Bonds a buy?
Written and accurate as at: Jun 21, 2022 Current Stats & Facts
Inflation noise gets louder, but real yields move markets.
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). The near-term mission of the RBA is to get back to a neutral 2.5% cash rate over the coming months, but 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. The RBA quotes higher savings as an essential 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 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. 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 inconsistent 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 from inflation and 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 the level of cash rates versus inflation, or the actual 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.
It is harder in Australia to see a cash rate well above inflation for at least the next two years, though they may 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, bonds above 4% are cheap. Given moves like the last week of trading, this may be hard. But asset allocators and portfolios underweight bonds suggest it’s time to get back to neutral. If you buy into the whole recession view, it is time to go overweight. But for us, momentum is still problematic in the short term.
Tim joined Pendal Group in February 2017 with responsibility for managing Australian Bond portfolios. Tim has extensive experience in banking, financial markets and funding. Tim joined Pendal Group from NSW Treasury Corporation (TCorp), where he was General Manager, Funding and Balance Sheet, responsible for defining and executing TCorp’s funding programme and strategy. Tim’s prior experience includes senior positions in Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation. Tim holds a Master of Economics in Development from the Australian National University and a Bachelor of Commerce from the University of New South Wales.