On the Up: What Do Rising Rates Mean for Bond Yields and Mortgages in Australia?

Australian bond yields have risen significantly over recent months with markets now expecting restrictive monetary policy settings.

Inflationary pressures have been stubbornly persistent in most economies this year given COVID-19 supply chain disruptions, labour shortages and energy price increases. Bond yields have risen as investors recalibrate inflation expectations and the destination of cash rates. With mortgage rates also starting to creep up, we assess what Australian investors should expect from the bond and mortgage markets over the coming year.

Central banks are tightening policy aggressively to combat inflation

Heading into 2022, markets and central banks were at odds over the pace and magnitude of rate hikes. The bond market has been expecting central banks to raise cash rates more aggressively than the banks themselves have been communicating. It is becoming apparent that the market was right. Over recent months, the U.S. Federal Reserve (Fed), the Reserve Bank of New Zealand and the Bank of Canada have commenced aggressive monetary policy tightening via asset sales and significant cash rate increases, including a 75 basis point increase by the Fed in June. In addition, in May and June, the Reserve Bank of Australia (RBA) began meaningful cash rate increases, raising the cash rate from a record low 0.1% to 0.85%.

Markets now expect the U.S. target interest rate to peak at around 3.75% in March 2023 from its current range of 1.50%–1.75% (see Figure 1). In Australia, markets expect the cash rate to rise to around 4.25% by June 2023. If these rate increases transpire, they would represent a significant step-up in a short time period.

Market expectations for U.S. and Australian cash rate levels have risen markedly

Cash rate rises are already priced into bond yields

Bond markets are forward-looking in the sense that they reflect investor expectations for cash rates and inflation in the future. Fixed-rate bond investors focus on these factors because they have a material impact on investment outcomes.

Just as a dividend announcement made by a company is priced into its stock value before it is actually paid, expected cash rate hikes are priced into bond values before the cash rate increases happen. If the cash rate is expected to rise quickly, this can lead bond yields to rise and thus bond prices to fall. The reason prices tend to fall is because the income from existing fixed-rate bonds is relatively less attractive than newly issued higher yielding bonds.

Based on bond market pricing as of June 20, investors anticipate the average cash rate in Australia over the next three years to be just over 3.5%. At June 20, a three-year Australian government bond was yielding 3.7%. Therefore, if the RBA rate hikes follow the path expected in Figure 1, bond prices have already taken into account expected cash rate increases over the next 12-18 months.

Mortgage rate increases should limit rises in the cash rate beyond current expectations

Banks obtain their funding from three main sources: shareholder capital, retail deposits and wholesale debt markets. A rise in funding costs from wholesale markets has a knock-on effect on mortgage rates since banks aim to match funding for fixed-rate mortgages with mortgage terms to lock in a profit margin. Fixed-rate mortgages began increasing in late 2021 (before the cash rate hike) because bond yields started to rise and the RBA discontinued its Term Funding Facility (TFF), which had offered banks low cost funding fixed for three years at the cash rate.

In February 2020, roughly 14% of new home loans were fixed-rate loans. The pandemic changed this significantly, with almost half of all new loans written in June 2021 and a little more than half of first homebuyer loans being fixed-rate. A big contributor to the change was the TFF, which allowed banks to offer three-year fixed-rate mortgages below 2%. The refinancing of those loans will start in late March 2023 when both fixed- and variable-rate mortgages could be at least 2% p.a. higher than existing fixed-rate mortgages.

Currently, many fixed-rate owner-occupier mortgages in Australia are being offered at around 4% per annum or higher. Variable-rate mortgages will increase with the cash rate as banks pass on the extra cost of funding. If market expectations are correct about where cash rates will be in 2023, a variable-rate home loan is likely to hit around 6% sometime next year.

The impending increases in mortgage rates will materially affect mortgage servicing costs for households and could weigh on house prices. Given the significant rise in household debt over the past decade, Australians are much more sensitive to increases in mortgage rates than in previous rising rate cycles. Unlike past decades, we estimate that a cash rate of around 4.25% (as is currently priced into markets) represents meaningfully restrictive policy settings for Australian households.

Australian bond yields have risen significantly over recent months with markets now expecting restrictive monetary policy settings

If market pricing for the cash rate were to be realised, it would have a significant impact on households’ ability to service their mortgages, particularly amid rising living costs caused by inflation. As a result, we think it will be difficult for the RBA to increase the cash rate beyond current market expectations, which should limit Australian bond yields from rising much further.

For more on what rate rises mean for Australian investors, read our recent Viewpoint: “Bracing for a Rise in Real Interest Rates in a Post COVID 19 World”.

The Author

Adam Bowe

Portfolio Manager, Australia

Tony Cahill

Account Manager, Global Wealth Management



PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
Level 19, 5 Martin Place
Sydney, NSW 2000

PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs.


The time period referenced throughout the presentation as pre-COVID-19 refers to the period leading up to Q1 2020. Post-COVID-19 refers to a forward-looking time period following market volatility in Q1 2020 and early Q2 2020.


Charts and data have been provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. Charts may not be to scale and users should take this into consideration when conducting analysis.


Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. 


The material contains statements of opinion and belief. Any views expressed herein are those of PIMCO as of the date indicated, are based on information available to PIMCO as of such date, and are subject to change, without notice, based on market and other conditions. No representation is made or assurance given that such views are correct. PIMCO has no duty or obligation to update the information contained herein.


Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.


Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of US government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Certain US government securities are backed by the full faith of the government. Obligations of US government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.