If the Bond market is right, mortgage costs are about to double

The market entered today’s decision not completely sure which way the RBA would go. Futures had factored in an official rate of 0.21% by the end of the day. As it turns out the RBA has raised rates by 0.25% to 0.35%, accompanied by some hawkish language around inflation and wage expectations. However, whether the RBA raised rates today or later is probably a moot point. An official rate of 0.4% was fully factored in for June. As investors, what we can be sure of is interest rates will continue to rise. Prior to today’s release, the market was expecting a terminal or peak rate of 3.5% by October 2023, that has increased to 3.6%. The market is also expecting the rate to be higher at the end of the year at 2.8% versus 2.6% before the rate increase.

The RBA needs to tread warily. An official rate of 3.5% would see mortgage rates roughly double in Australia. As shown on the below chart, the percentage of income applied to paying interest (green line) will move from around 5% now to close to 10%. Clearly, highly indebted households will be under significant stress.

Household Indebtedness and Sensitivity to Interest Rates

The RBA is responding to inflation surprising on the upside for Q1 22, with underlying trimmed mean inflation now running at 3.7% YoY, while headline inflation printed at 5.1%. The underlying QoQ increase of 1.4% was the highest number since Q4 1990. Sticky inflation pressures from global supply chain issues and commodity prices suggest that inflation will continue to overshoot the RBA’s 2%-3% underlying target. That said, we expect headline inflation to peak in H2 22, probably around the 6% mark.

The Q1 inflation number showed a broad spread of cost rises across categories, with education, transport and food seeing the largest increases. The key going forward, as to whether the market has factored in enough rate rises, is how wages develop. To date, wages have been reasonably well behaved at the aggregate level with the wages price index at 2.5%. This reflects the structure of the enterprise bargaining system and the time it takes for renegotiation to come due and for that negotiation to be concluded. Clearly, that can change with unemployment set to fall below 4%.

Markets have moved quickly to factor in the reality of stickier, less transitory inflation. Three year bond yields are now paying a yield of 2.9%, almost double what it was a month ago. It was only on March 11th that Governor Lowe said, “it’s not guaranteed but plausible that rates will go up in 2022.” That hesitant language is out of date already.

In terms of what it means for portfolios, investors need to ask if the market has factored in all the inflation and rate rises to come. The answer to that question will inform us as to whether bond yields have or are about to peak. We don’t have the answer to that, mainly because the Ukraine war has created massive disruption and uncertainty in commodity markets. Also, the Chinese policy of full Covid lockdown in major cities is disrupting supply chains.

If yields have peaked, certainly the sell off in bonds will be finished or close to finishing. Also, the correction in equities will be mostly done. We say “mostly” done because rate rises by central banks are aimed at slowing the economy, which in turn negatively impacts company earnings. Company earnings are a lagging indicator of the economy and will continue to be impacted by official rate rises. That said, we don’t expect a recession in major markets. The New York Federal Reserve puts the probability of a recession in the US at 9.1%. Without a recession, equity returns will likely start recovering but at a subdued pace at least initially. Analysis by Jonathan Golub our US strategist shows the average return on the S&P500 after a first rate hike is 9% p.a for 3 years using data since the seventies.

For now, we are positioning client portfolios with a neutral bond weight but short duration. That means bond portfolios are skewed to short dated securities that are less impacted by inflation and changes in yield. We have a mild overweight to equities, largely because we don’t see recession. Of course, that view can change, if inflation is stickier and higher than expected, central banks will have to be more aggressive which could cause a short lived recession. Cyclicals tend to do better in the current environment which we express through an overweight to Australia with its large mining sector. As a hedge, we also have a positive view on the healthcare sector which tends to do better in times of uncertainty. We also recommend clients have a full allocation to those alternatives that don’t have a strong correlation with listed markets such as private credit, private equity and hedge funds.

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