Central banks are changing their tone, and this is how to read it

I share my views on monetary policy, inflation, and why I believe there’s a strong case for increasing allocations to bonds

The Reserve Bank of Australia (RBA) just hiked rates for the tenth time, bringing the official cash rate to 3.60%. Meanwhile, the market is now pricing in for the US Federal Reserve to lift rates above 5.5%.

But while the hiking cycle continues, the tone from central bankers has begun to change. Expect central banks to proceed from here with more nuance in their words and actions.  

In this month's trade floor update, I sit down with PIMCO Account Manager David Orazio. We discuss how investors should interpret the latest moves and guidance from central banks, what the future of monetary policy holds, and how the bond market is responding. 


Text on screen: David Orazio, Account Manager

Orazio: Welcome to this month's trade floor update. Today, I'm joined by a portfolio manager Aaditya Thakur. It's great to have you here today.

Well, another month. Another rate hike by the RBA. That's ten in a row now, bringing the cash rate to 3.6%. How high do central banks need to go in their fight against inflation? And what is the market pricing in terms of cash rate expectations?

Thakur: Yeah, it's only March and we've already had so much happen this year. We've had some more resilient economic data globally, less so here, but definitely globally, and that has forced up the pricing of central bank hikes around the world. So as we sit here, the market is now pricing the US Fed to raise their cash rate to a little above 5.5%.

The ECB to get to around 4%, the Bank of England to get to 4.75%, and closer to home the Bank of New Zealand is priced to get to 5.5% and the RBA to get to 4%. So these are, what bond market pricing is already implying in current valuations. So not only are these levels of cash rates very high historically over the past ten, 15 years, but we're now unambiguously in a tight, restrictive territory.

So I think from here we're going to start to see a little bit more nuance from central banks, particularly from the RBA. And there was some evidence of that already in the statement that accompanied the interest rate hike. So they did soften the language around the need for multiple further hikes, providing them with some optionality. You know, if in case they feel they need a pause, they did explicitly say that inflation has likely peaked here based on more timely monthly indicators.

And they also mentioned that wage growth is still in line with their inflation target. And that window for a price wage spiral is really closing. So I think investors need to keep in mind not only that, the final destination, but also look out for these signs of moderation and nuance because they're signs that we're getting close to the end of the hiking cycle, which could be as close as the middle of this year.

And that's really a time when bonds really start to outperform, particularly on a risk adjusted basis.

Orazio: I want to pick up in your comment on inflation AT, very hot topic with our clients at the moment. Obviously everyone feeling the pinch in terms of an increase in cost of living expenses. What's our outlook for inflation in 2023?

Thakur: Yeah, I think for many people it's really the first time in their adult lives that they're feeling the impacts of inflation in the kind of day to day life. So it's easy to get lost in the noise and the emotional response. But when you look at the data, what we can see is, and it might surprise a lot of viewers, you know, core inflation in the US actually peaked around February last year.

So that's 12 months ago now. And it has been slowly coming down. And this is really the point. The uncertainty around inflation this year is very different to last year. Last year it was about how high will inflation get this year, The uncertainty around inflation is how quickly or slowly is it coming down? Because that will relate to how quickly or slowly central banks can ease monetary policy back to a more neutral setting.

But the direction of travel is down, and that's helping to keep a lid on volatility in bond markets and help support a recovery in bonds as we reach the end of the hiking cycle.

Orazio: Now, there's a lot of talk about what type of landing that the global economy will experience in 2023, whether it's a soft landing, a hard landing, and even in the last couple of weeks, I heard a new term no landing. So how do bonds perform in each of these scenarios?

Thakur: Yeah, I think we've got to come back to, valuations. Valuations had one of the biggest adjustments for bonds last year and really that should demand a response from asset allocators. When we look at forward longer term return expectations for bonds, they're now not too far off equity like levels, but at a third to half the volatility.

So from a strategic asset allocation point of view, that really underpins our case for a higher allocation to bonds. But even for those who are remaining a little bit skeptical, we should think about some possible scenarios because given the starting point of yields and carry in portfolios today, those set of possibilities are very different today than they were last year.

So even on the downside, let's take the RBA. The market pricing is for the RBA to get to 4%. Now let's say there was some new information. The market was shocked and suddenly priced in the RBA to get to 5%, so that's a full hundred basis points above current market pricing. That would imply mortgage rates of 7 – 7.5%, which I think everyone would agree would be very painful for the economy in that kind of scenario.

Expected returns for a core bond strategy over a 12-month horizon would still be close to flat because the marked to market impacts of higher interest rates would be offset over those 12 months by the carry of the portfolio over the 12-month period. So a downside scenario would be kept close to flat. And on the upside, if recession risk do suddenly come back on the table, then you could very easily see, bond fund strategies return very high single digit returns.

So if you think about a probability weighted outcome between those scenarios, if those two outcomes kind of bookend the range of possibilities, then something in the middle is a really positive picture for bonds. And that's really underpinning, our case for increasing allocations for bonds, particularly for those who have been structurally underweight.

Orazio: Thanks. I really appreciate your thoughts today. Now, there's a lot to unpack there. However, there are signs that the heavy lifting that central banks have done over 2022 is starting to slowly make its way through the economy. And that's good news for bond investors. We have yields at decade highs and we believe over 2023 that bonds can revert to their traditional role in portfolios of delivering resilient income, defense and diversification for portfolios over 2023.

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Aaditya Thakur
Portfolio Manager

Aaditya is a senior vice president and portfolio manager focusing on Australian dollar and global portfolios. He has 13 years of investment experience and holds a master's degree in commerce (finance) from the UNSW. He is also a CFA charterholder.


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