What the RBA's latest hike means for markets?

Welcome to this month's trade floor update. The RBA has raised rates for the second month in a row, and we haven’t seen the end of it. It’s a good time to be a bond investor, but a scary time for mortgage-holders and markets that were very dependent on a zero interest rate environment. 

In this June 2022 Trading Floor Update, I discuss how rate rises will affect the path ahead for bonds, property and mortgage rates.

This transcript has been edited for length and clarity 

The RBA has raised rates for the second month in a row, what does that mean for bonds?

First thing is that the inflation backdrop has to result in the normalisation of interest rates. What we've seen so far is a 25bps hike followed by a 50bps hike, and I think that means there's clearly some urgency to get back to normal, but it doesn't really change the destination. So what is normal? We think normal is going to be 2.5%, give or take around 0.5%, depending on what happens in the real economy and with inflation down the track.

But we're on a pathway to around 2.5%. There are a few commentators out there that were hoping that wouldn't eventuate, but we do think we're on a pathway there. 

The great news for bond investors is that it is all fully priced, in fact with the forward curve suggesting that rates could go all the way to 3.5%, it is more than priced. 

So bond markets have adjusted very early, and they're always forward-looking, but in this case, they're way ahead of central bank activity, which means investing in bonds is actually a very attractive asset class right now.

Inflation backdrop has to result in normalisation of interest rates

What does this mean for mortgages?

Previously we’ve suggested that the forward curve from the bond market suggests mortgage rates should 5.5% - 6.5%, a pretty scary number. We may not need to get that far but households out there doing their financial plans should keep this in the back of their minds because it is possible. 

Additionally, the point about mortgage rates is that the property market has barely adjusted. The bond market started moving in the third quarter of 2021, which again is very forward-looking and a lot of that price action has already happened with the property market and some other markets, especially markets that were dependent upon zero interest rates. So they are all much more vulnerable to repricing.

The forward curve from the bond market suggests mortgage rates should 5.5% - 6.5%, a pretty scary number...but households out there doing their financial plans should keep this in the back of their minds because it is possible

How are we positioning portfolios?

I think the most important takeaway is that with interest rates having moved already, as we're mentioning bond markets being forward-looking. What we started to do is cover our underweight to interest rate exposure or duration. 

When we think about US 10-year treasuries, around 3%, Commonwealth government bonds in the mid 3% range in the ten year part of the curve, and 3.5% cash rate. All these things suggest it's time to remove any structural underweight to bonds. 

So if there are any investors out there that are still underweight bonds, now's the time to think about moving back to target, and at some point moving above target. We do think there's still a disconnect between risky assets and the bond market. 

Arguably this is the biggest disconnect I've ever seen in my career. So when you think about bond markets already starting to move back in Q3 of 2021, the property market has only just started to roll over now, the equity markets are a little bit more priced, but nothing dramatic, and we’ve seen some activity in tech stocks and other things that were really reliant upon very low-interest rates to justify their valuation. 

All those things are in play, but as we keep reiterating, the bond market has been priced for this for a while. 

When it comes to credit assets, we think there are some attractive opportunities there. It is a little defensive in terms of us wanting to make sure that the underlying cash flows are very robust. But when you think about how in the market, a major Australian bank issuing tier 2 debt north of 6%, these are now very attractive opportunities for portfolio construction.

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Robert Mead
Managing Director and Co-Head of Asia-Pacific
PIMCO

Robert co-oversees the portfolio management teams in Asia. Previously, he was a portfolio manager in Munich and head of the European investment grade corporate bond team. He has 29 years of investment experience.

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