RATE HIKE expectations turned up another notch last week after a higher-than-expected US CPI and a 75bp lift from the US Fed.
Three-year bonds in Australia rose from 3.12% to 3.62% — another 50bp move.
To put this in perspective that was more than the entire market range in 2018.
By the end of last week terminal cash rates were priced at 4.25% in mid-2023 and 3.8% by the end of this year.
This is well ahead of even a hawkish RBA’s expectations. Comments from Phil Lowe suggested they were too high even with the expectation of inflation hitting 7% late this year. This saw a small rally today (Tuesday).
Clearly the near-term mission of the RBA is to get back to a neutral 2.5% cash rate over the coming months.
Very little will stop them.
However, the broader debate is just how resilient the household sector — and to a lesser extent the business sector — is to these higher rates.
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The RBA quotes higher savings as an important buffer. But it will not be the median household in trouble when mortgage rates hit 5-6%. Mortgage stress will fall on young families with a high propensity to spend — families without any savings buffer.
The question of whether bonds are a buy at 4% is being increasingly asked.
Let’s break it down into inflation and real yields.
For all the panic and commentary on inflation this last week, market expectations of longer-term inflation have not moved.
In fact a 10-year inflation swap is still at 2.5% — a vote of confidence that the RBA will hit its inflation target across the decade.
The rising nominal yields were all driven by rising real yields. This is not consistent with the view building increasingly in risk markets of a US recession in 2023.
In Australia 10-year real yields are now around 1.65%. This is your risk-free return above inflation… That is, you are protected for inflation plus you get an extra 1.65% and no credit risk.
Sounds quite compelling and real yields are at levels not seen since 2014.
Real yields are supposed to represent the productive capacity of the economy to generate more return from existing resources, meaning borrowers are happy to pay a return above inflation.
Maybe there is a surge in productivity building. There have been some encouraging signs in business investment recently, though higher rates may temper that.
The other factor that drives real yields is simply the level of cash rates versus inflation, or the real cash rate.
These are still sharply negative, though on future expectations markets are looking for Fed Funds around 3.5% in a year and forward inflation expectations suggest an inflation rate at a similar level.
In Australia it is harder to see a cash rate well above inflation for at least the next two years, though they may also eventually converge around 3.5% in early 2024.
This all makes real rates look like good medium-term value.
If you buy the market’s medium-term view that inflation will come back into the RBA band, it means bonds above 4% are cheap.
Given moves like the last week of trading this may be hard. But for asset allocators and portfolios underweight bonds it does suggest it’s time to get back to neutral.
If you buy into the whole recession view then clearly it is time to go overweight. But for us, momentum is still problematic in the short term.
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.
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