This is how much the RBA will hike rates in 2022 - and this is what we will do

Charlie Jamieson

Jamieson Coote Bonds

The outbreak of conflict between Russia and Ukraine sent commodity markets rapidly higher, further fueling inflation concerns in the near term via the energy channels. 

Bonds initially enjoyed a flight to quality movement as markets were concerned over the prospect of an escalation to global or nuclear conflict. But as the days passed and NATO refused to be drawn in, markets pivoted to expect conventional warfare in a contained and localised battle. This removed the flight to quality from bonds and saw risk markets enjoy a stunning recovery over the month. 

The subsequent lift in inflation expectations via the energy channels shifted the rhetoric of the US Fed - suggesting it is intent on destroying demand in the economy to cool inflation pressures. 

The US Fed will now be taking markets on their fastest hiking cycle of recent times as the economy is already cooling rapidly from diminishing stimulus and higher energy costs.

During the month, the Reserve Bank of Australia (RBA) finally started acknowledging what markets have been suggesting for some time – that interest rate hikes will be required in the calendar year 2022. 

In the following video, I outline our base case for how the RBA will likely respond. I also discuss what the recent moves in the credit market mean for investors seeking to rebuild liquid defensive exposures. Watch the video below to hear more.

Transcript

Hi, I'm Charlie Jamieson, chief investment officer at Jamieson Coote Bonds. And this is a review of markets in March 2022. What an extraordinary month of March, obviously we've had to deal with a lot of issues with the Ukraine - Russia war, which caused absolute chaos in global commodity markets. Plus we've also had a US Federal Reserve, which has become incredibly hawkish fighting the very large amounts of inflation, to which particularly the US economy is currently being exposed. And that's seen bond markets really on the back foot, quite violently throughout the first quarter and particularly in March with expectations now that the Federal Reserve needs to hike rates very, very quickly across this year. They no longer really have the choice to dampen demand around the edges. They really need to absolutely destroy it to bring inflation back under control. What is happening is really quite historically extraordinary. 

Since we've had the first rate hike from the Federal Reserve in March, 13 days later, we've got an inversion in the US curve in the very widely followed two year versus 10 year bond relationship. And that relationship has had a perfect predictor of recessions in the following periods of differing timeframes. 

This cycle is clearly so different. Everything is happening so much faster. For instance, in the last cycle in 2019, it wasn't until the ninth interest rate hike that we experienced that curve inversion and that curve inversion is basically suggesting that in time the federal reserve will need to cut rates to put their foot on the accelerator a little bit. Clearly, the Fed is telling us they're going to be jamming their foot on the brake, really hard trying to slow the economy down quickly, but the markets are then pricing in rate cuts thereafter. 

In 2006, it took until the 16th rate hike for the curve to invert. So for this to be happening after only 13 days from the first rate hike, it really is very, very extraordinary indeed.

And as much as we have been pricing in a higher rate-hiking pathway for central banks, those expectations of cuts thereafter have always been pretty much part of that pricing. And so now the market is suggesting that towards the back part of 2023, the Federal Reserve will actually be cutting rates. And this is one of the reasons we think that risk assets are holding on really well. I guess, after a very tumultuous start to the year, the risk complex is broadly doing pretty well, despite central bankers telling us that they've got this very substantial hiking pathway that we're going to have to go through as a global marketplace. 

In Australia, Australian bonds have obviously had a huge sell-off in following those US kinds of lead from the Federal Reserve. We just don't think that the RBA is going to get nearly as far as the US Federal Reserve, nor do they need to. We don't have the same kind of inflation issue here, but clearly, rates are going to be moving higher over the course of 23. 

We think that they'll get up towards 1% by the end of the year and follow on with a couple more rate hikes into next year, into 23 before, again, a pause. 

