UBS Australian Bond Fund (SBC0813AU) Report & Performance

Australia’s sovereign yield curve steepened over July with the front end declining and the long end rising in-line with the offshore bond markets due to some signs of cooling core inflation in both the US and Australia. Australian 3-year Government bond yields fell -18bps, ending the month at 3.87% while the 10-year Government bond yields increased 4bps to end the month at 4.06%. Australian 10-year Government bonds outperformed US equivalents with the spread ending the month at 10bps from 18bps the previous month. Credit spreads tightened (Bloomberg AusBond Credit 0+ index tightened from 127bps to 125bps). The Bloomberg AusBond Composite 0+ year Index returned 0.52%. In early July, the RBA left the official cash rate target unchanged at 4.10%, citing the need to provide the Board with more time to assess the economic situation.

Market pricing prior to the meeting implied slightly less than a 50/50 probability of a 25bp change in the policy rate. In terms of inflation, the Board didn’t change the wording that “inflation in Australia has passed its peak” and that it is “still too high”, although adding a dovish tone that “monthly CPI indictor for May showed a further decline”. As for forward guidance, the Board kept its wording that “some further tightening of monetary policy may be required” and reiterated data dependency. Later in the month, the Minutes of the RBA’s July Board meeting showed the Board considered two options: to hold the cash rate steady or hike by 25bps. It noted the former case is the stronger one on the grounds of “uncertainly around the outlook and the significant increase in interest rates to date”. In contrast, although the RBA delivered a 25bps rate hike at the June meeting, the Minutes noted the two options were “finely balanced” and that there was “considerable uncertainty regarding the outlook”.

The domestic economic data over July was mixed. In the same manner as last month, the labour market showed little signs of easing as the unemployment rate declined to 3.5% and surprised the market consensus of 3.6%.

Employment change was stronger than the market had expected too – reconfirming a still resilient labour market.

The monthly and quarterly CPI prints, however, showed some additional cooling. The monthly June CPI was in line with market expectation printing 5.4%, declining from 5.6% the previous month. Later in the month Q2 CPI release came in softer, with headline inflation coming down to 0.8% QoQ from 1.4% the previous quarter, and the trimmed mean core CPI at 0.9% QoQ from 1.2% in Q1 versus the consensus of 1.1%.

Australian Government bonds sold-off sharply over June in-line with offshore bond markets due to persisting concerns over sticky core-inflation and a still resilient economy in the US. Australian 3-year Government bond yields rose 68bps, ending the month at 4.05% while the 10-year Government bond yields rose 42bps to end the month at 4.02%. Australian 10-year Government bonds underperformed US equivalents with the spread ending the month at 18bps from -4bps the previous month.

Credit spreads tightened (Bloomberg AusBond Credit 0+ index tightened from 135bps to 127bps). The Bloomberg AusBond Composite 0+ year Index returned -1.95%.

In early June, the RBA raised the official cash rate target by 25bps, another surprising rate hike against the consensus and market expectation which only priced in 8bps of tightening prior to the meeting. 20 out of 30 economists surveyed by Bloomberg predicted a pause for this meeting. The RBA’s main reasoning for this surprising rate hike was to “provide greater confidence that inflation will return to target”. The RBA was mainly concerned over the stubborn services inflation and the rising unit labour costs. In fact, the April monthly Consumer Price Index was stronger than expected printing 6.8% YoY from 6.3% prior. In terms of forward guidance, there was no major changes in the language that “some further tightening of monetary policy may be required”.

Elsewhere on the domestic economic data front, the Australian Bureau of Statistics unveiled its latest quarterly GDP statistics which was softer than expected (Q1 SA 0.2% QoQ vs C 0.3%). GDP per capita fell 0.2%, the first contraction since December 2018 if one excludes the periods affected by COVID-19. Household spending also continued slowing as it rose 0.2%, the weakest quarterly result since the decline recorded during the COVID-19 Delta-variant lockdowns in September 2021. The remaining domestic economic data series were mixed. The labour market showed little signs of easing as the unemployment rate declined again to 3.6% while the participation rate increased to 66.9% from 66.7% the previous month. The monthly May CPI, however, surprised the market to the downside printing 5.6% compared with the consensus of 6.1%, declining from 6.8% the previous month.

