The Point

TIM HEXT: Inflation will test Fed’s patience, but RBA has cards up its sleeve

US rates are headed for 4% or more after inflation remained high in August.

But the RBA may have more patience, says Pendal’s Tim Hext.

“We still expect goods deflation in the months ahead,” says Tim, who manages our government bond strategies.

“But US wage growth is spreading inflation wider into services. Services inflation is now the battleground.

“As always, Australian bonds will follow the US. But the RBA seems prepared to show a bit more patience due to factors such as wages and our floating-rate mortgage market.

“The RBA remain on course for 3% cash rates by year end (either 2.85% or 3.1%).

“Credit and equity markets were hit by the high inflation numbers, but for now look to be range-trading rather than breaking down.”

TIM HEXT: Interest rate pain probably won’t get too bad despite tough talk

Despite hawkish words from central bankers, cash rates are likely to sit around 3% next year, says our head of government bond strategies Tim Hext.

“One cannot blame them for hawkish comments on inflation, including talk of bringing on the pain,” says Tim.

“After all, their lack of forward-looking policy failed to pick up inflation soon enough in 2021.”

July’s rally — now a distant memory — comes down to the idea that inflation will fall and then stabilise around 4% in the next year.

That’s still too high, meaning rate cuts would be unlikely. But hikes would then stop around neutral and central banks would feel they had time on their side.

If Australia’s central bankers exhibit any patience our cash rates are likely to sit at 3% in 2023, says Tim.

Falling global inflation should allow our central bankers more confidence that we are not in some 1970s style spiral.

“For now, bonds have once again entered the buy zone. I’ll avoid predictions on equities. But I make the observation the landing in the US may not be as hard as many are predicting.”

Tim Hext: Hawkish central banks are telling markets to pay attention

Markets ignored central bank hawkishness in July, says head of government bond strategies Tim Hext.

“Recession talk was all the rage, which meant rate hikes were largely discounted. Financial conditions — measured by bond rates, credit spreads and equities — eased back to May levels.

“Clearly central banks were not impressed. This week they came out swinging, evangelising restrictive rates needed to rein in inflation.

“In Australia we’re likely to get another 50bp hike in September.

“Rates should finish the year around 3%. High levels of household debt (and heavy stress on 2020 and 2021 buyers) means consumers will be hit hard at that level — let alone at higher rates.

“While the RBA will remains hawkish I doubt they will risk sending households broke by raising rates to 4% — even if markets are now playing with the idea.

“I still prefer inflation bonds for now — but 10-year bonds north of 3.5% are interesting again.

Fixed interest: why bonds look promising and how to take advantage

A re-assessment of fixed income securities and yields — and their defensive qualities — have recently made bonds attractive again, says Dale Pereira, who heads up client solutions at Pendal.

“Bond returns don’t predict the future — they reflect what’s happened,” says Dale.

“That’s where the opportunity lies: they may be showing negative returns now, but the future looks a lot brighter.”

Bonds typically lead equities in terms of market reaction, says Dale.

“From the end of 2021 and into the first half of 2022, bond yields moved in line with expectations of future rate rises — which in turn reflected inflation expectations.

“But markets often over-react when extrapolating good and bad news. And that’s probably the case now.

“The market has likely priced in too many rate rises. It’s priced in a good chance that central banks won’t be able to control inflation. (Though recently that pricing has started to dissipate, making yields less volatile.)

“This means the bond market is at a much better entry point for investors.”

Amy Xie Patrick: The value proposition for bonds right now

Investors have been hesitant to include bonds in portfolios in recent years — but that’s changing, says Pendal’s head of income strategies, Amy Xie Patrick.

“The bond story of recent years has been flipped on its head. Buying 10-year government bonds in Australia can get you nearly 4 per cent. At the height of the pandemic, it was 50 basis points.

“Now the credit risk-free rate is 4 per cent, which raises the bar for other asset classes.”

Is 4 per cent a good return, given inflation is currently higher than that?

“Inflation markets infer that over 10 years inflation will average around 2.5 per cent, which is the RBA’s inflation target,” Amy says.

“Ten-year bonds are yielding a nominal rate of 4 per cent. By owning a 10-year Australian bond, you are taking effectively no credit risk, keeping up with the 2.5 per cent long-term rate of inflation and then getting another 1.5 per cent.

“You’re getting paid to own something without credit risk and keep up with inflation.”

Tim Hext: RBA heads back to neutral. But where is neutral?

The Reserve Bank considers a neutral rate around 2.5% and a bit. But how much is the bit?

“The concept of a neutral cash rate is very fluid,” says Pendal’s head of government bond strategies Tim Hext.

“The best notion is a rate that reflects long-term inflation expectations plus any adjustment for productivity.

“That is, you should expect your cash returns through the long-term cycle to keep pace with inflation and (assuming positive productivity) deliver some small extra return.

“This leads to the notion of 2.5% (the RBA target) plus a bit.”

The size of that “bit” depends on productivity. Strong business lending and new, Covid-driven efficiences are positive signs for productivity.

Against this are the challenges of reduced globalisation and sustainable energy.