Summary:
US Fixed Income
The US employment report for January released on Friday was hotter than expected: payrolls up by 143,000; unemployment rate ticked down to 4%; average hourly earnings up 0.5%; participation rate also up. Yields consequently increased.
Later on Friday the University of Michigan Sentiment Index data showed that consumers expect inflation to be a full percentage point higher in 12-months from 3.3% to 4.3% on account of tariffs. The heightened near-term inflation expectations drove down consumer sentiment to a 7-month low in early February. While not the largest move in yields, the data releases are very significant Fed policy wise. Unemployment rate coming down and inflation expectations going up is effectively Fed kryptonite. The data reinforces the prevailing view of ‘higher for longer’ and the that Fed can be quite patient, not needing to move anytime soon and more so given the uncertainties regarding tariffs. On the topic of the latter and which will likely impact Fed timing, it may take some time on what the full details are and, consequently, have true clarity between the economic data and ultimately what the interest rate term policies will be. In short, yields may well be range-bound for the foreseeable future and at levels the majority of fund managers view as very attractive rates notwithstanding the very tight spreads (see chart below). It is the latter that may represent the key risk (i.e. a widening) for sectors/companies with material sales and supply chain exposures. It highlights the need for a selective approach rather than a broader market beta play, and the more so the lower in the ratings scale the exposure is.
Meanwhile, traders maintained bets for a quarter-point rate reduction in September. All told, the swaps market suggests around 35 basis points of rate cuts for this year, less than 50 percent odds of a second quarter-point reduction. So, the market’s view is that the developments definitively removes market expectations for the window to cut in March. Australian corporate bond spreads remain tight to very tight by historical standards, and as per the U.S. bond market. There are two factors at play here, one fundamental, one technical. Fundamentally, Australian corporate credit quality remains solid and is expected to continue to do so over the foreseeable future. Technically speaking, for some time now there has been excess demand in the market driven in part by investment product proliferation, Australia being perceived as providing attractive relatively yields to other jurisdictions, and, potentially, listed bond markets being crowded out to a degree by way of private debt. (refer to ‘Australian Bond Demand’ section below for more context). Historically tight spreads, however, infer risks, specifically a widening. The general perception in both the Australian and U.S. markets is that tariffs is on the basis of probabilities of the most material risk in this regard.
Figure 1: Moody’s US Aaa Corporate Bond Yield
Fig 2: ICE BofA US High Yield Index Effective Yield
Figure 3: Australian Corporate Bond Spreads
The yield on the S&P Australia IG Corporate Bond Index continued it decline over the week from its more recent peak on January 13 (5.24%) to 4.96% by Friday.
Figure 4: Yield to Maturity – Australian Government Bonds vs IG rated Corporate Bonds
Australian corporate bond spreads remain tight to very tight by historical standards, and as per the U.S. bond market. There are two factors at play here, one fundamental, one technical.
Fundamentally, Australian corporate credit quality remains solid and is expected to continue to do so over the foreseeable future. Technically speaking, for some time now there has been excess demand in the market driven in part by investment product proliferation, Australia being perceived
as providing attractive relatively yields to other jurisdictions, and, potentially, listed bond markets being crowded out to a degree by way of private debt. (refer to ‘Australian Bond Demand’ section below for more context).
Historically tight spreads, however, infer risks, specifically a widening. The general perception in both the Australian and U.S. markets is that tariffs is on the basis of probabilities of the most material risk in this regard.
Figure 5 : Australian Corporate Bond Spreads
Source: S&P Global
Another measure, the cost of credit default swap premiums, declined over the week. The Australian credit default swap index, the iTraxx Australia Series 42, decreased by 5.00 points to 67.00 points.