Australian Government bond yields rose modestly across the term structure.

Australian credit spreads tightened over the month.

The RBA raised the cash rate target by 25bps in May.

Global markets wrestled with the dichotomies of continued strength in services versus weakness in factory activity, as well as receding US recession risk occurring alongside a loss of economic momentum in China. The yield on the 2-year US Treasury started the month at 4.01% and ended 39 basis points higher at 4.40%. The yield on the 10-year US Treasury ended April at 3.42% and stood 22 basis points higher at 3.64% at the end of May.

In the US, economic resilience continued in May, particularly in the labour market. The US non-farm payrolls report showed job growth exceeded economists’ expectations for the 13th consecutive reading, with a pickup in wage growth and the unemployment rate dipping to the lowest level since the late 1960s. Price pressures remain high, with both core CPI and core PCE inflation well above 2% and failing to meaningfully decelerate in recent readings (on a three-month annualized basis). The Senior Loan Officer Survey pointed to a modest tightening in credit conditions in the aftermath of regional bank stress earlier in the year. Importantly, institutions cited concerns over the economic backdrop as the cause of tighter conditions, rather than concerns about ability to access liquidity or capital adequacy. The White House and Republican House Speaker came to an agreement to raise the US debt limit through Jan. 1, 2025. This deal involves to a modest amount of fiscal drag in the coming years, but significantly reduces near-term economic and financial left-tail risk. In early May, the Federal Reserve delivered a 25 basis point interest rate increase.

In Europe, the composite PMI edged lower from April to May, as did investor sentiment. Industrial production more than offset February’s larger than expected increase with a bigger than expected decline in March. Retail sales declined for the second consecutive month. Revised data showed that Germany’s economy contracted in back-to-back quarters through Q1. The European Central Bank’s bank lending survey showed a further tightening in credit conditions, with corporate loan demand slumping due to high interest rates. In early May, the European Central Bank delivered a 25 basis point hike. President Christine Lagarde signalled that the central bank had not yet reached a sufficiently restrictive policy stance, and that more policy tightening would be in the offering. In the UK, the Bank of England hiked rates by 25 basis points, citing risks to inflation that were still skewed significantly to the upside, and no longer anticipates that the economy will fall into recession in the near-term. Wage growth remains elevated, and employment grew by more than anticipated in the three-month period ending in March.

In Japan, preliminary manufacturing and services PMIs came in above 50 for May. Capital spending rose 11% year-on-year as of Q1, far surpassing expectations for a 6% rise. Services inflation, which has been 0.5% or lower throughout the history of the series (excluding the impact of tax increases), is currently running at 1.7% year-on-year as of April.

In China, concerns about the vigour of China’s economic recovery mounted amid a slate of data affirming a material loss of momentum. Growth in industrial production of 5.6% year-on-year for April was quite weak, considering the Shanghai lockdown one year ago. The youth unemployment rate was over 20% in April, the highest in series history (going back to 2018). Activity in the property market has been weakening since the start of April. Sluggish imports underscored concerns about industrial activity going forward. Purchasing managers’ indexes painted a more mixed picture, with the CFLP Manufacturing PMI at 48.8 and the Caixin Manufacturing PMI at 50.9 in May.

Australian Government bonds remained largely flat over April in-line with offshore bond markets as concerns over the US banking sector became less acute with equities rising and market volatility subsiding. Australian 3-year Government bond yields rose only 6bps, ending the month at 3.00% while the 10-year Government bond yield ended the month at 3.34% just 4bps higher. Australian 10-year Government bonds underperformed US equivalents with the spread ending the month at -9bps from -17bps the previous month. Credit spreads tightened slightly (Bloomberg AusBond Credit 0+ index tightened from 148bps to 143bps). The Bloomberg AusBond Composite 0+ year returned 0.19%.

