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TIM HEXT: Where fixed interest opportunities are emerging

Where are the opportunities emerging in fixed interest? Here are the latest insights from Pendal’s head of government bond strategies TIM HEXT

SO FAR 2022 has been an extraordinary year for markets.

This past week was perhaps the first where you could draw breath. 

I am normally hesitant to forecast too far ahead given elevated uncertainties. “Conviction” is generally a positive word, but at times like this the negative simile of “entrenched” can be dangerous.

So let’s summarise where we are up to (at end of Monday, May 16):

Data pointMarket Pricing
Cash rates — Dec 20222.7%
Cash rates — Dec 20233.6%
3-year govt bond2.83%
10-year govt bond3.38%
5-year inflation break-even (implied inflation)2.55%
10-year inflation break-even2.35%

Several things stand out in the above numbers.

Find out about

Pendal’s Income and Fixed Interest funds

First and most importantly the RBA is tightening because inflation is now well above its target band — and likely to stay there until mid-2024.

Below are our best guesses for the headline inflation rates going forward. They are conservative and risks are probably to the upside.

Period  Estimate Quarterly Headline CPIEstimated Annual Headline CPI
Current (Q1 2022)2.1%  (actual)5.1% (actual)
Q2 20221.2%5.6%
Q3 20221.1%5.7%
Q4 20221.3%5.7%
Q1 2023 0.9%4.5%
Q2 2023 0.8%4.1%
Q3 2023 0.8%3.8%
Q4 2023 0.7%3.2%

The fuel excise relief pushes Q2 2022 down 0.4%. But Q4 2022 gains back 0.4% when the full-rate duty returns (if indeed it ever does).

Clearly forecasting inflation over a year out involves some guesswork.

We assume goods prices moderate with some supply chain easing but service prices continue to rise above target with wages and strong employment.

When we look at the two tables above, the most glaring mispricing or opportunity is in 5-year inflation bonds.

Current breakeven pricing — ie the inflation rate that would make you neutral about owning them versus nominal bonds — is near the RBA target of 2.5%.

However for at least the next two years CPI is averaging close to 4.5%.

Unless you think inflation in the following three years will be around 1%, this is just wrong. And we haven’t even included the extra carry from owning these bonds.

A brief lull in inflation concerns has seen these 5-year inflation bonds cheapen and we have been adding them to our nominal portfolios.

Market expectations

As for market expectations on cash rates, like most observers I think they are a bit too high.

I think they will get to 2% this year, not 2.7%.

By mid next year inflation should be moderating, so it’s unlikely they will need to push above 3%.

Needless to say the mortgage fixed-rate cliff and variable rates 3% higher should be enough to drop the economy down a few gears. We get wage and employment data in the days ahead which will again recalibrate expectations.

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

About Pendal Group

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

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This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at May 17, 2022.

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