Published in The Australian - 6 November 2023

After another wild month in markets, some clarity in the outlook has been restored as the US Federal Reserve held interest rates steady in its November meeting, helping asset markets recover slightly from a bruising period of underperformance. After reaching the lofty heights of five and beyond in many high-quality government bond market yields (including Australian 10-year bonds), this extended pause in global benchmark interest rate hiking will probably mark the top of the interest rate cycle for rate hikes, with markets now considering the evolution of the US Federal Reserve funds rate into 2024.

On average, the time from the last interest rate hike to the first cut is only eight months. However, there has been little average about this unique post-Covid cycle. Should the averages hold, that would suggest rate cuts as early as March 2024. While it is easy to get caught up in the day-to-day speculation, for long-term investors the set-up is compelling. We continue to see many clients building laddered exposures to fixed income to remove the day-to-day noise and average in over time.

In that regard, the yield available on fixed income looks mouth-watering when compared to the post-Covid average – currently close to 5 per cent in many government bonds, when compared to post-GFC averages of around 2.5 per cent or a pandemic low of 0.4 per cent in the benchmark US Treasury 10-year bond yield. Amid elevated yields that outpace cash returns, it’s only the short-term volatility that is precluding many institutional investors from adding more to their fixed income allocations, as speculators continue to whipsaw the market. With medium and long-term valuations significantly restored, the short term remains challenging to predict given the extraordinary spending of the US government.

US government spending remains extremely elevated and with an election year coming in 2024, significant budget deficits look set to continue despite being very late in the economic cycle. This generates an increasingly difficult funding program for the US government that requires enormous issuance of government bonds and treasury bills to satisfy cashflow requirements.

This program, and its mix of short-dated treasury bills or long dated bonds, has been the subject of much discussion in markets, leading to higher US bond yields making supply concessions to absorb the higher funding issuance needs. As yields have risen over October, they have swept many other markets to weaker outcomes as the global cost of capital rises (benchmarked off the US 10-year bond yield), changing valuation metrics and investor appetite for risk the world over.

Given the highly credible alternatives of high-quality fixed income, such as government bonds at 5 per cent and many high-quality corporate bond names at 6.5-7 per cent, as well as high yield (often described as junk bonds) offering higher yields albeit with added credit risk, it’s evident that not all bonds are created equal. The hurdle rates for other more traditional asset classes are now very high. Anticipating economic weakness into 2024, we expect a flow of funds rotation aimed at capturing these elevated fixed income yields. It is important to remember the “fixed” nature of the cashflow streams, which provide portfolio certainty for retirees, as opposed to company dividends which can be variable throughout the economic cycle.

While the US and European central banks are firmly on hold after the large rate increases of 2022-23, conversely, in Australia the markets are now expecting a further interest rate rise on Melbourne Cup Day after slightly higher inflation outcomes were reported in the October data.

Sadly, while hiking interest rates will bring additional pain for those already in mortgage stress, further killing demand and reducing discretionary spending in the economy, it will do little to temper the drivers of this inflation acceleration such as a rise in petrol prices (subject to global oil markets), utility bills (wholesale markets have already softened) and insurance costs (reflecting higher climate change risks). The rate hike decision hangs in the balance, yet to maintain credibility – something notably absent from the RBA during much of the hiking cycle – the central bank ought to proceed with the hike.

Australia has witnessed a positive trend in its quarterly inflation data, with a decline from 7.8 per cent in the December 2022 quarter to 7 per cent in the March 2023 quarter, further dropping to 6 per cent in the June 2023 quarter, and most recently, registering 5.4 per cent in the September 2023 ­quarter.

However, there’s a growing sense of impatience as these figures have not aligned closer to the normalised outcomes observed in both the US and European inflation markets.

Should the RBA hike as markets expect, it can always quickly rates lower into 2024, but it is important to convey to consumers and markets that it is a credible inflation fighter.

What is surprising is the relative ‘‘cheapness’’ of Australian government bonds, trading significantly above any forward RBA cash rate expectations. This is at odds with all major developed bond markets except Japan (a unique example), where similar economies to ours enjoy significantly higher bond yields when compared to their current cash rates. In Canada, it is some 1.15 per cent richer than the cash rate. Similarly in Britain it’s about 0.87 per cent richer than the Bank of England cash rate. In Germany, its 1.79 per cent higher than the European Central Bank rate. In the US, despite concerns over its budget deficit, it’s still 0.83 per cent more expensive than Fed funds rate.

Little old Aussie 10-year bonds are 0.7 per cent cheap (not richer) than the current RBA cash rate! Perhaps the lure of 5 per cent government guaranteed continuously compounding cashflows, along with instant liquidity (think lock-ups on other products frustrating folks who wanted to buy deeply discounted equities during the Covid period) will help address this cheap valuation pocket for the asset class.