What rate hikes mean for mortgages and household spending

Bond yields are backing up big time – the US 10yr Treasury yield is up by more than a percent now sitting above two and a half percent. The Australian 10yr government bond yield is up more, kissing 3% recently.

So where to from here?

I think it's time we step back from the noise a little and focus on valuations. So when we look at the cash rate in New Zealand, Australia, Canada, and most parts of the developed world, think neutral will come in around two and a half or three percent.

We think neutral is at the 2.5% level but the majority of this rate hike cycle has already been priced in. Currently, the market's pricing in a cash rate well above three percent and that's signalling that central banks are going to have restrictive monetary policy conditions next year.

Yields can drift a little higher from here, but we're more arguing the degree of how tight central banks need to go now, not going from zero back to somewhere near neutral.

For homeowners, this means average mortgage rates in Australia for a standard variable package used to be at two point something. Now the market's telling you they think the interest rate will have a five handle in front of it.

Portfolio positioning

We've been trading short duration with slow drips coming as rates creep higher. If you are looking at cash rates being 3% and a 10yr yield attracting 3%, maybe that can go a little bit higher.

And so we certainly think that the longer tenors have some flexibility to drift a little higher from here. But as I said, we still think the vast majority of the move has already been made. In terms of places where we prefer to own duration a little closer to home.

So places like New Zealand where interest rates or monetary policy is pricing well through 3% closer to 4% now in New Zealand and in Australia, getting close to 3.5% next year. As yields rise from here, we will add to our duration trade.

Opportunities in the credit market

As central banks are looking at lifting interest rates, they're also withdrawing a lot of other support mechanisms they had in place. In Australia, that means losing the term funding facility.

If you look at just how far bank spreads have moved, that's a really attractive place at the moment.

Here in Australia 18 months ago, the major banks' three year senior unsecured bonds were trading at around 50 basis points or below. 

That's a level, not a spread.

Now they're trading up at 3.3%. With inflation somewhere around three percent as of the last official read, there are much more opportunities to construct bond portfolios that have reliable income above inflation now. So I’d certainly pinpoint global financials as being one of those opportunities. 

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