US Federal Reserve to raise interest rates harder and faster

In the AFR I write that you should buckle-up and prepare for a wild ride in 2022. Investors will have to resolve the cognitive dissonance of buying equities at record valuations on the Ponzi-like presumption of the low-rates-for-long meme juxtaposed against a US economy racked by the strongest inflation and wage pressures in decades, which scream out for higher interest rates.

In the last seven days we have seen the US unemployment rate slump from 4.2 per cent to 3.9 per cent, way ahead of economist forecasts, while wage growth in December also destroyed expectations, printing at 4.7 per cent compared to a consensus estimate of 4.2 per cent. This tells us that the US economy is both fully employed and producing wage claims that will continue to bleed into higher inflation.

These data were followed by a 5.5 per cent core inflation print, the highest since 1991 and almost triple the US Federal Reserve’s 2 per cent target. Despite inflation exceeding economist projections, equities managed to climb and bond yields fell because the market was evidently concerned about the prospect of a worse outcome.

The global Omicron wave is only going to exacerbate supply-side blockages that analysts were hoping would dissipate in 2022 and alleviate the secular wages growth and inflation that is compelling all central banks to withdraw the extreme monetary policy stimulus that was put in place to placate the pandemic.

We’d previously argued that the Fed hiking rates only three times in 2022, which was the market’s expectation in December, was hard to rationalise when the neutral cash rate is 2.5 per cent (it is currently around zero per cent). While markets are now handicapping four hikes in 2022, the Fed should be targeting getting back to neutral as quickly as it can.

Think about it this way. In 2018 the Fed lifted its cash rate to around 2.5 per cent when the US jobless rate was at exactly the same level it is today, but wages growth was less than 3.5 per cent (compared to 4.7 per cent currently) and core inflation was running at 2 per cent (or less than half the 4.7 per cent pace of the Fed's preferred PCE measure).

It makes no sense: the Fed should be hiking in January and move in 50 basis point increments. It will only entrench the budding wage/price spiral by not touching its interest rate lever until March, and then only bumping-up rates by a miserly 25 basis points. What a farce.

There are certainly some cracks starting to appear in the equity ponzi edifice. The tech-centric Nasdaq index has dropped 8 per cent since its late November peak. And Bitcoin, which is highly correlated with equities, plunged below US$40,000 during the week after breaching 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 touch earlier in mid February. The first hike in March from the Fed should help crystallise an increase in long-term interest rates, which struggle to price-in more than future four hikes. Higher discount rates will put more downward pressure on long duration asset valuations, including listed equities, private equity, venture capital, crypto, property and fixed-rate bonds.

Smart bond issuers are getting ahead of the end of global cheap money party. This was exemplified by CBA’s Treasurer Terry Winder, who managed to print the single largest Aussie bank or corporate bond trade ever during the week. CBA raised a record $4 billion via a 5-year senior bond issue that had a $3.1 billion floating-rate and $900 million fixed-rate tranche (we participated).

CBA says the record was previously held by Mayfield Group, which issued a single tranche $3.5 billion deal in 2005. The $3.1 billion floating-rate tranche is also the biggest Aussie dollar single tranche from a bank (Westpac issued a $3.05 billion deal in 2015).

We had argued that the secondary fair value curve for this bond was about 70-71 basis points over the quarterly bank bill swap rate, and recommended a new issue concession in the 75-80 basis point range. CBA is one of the smartest bond issuers globally, and generally adheres to the “long term greedy” maxim of looking after its creditors. Treating your lenders poorly when you are a 15 times leveraged bank running huge asset/liability mismatches is liable (excuse the pun) to get you into strife when markets sour and creditors refuse to fund you at reasonable rates.

This situation was complicated by the fact that the major banks did not have much of a long-dated bond curve in Aussie dollars due to the fact that they had been funding themselves with the $188 billion borrowed from the RBA under the Term Funding Facility. The exact fair value estimate for a new 5-year bond depended on your curvature assumptions, and one could make credible arguments that fair value was in the high 60 basis point territory (rather than the 70-71 basis points we figured).

CBA’s Treasurer did the right thing launching at a proposed spread of 75 basis points. Unprecedented book demand 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 wide of other estimates that made the deal look cheap. As it happened, the bond performed well on the break, tightening in to as much as 66.5 basis points before settling at 68 basis points.

Everyone was, therefore, relatively well served by the results: the issuer got the cheapest 5-year senior money in Aussie dollars in the post-GFC but pre-COVID period (there have been cheaper deals since March 2020, such as NAB’s 5-year bond that printed at 41 basis points in August last year) while investors were rewarded with performance.

One interesting feature of this transaction was the unusually large, $900 million fixed-rate tranche. Since APRA has required super funds to benchmark their fixed-income performance against the fixed-rate Composite Bond Index, capital has gradually started drifting away from floating-rate into fixed-rate strategies. Prior to the GFC, the majority of Australian bond issues were in fixed-rate format.

Yet the introduction of liquidity rules that allowed banks to buy one another’s bonds via the $140 billion Committed Liquidity Facility meant that there was a shift towards issuers providing floating-rate product, which was preferred by banks that like to hedge back to a floating-rate return.

The recent closure of the CLF reduces the ability of banks to buy each other’s bonds and hence the demand for floating-rate securities, all else being equal. Combined with growing super fund demand for fixed-rate securities that minimise tracking error to the Composite Bond Index, Australian investors should be welcomed by much more fixed-rate issuance than we have seen in recent years.

And 2022 is certainly a big one for corporate bond maturities in Aussie dollars: some $81 billion come due for repayment.

It is important to note that there will still be some 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 as a substitute for government bonds. LCR banks are now only allowed to hold government bonds.

And the demand for government bonds will be significant: on our modelling, banks have to buy about $408 billion of government bonds over the next few years as the CLF comes to a close, balance-sheets continue to grow (driving regulatory liquidity needs), and the RBA destroys over $188 billion of digital cash as the banks repay the Term Funding Facility and bonds mature off the RBA's balance-sheet. (This digital cash is currently included in the banks' LCRs and will evaporate over time.)  

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