Economic and Market Commentary

April 2022 Update from the Australia Trade Floor

Adam Bowe discusses the latest market and policy developments impacting the investment environment.

MORE ABOUT INFLATION AND INTEREST RATES

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Text on screen: Hugh Holden, Senior Vice President, Australia

Holden: Hello and welcome to our monthly trade floor update. I'm joined by portfolio manager Adam Bowe.

And we've seen a significant rise in bond yields to start the year. Just by way of example, the US 10-year Treasury yield is up by more than a per cent now, sitting above 2.5%. The Aussie 10-year government bond yield is up even more, sitting close to 3%.

Text on screen: Australian Commonwealth Government Bonds

We've covered some of the reasons for these moves on past videos, things such as higher inflation prints, the global economy emerging from pandemic settings, and a change in central bank rhetoric around the path of interest rates.

So, Adam, that's where we've come from, but perhaps more importantly, where to from here?

Text on screen: Adam Bowe, Portfolio Manager, Fixed Income, Australia

Bowe: Yeah, it's a great question. So, starting about, as you said, where are we? So we've got, in Australia, 10-year bond yields back up around 3%. So that's roughly where they were averaging in the few years leading up to the pandemic. So we moved all the way back to where we were pre-pandemic.

In terms of cash rates, we were up in most parts of the developed world, like Australia and the US, we're now pricing cash rates above 3% next year.

Text on screen: Australian market policy pricing

So I think, to answer the question where to from here, we step back from the noise a little and focus on valuations. So when we look at the cash rate in New Zealand, in Australia, Canada, most parts of the developed world, think neutral, sort of 2.5%, maybe 3%, but 2.5%. And with cash rates now pricing above 3%, that's signalling that the market's telling you that central banks are going to have restrictive monetary policy conditions next year.

So you can think of that just in terms of your balance sheet at home. So, average mortgage rates in Australia, if you're looking at a standard variable of two-point-something. So imagine middle of next year, the market's telling you they're going to be five-point-something. That's what's priced. And so you’ve got to ask yourself, does that have an impact on your spending and investment decisions, both the household and businesses? Our response to that is, it does.

As I said, we think neutral is 2.5-ish, so 3.5% or a bit above 3% is starting to get restrictive. We think that has a material impact on spending and investment. And so, from my point of view, the majority of this rate hike cycle has already been priced.

Yields can drift a little higher from here, but it's more, we're arguing the degree of how tight central banks need to go now, not going from zero back to somewhere near neutral. So I think that's an important context to start the discussion.

Holden: Okay. And then, I guess given some of those movements in market pricing and valuations, how are you positioning portfolios now, maybe starting with duration?

Bowe: So we've been trading short duration. We're starting to just drip that now as rates go a little higher. We're still running a little short. So as I said, if you're looking at cash rates being 3% and you’ve still got a 10-year bond at 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. So running a little short duration, but trimming that as yields increase.

And 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. So we think they're probably going to be much more anchored parts to own duration. So a little short in places like New Zealand, Australia, and adding to duration as yields rise from here.

Holden: Okay. And then finally, credit sectors. Has the recent volatility created any opportunities there?

Bowe: It certainly has. As central banks are looking at lifting interest rates, they're also withdrawing a lot of other support mechanisms they had in place, like liquidity provisions.

In Australia last year, the banks had the term funding facility, so they were able to access three-year money for 10 basis points from the RBA. So if you look at just how far bank spreads have moved, that's a really attractive place in global credit markets at the moment.

So looking just close to home in Australia, if you go back 18 months ago, the major banks three-year senior unsecured bonds were trading around 50 basis points, even below. That's a level not a spread. Now they're trading up at 3.3%, 3.4%. So at 3.3, 3.4% with inflation somewhere around 3%, there's much more opportunities and a deeper set of opportunities to construct bond portfolios that have reliable income above inflation now.

So certainly pockets of global credit markets are more attractive. I’d pinpoint global financials as being one of those.

Holden: Excellent. Well thanks Adam, thanks for your time and thanks everyone for joining us. Hopefully you found that useful. If you would like any more information, please visit PIMCO.com.au. Thank you.

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