But the bond market over the course of March suggested that we'd get up to around 3.5% for an RBA cash rate. That is just really extraordinary tightening. And I think we can all think if we join the dots, what would actually happen to the economy in that process? Clearly, discretionary income would be far lower through the property funding mechanism. We know that things like property and construction would be very challenged. So it's of course it's possible, but it's just not probable. We think that anybody wants to take the economy to that place and cause a huge amount of pain for folks. 

We haven't had a rate hike here for more than 10 years, let alone talking about four, six, eight or 12 as the bond market was suggesting. It just seems a bridge too far. So we feel that bonds will actually start to do quite well from here on because we've just got so much priced into those markets and there's been such a release in terms of the way the market has been constructed. Obviously, a lot of folks have been exiting bonds and we actually think that, at the end, that will leave quite good value there, but we need the whole complex to stabilise. 

Certainly, when we talk to a lot of our bigger clients, they're very excited and interested in rebuilding their defensive allegations, having been very underweight, but everybody wants to see that period of stability before they might move forward and look through into that.

When we think about inflation, obviously we had huge moves as a result of this war and conflict and who knows how that will ultimately turn out. We think that it'll probably last quite a while longer yet, sadly. But it's interesting to look at some of these commodity moves that have been, expectations have been so high for their performance. As we're filming today, oil is at $98. It was at $103 on the 1st of March. If we look at something like wheat, which is so important from Ukraine and from Russia, it's around about where it was on the 1st March, but other things are clearly a lot higher, some base metals, natural gas. And it's going to have a big impact across the inflation spectrum. 

Before the outbreak of war, we had expected inflation would start to come down quite quickly because of the base effect and for big powerful movers, things like used car prices, which have actually been going backwards for most of the year now. 

Now they were the single largest driver of inflation last year in the United States. Their price went up 40.5%. This year in January they went flat. In February they were minus 2.2. And we've just got the March data at minus 3.8. So what had been incredibly powerful in adding to the inflation story has gone mute, has now gone negative. And there are other things that we can expect will look like that as we start to hit the brakes on the economy and destroy some of this demand. 

So we absolutely expect that hiking rates very quickly will bring inflation down. It will kill inflation, but it might just kill the economy as well. 

And that's what we've got to search around for and be very careful. The Fed is talking a lot about trying to engineer a soft landing. We know historically that hasn't worked very well.

They tend to hike until something breaks, and there's a very complex series of feedback loops inside the economy. I often talk about the end of 2018, when we had the end of the hiking cycle there, big sell-off in the bond market. And that froze global credit markets in November 2018 and before equity suffered in December 2018. So there is a very sensitive way to go about this. I've said before, it's a bit like central bankers having to walk down a razor blade. They've created this environment, which is very difficult to extract themselves from, and a lot can go wrong very quickly. So caution is absolutely suggested for a lot of folks over 2022, as we've been saying throughout the year.

For Australia, clearly, as the federal reserves start to hike and hike quite quickly, their front end bond yields will become very high. And that tends to see a lot of capital move towards the US dollar. It's called interest rate differentials. 

And certainly our expectation is that the Federal Reserve will hike a lot faster than the RBA will be able to deliver hikes to the system. We still think that the RBA will get going in August and get to about 1% as we said by Christmas. 

Whereas the Fed is clearly in fast forward, we've written a few times, it needs to be hiking in increments of 50 basis points. And we expect it will go back to back 50s from here on, and they really need to start to get moving and get back in front of their curve, which they've clearly fallen behind. They should have been hiking last year as the economy was recovering from COVID.

So that combined with potentially a peak in the commodity story for now. Might see a little bit more support for the US dollar and the Aussie, which has clearly been rising through a lot of this global conflict and turmoil, which is a bit unusual. Could come under a little pressure as a result. So something to think through again, if you do have FX exposures offshore and a dynamic hedging programme, just to think through what is going to occur. Almost with certainty, the Federal Reserve will be going much faster than others. And that generally bodes very well for the US dollar. Thank you very much.

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Charlie Jamieson
Chief Investment Officer
Jamieson Coote Bonds

Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...

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