The final quarter of 2021 was a tough period for all debt markets globally including floating rate notes. Domestically senior unsecured credit markets had another strong year on year (YoY) result, but the last quarter was both volatile and unpredictable. The volatility was driven by inflationary pressures starting to cement themselves in the data prints and further driven by opaque messaging and actions from the Reserve Bank of Australia (RBA).
New data sparked what can only be described as a ferocious sell of rates across the curve. Inflation, wages pressures, a new and weaker COVID variant, and an economy that was reopening all created the perfect storm for bonds. The last few trading days of October was where the majority of the damage was seen as fixed yields sold off in excess of 50 yield points across the curve and senior unsecured floating rate spreads moved 15-20 yield points wider. This spread widening represents the biggest sell off in some parts of the curve since the Lehman’s default which sparked the Global Financial Crisis (GFC) and which is best illustrated with a few specific data points.
Firstly, on Wednesday 27 October 2021 the Q3 Consumer Price Index (CPI) print for 2021 was released and it was a strong headline number of 3.00% YoY. It was also a strong number from a trimmed mean perspective of 2.1% YoY and this was the number that spooked the market as the trimmed number is what Governor Lowe is focused on. And finally, it was apparent and in writing that inflation was inside the RBA’s explicit focus band.
The second catalyst for volatility at the end of Q3 & Q4 was a significant shift in RBA monetary policy with the withdrawal of Yield Curve Control (YCC). At the very onset of the COVID-19 market weakness the RBA implemented several bespoke forms of monetary policy support including YCC to keep the front end of the Australian Commonwealth Government Bond curve low at ~0.10% out to April 2024. YCC was manufactured by both buying bonds in the market daily and charging eye watering borrowing costs if a trader wished to short these bonds.
On the day after the strong CPI print, the market expected the RBA to continue to communicate which bonds would be purchased as part of the YCC program, but participants received silence. Many believed the RBA had inadvertently missed a day of YCC and as a result the market had a weak return. However, on 29 October 2021 there was radio silence again from the RBA and the market reacted with soaring yields. The market was at times illiquid and this shift signalled a turning point for the Australian rates market from near dated Bank Bill Swap Rate (BBSW) yields to longer dated 20-year Australian Commonwealth Government Bond (ACGB) yields and everything in between.
A recovering economy, inflationary pressures that were seen by some as transitory were now deemed real and a market addicted to central bank liquidity and emergency monetary policy measures was abruptly forced to reassess market pricing with no communication from the RBA.
So as 2021 drew to an end, many market participants refined their short-and medium-term yield curve expectations with a particular focus on what central bank action was expected in 2022. The RBA will likely struggle to keep the official cash rate at 0.10% until early 2024 but that doesn’t mean that they can and will keep the official cash rate at 0.10% until 2023. Governor Stevens has made it explicitly clear that the RBA board will not raise rates until there is sustained wage inflation, however this will start to appear domestically as the unemployment rate approaches 4.00%. Outside of the official cash rate, banks have already started to pass on higher funding costs to mortgage holders - in essence doing a part of the central banks work for them.
As referenced in the introduction, floating rate spreads moved markedly wider in October. Where NAB issued a 5yr note in August 2021 at 0.41% to BBSW for 5 years, this bond was trading at ~+0.65% to BBSW as at the end of 2021. This increased cost of funding for any new issuance in early 2022 will be immediately passed onto borrowers and some!
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