Global markets calmed in April after March’s bout of concern over the health of US regional banks and European financial institutions abated. Government bond markets were relatively stable in April. The yield on the 2-year US Treasury started the month at 4.06% and ended just 5 basis points higher at 4.11%. The yield on the 10-year US Treasury ended March at 3.49% and stood only 3 basis points higher at 3.52% at the end of April. The total return on the Bloomberg US Treasury index was 0.5%. The Bloomberg Pan-European Aggregate index returned 0.3%. US high yield bonds returned 1% and Euro high yield 0.5%.

Australian Government bonds rallied over March in-line with offshore bond markets as concerns over the banking sector mounted and markets quickly priced in rate cuts within this year primarily in the US. Australian 3-year Government bond yields declined 66bps, ending the month at 2.94% while the 10-year Government bond yields fell 55bps, to end the month at 3.30%. Australian 10-year Government bonds outperformed US equivalents with the spread ending the month at -17bps from -7bps the previous month. Credit spreads widened over the month (Bloomberg AusBond Credit 0+ index widened from 131bps to 148bps). The Bloomberg AusBond Composite 0+ year returned 3.16%.

In early March the RBA raised the official cash rate target by 25bps in-line with market consensus, the 10th consecutive hike to a level of 3.60%. Yields declined after the meeting as the market primality focused on the dovish language in the statement. The statement clearly stated that “monthly CPI indicator suggests that inflation has peaked in Australia”, and that there is “lower risk of a cycle in which prices and wages chase one another”. In terms of forward guidance, the statement amended “further increases” in the February statement to “further tightening” and refrained from using plural. The RBA would also assess “when” and how much further tightening is needed, implying a possible pause – which was delivered in the April meeting.

On the economic data front, the Australian Bureau of Statistics unveiled its latest quarterly GDP statistics which was softer than expected (Q4 SA 0.5% QoQ vs C 0.8%). GDP growth slowed in each of the last two quarters, and the 0.3% growth in household spending was the weakest quarterly rise since the delta-variant lookdowns in September 2021. Later in the month, the February labour force survey showed continuous tightness in the labour market. The unemployment rate fell again to 3.5% versus the consensus of 3.6%, still at historically low level. In terms of the monthly CPI series, inflation surprised to the downside in January at 7.4% YoY versus the consensus of 8.1%. The February CPI of 6.8% YoY was also below the consensus of 7.2%, mainly driven by a sharp decline in travel and accommodation prices, strengthening the view of market participants that inflation has peaked in Australia.

Australian Government bonds sold-off over February in-line with offshore bond markets against the backdrop of markets once more pricing in higher future policy rates due to unexpectedly strong US economic data. Australian 3-year Government bond yields rose 42bps, ending the month at 3.60% while the 10-year Government bond yields surged 30bps, to end the month at 3.85%. The spread of Australian 10-year Government bond yields against US 10-year Government bond yields turned negative again, ending the month at -7bps. Credit spreads tightened over the month (Bloomberg AusBond Credit 0+ year index tightened from 136bps to 131bps). The Bloomberg AusBond Composite 0+ year returned -1.32%.

In early February the RBA raised the official cash rate target by 25bps, the 9th consecutive hike to a level of 3.35%. The RBA’s reasoning for the decision was largely focusing on the persistence of high inflation. Notably, the decision came shortly after the Q4 CPI release which surprised forecasters to the upside with the RBA’s preferred core inflation measure – the Trimmed Mean Index – rising 1.7% QoQ (6.9% YoY). According to the RBA minutes, the board considered two options of hiking 50bps and 25bps, which was deemed to be hawkish given that in the last meeting the discussion covered the possibility of pausing rate hikes altogether. The forward guidance was seen as hawkish too as the statement emphasized “further increase in interest rate will be needed”, excluding the phrase from the Dec. meeting that “it is not on a pre-set course”.

Elsewhere on the data side, labour market and wages releases came in weaker than expected in February. The labour force survey showed that the unemployment rate unexpectedly increased to 3.7% in January versus the market expectation to hold steady at 3.5%, although still at a historically tight level. Wage growth also came in softer than expected in Q4 at 0.8% QoQ (3.3% YoY) versus expectations of 1.0% QoQ. Retail sales on the other hand rose to 1.90% later in the month, partially recovering the large contraction reported in December.