The global wave of omicron will only exacerbate the supply-side bottlenecks that analysts hoped to dissipate in 2022 and dampen wage growth and inflation that are forcing central banks to withdraw the extreme monetary stimulus that were put in place during the pandemic.
The Fed is expected to rise in January
We previously argued that the Fed only raising rates three times in 2022, which the market expected in December, was hard to rationalize when the neutral cash rate is 2.5% (it is currently around 0%). With markets now expecting four hikes in 2022, the Fed should aim to return to neutral as soon as possible.
Think of it this way: In 2018, the Fed raised its cash rate to around 2.5% when the US unemployment rate was exactly the same as it is today, but wage growth was below 3.5% (vs. 4.7% now) and core inflation was 2% (less than half the 4.7% pace of the Fed’s preferred personal consumption expenditure measure) .
This makes no sense: the Fed is expected to rise in January and move in 50 basis point increments. By not touching its interest rate lever until March, and then only raising rates by a measly 25 basis points, it will only entrench the incipient spiral in wages and prices. What a prank.
There are certainly cracks starting to show in the Ponzi equity edifice. The tech-centric Nasdaq index has fallen 8% since its peak in late November. And Bitcoin, which is highly correlated to stocks, dipped below US$40,000 ($55,000) over the week after rising above US$52,000 in December.
Markets expect the Fed to end its bond buying program in March. There is also a firm consensus that the Reserve Bank of Australia will complete its program a little earlier, in mid-February.
The Fed’s first hike in March should help crystallize a rise in long-term interest rates, which are struggling to integrate more than four future hikes. Higher discount rates will put downward pressure on valuations of long-lived assets, including listed stocks, private equity, venture capital, crypto, real estate and fixed rate bonds .
The ABC beats the end of the global cheap money party
Smart bond issuers are anticipating the end of the global cheap money fest. This was exemplified by CBA Treasurer Terry Winder successfully executing the largest Australian bank or corporate bond transaction ever during the week. The ABC raised a record $4 billion through a five-year senior bond offering featuring a $3.1 billion floating-rate tranche and a $900 million fixed-rate tranche ( we attended).
The ABC says the record was previously held by Mayfield Group, which issued a $3.5 billion single-tranche deal in 2005. The $3.1 billion floating-rate tranche is also the largest tranche bank’s single Australian dollar deal (Westpac issued a $3.05 billion deal in 2015).
We argued that the secondary fair value curve for this bond was about 70 to 71 basis points above the quarterly exchange rate for bank bills and recommended a new issue concession in the range of 75 to 80 basis points.
The CBA is one of the smartest bond issuers in the world and generally adheres to the “long-term greedy” maxim of looking after its creditors. Treating your lenders poorly when you’re a 15x leveraged bank managing huge asset/liability mismatches is likely (pardon the pun) to embroil you in conflict when markets go down and creditors refuse to finance you at reasonable rates.
This situation was complicated by the fact that the big banks did not have much of a long Australian dollar bond curve due to the fact that they had financed themselves with the $188 billion borrowed from the RBA under the the Term Funding Facility. The exact estimate of the fair value of a new five-year bond depended on your assumptions, and one could make credible arguments that the fair value was in the high territory of 60 basis points (rather than the 70- 71 basis points that we had estimated).
CBA’s Winder did the right thing by throwing to a proposed 75 basis point spread. Unprecedented demand for pounds north of $5 billion then allowed his syndicate team to compress the price to 70 basis points, which, while in line with our fair value curve, was still far off other estimates that made the deal cheap. As it happens, the bond performed well on the breakout, tightening to 66.5bps before stabilizing at 68bps.
Everyone was therefore relatively well served by the results: the issuer got the cheapest five-year senior silver in Australian dollars in the post-GFC but pre-COVID period (there were cheaper offers since March 2020, such as the five-year bond which printed at 41 basis points in August last year), while investors have been rewarded with performance.
An interesting feature of this transaction was the unusually large fixed rate tranche of $900 million. Since APRA demanded super funds to compare the performance of their fixed income securities to the composite fixed rate bond index, capital gradually began to move away from floating rate strategies towards fixed rate strategies. Prior to the GFC, the majority of Australian bond issuance was fixed rate.
Yet the introduction of liquidity rules that allowed banks to buy bonds from each other through the $140bn Committed Liquidity Facility (CLF) meant there was a shift towards issuers offering interest rate products preferred by banks that like to hedge against a floating rate return.
The recent closure of the CLF reduces the ability of banks to buy bonds from each other and therefore the demand for floating rate securities, all other things being equal. Combined with the growing demand for super funds for fixed-rate securities that minimize the tracking error relative to the composite bond index, Australian investors should welcome more fixed-rate issues than we have seen these last years.
And 2022 is certainly a big year for Australian dollar corporate bond maturities: some $81 billion needs to be repaid.
Importantly, there will still be bids for bank-issued bonds from smaller banks that are classified as Minimum Liquidity Holding (MLH) institutions rather than Liquidity Coverage Ratio (LCR) banks. MLH banks can continue to hold bank paper in lieu of government bonds. LCR banks are now only allowed to hold government bonds.
And the demand for government bonds will be significant: on our model, banks need to buy about $408 billion in government bonds over the next few years, as CLF draws to a close, balance sheets continue to grow (generating regulatory liquidity needs) and the RBA destroys over $188 billion of digital cash as banks repay the funding facility term and the bonds mature on the balance of the RBA-sheet. (This digital currency is currently included in banks’ LCRs and will evaporate over time.)