixed bond, which priced at +70 and 2.40% respectively. Whilst this is historically cheap, spreads have widened significantly off their lows when compared to a 5-year NAB FRN that was issued in August 2021 at +41.

Issuance had previously been subdued as banks turned to cheaper TFF funding. Further, investor demand for new issuance has caused pricing to set 5 basis points below from guidance levels. As investors are no longer starved of new issuance, demand for single lines may decrease and put further upward pressure on yields.

Investment Considerations

Duration

Due to the steepness of the curve, investors should consider adding some longer term investments to their portfolio. Investing for shorter timeframes, passes up additional interest income, which becomes very difficult to recover. For example, the highest BBB one year term deposit is 1.10%. Interest earned on a $1m, 12-month investment is $11,000. A competitive, 6-month BBB investment now is 0.60%. The interest earned is close to $3,000. Therefore, to regain the interest left off the table through the shorter tenure (~$9,000), the reinvestment rate in the second 6-months needs to be around 1.60%. This gets exponentially worse as rates increase with term.

With the shape of the yield curve so steep, investors are rewarded on investments 6 months onwards. The largest reward for longer duration is seen on investments greater than a year. Therefore, it is crucial for investors to manage cash flow requirements, by staggering investments at the front end of the curve to maintain liquidity needs and investing surplus funds for longer terms. With the economy on the precipice of a tightening cycle, this strategy will be more heavily relied on.

Australian Economy

Covid continues to dominate the Australian economic and monetary policy outlook. Whilst the economy was not completely derailed by Omicron, it certainly had an impact. Society is transitioning to ‘living’ with the virus, yet people have still been reserved, and consumer confidence fell by 2.1%. Voluntarily lockdowns have seen consumption decrease (retail sales down 4.4%), and business confidence deteriorate as a result. Omicron, and any future strain could adversely affect the economy However, it does appear that the worst is behind us.

The largest factor at play within the economy remains inflation and within that, wage growth. Supply chain disruptions continue to be the talking point and inflation is starting to hurt households, particularly at the petrol pump. The latest inflation print showed inflation at 2.60% (Trimmed Mean) YoY. The largest component within the read was the prices of dwelling, which was up 4.20% QoQ. The inflation outlook appears to be systemic, with the CPI excluding volatile items also coming in at 2.60%.

Employment data continues to be strong, with unemployment falling by 0.40% and now resting at 4.2%. Whilst the economy is in a strong position, and full employment part of the RBA’s mandate, a strong labour market is placing further pressure on inflation. Total employment was up in the past month, with 64,800 new jobs being created. With the borders being opened to tourists in the coming months, an inflow of cheap labour may resolve some of the staffing issues in key sectors, such as hospitality, and could place downward pressure on wages growth.

Nicholas Allan

Associate - Money Market