Fixed interest: Check your ‘duration’ settings before inflation turns

Fixed interest investors should get their portfolio settings right now, before US inflation tops out and starts falling in the second half, says Pendal’s TIM HEXT

• Markets set to trade in narrow range
• Inflation to move quickly lower in second half
• Find out about Pendal fixed interest funds

FEELING moody? It’s understandable says our head of government bond strategies Tim Hext.

Right now, US inflation reports are resetting the mood of investment markets every month, says Hext.

“The mood runs for about a month or so until the next set of numbers.

“Central bank officials in the US and Australia come out and express concern if the numbers are too high. Then they warn they’ll have to do a lot more.”

On the other hand, when inflation data is lower – like late last year in the United States – investors start thinking the rising interest rate cycle is nearer the end.

“We’re going to be in this environment for the first half of this year and we are going to be range-trading as the narrative goes backwards and forwards,” Hext explains.

But the uncertainty won’t last – and investors should be ready, says Hext.

“By the second half of the year, we are going to get a much clearer picture and we are going to see that inflation hasn’t just topped out but is coming down.

“Inflation could head back towards central bank target ranges faster than they think.”

Inflation to fall this year

Pendal’s income and fixed interest team estimates inflation will fall towards 4 per cent by the end of 2023. That compares to the Reserve Bank’s forecast of 4.75 per cent.

“The Reserve Bank is going to be pleasantly surprised by inflation,” Hext says.

“In this current March quarter, the number will still be higher because of utility charges, but then in the second, third and fourth quarters, there’s a chance we get readings below one per cent.”

Goods inflation is weakening, in large part because supply chain disruptions during COVID is broadly over. Services inflation continues – about two-thirds of the way through, Hext says. That’s why the inflation data remains elevated, and choppy.

“Investors will start believing the soft landing story,” Hext says, whereby the economy slows bringing inflation down, but doesn’t go into a recession.

“There is a risk though. Central banks might feel they haven’t done enough, particularly the US Federal Reserve.”

Hext believes there will be a couple more interest rate hikes in Australia in coming months, starting next week at the Reserve Bank board meeting.

As to how far the official cash rate set by the Reserve Bank goes, Hext says ten-year bond rates normally top out around the same level as the cash rates peaks.

“That’s where we are now. We are around about 385 basis points for ten-year bonds.

“The big message is that investors have a bit of time on their hands now, but things will start to move quite quickly by the middle of the year.

“So investors should be getting their duration sorted.”

That means checking the duration of your fixed income investments and their sensitivity to interest rate changes.

“Investors should be getting back to at least where their model portfolios tells them they need to be in the medium-to-long term.”

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal Group

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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