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Economic and Market Commentary

June 2022 Update from the Australia Trade Floor

Rob Mead discusses how rate rises will affect path ahead for bonds, property and mortgage rates

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Text on screen: Lucy Garth, Head of Marketing, Australia and New Zealand

Garth: Hi. I'm Lucy Garth. I'm here today with portfolio manager Rob Mead for this month's trade floor update.

Rob, we've got a fair bit to get through, so we'll just get straight into it. The RBA has raised rates now for the second month in a row.

What does that mean for bonds?

Text on screen: Rob Mead, Co-head of APAC Portfolio Management and Head of Australia

Mead: Well, it is topical, that's for sure. So I think there's a couple of really important take outs. And the great news is that on these videos every month, we've been giving that same thematic.

So first thing is the inflation backdrop has to basically result in normalisation of interest rates. What we've seen so far, as you mentioned, 1 x 25 hike and now followed up by a 50. And I think that means there's clearly some urgency to get back to normal. And we'll have a bit of a chat about what we think normal is, but it doesn't really change the destination.

So I keep talking about normal. What is normal? We think normal is going to be something like two and a half percent, give or take, maybe even half a percent, depending on what happens in the real economy and what happens with inflation down the track.

But we're on a pathway to something like two and a half. There's a few commentators out there that were hoping that that wouldn't eventuate. But we do think we're on a pathway there.

Now, the great news for bond investors is that's all fully priced. In fact, it's more than priced. The forward curve suggests that rates could go all the way to three and a half. We don't think we need to go that far. So bond markets have adjusted very early. 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.

Garth: So what does that mean for mortgages?

Mead: Yeah, it's a great question. Mortgage rates I think, again, in our previous discussions we’ve suggested that the forward curve from the bond market suggesting mortgage rates should be five and a half to six and a half. So it's a pretty scary number. We may not need to get that far, but I think for households out there when they're doing their financial plans, they should have those sorts of numbers in the back of their minds because that is possible.

And I think to your point about mortgage rates is the property market has barely adjusted so the bond market started moving in the third quarter of 2021. It's again, as I mentioned, it's very forward looking and a lot of that price action’s already happened with the property market and some other markets, especially markets that were dependent upon zero interest rates, they're all much more vulnerable to repricing.

Garth: So within that context, Rob, how are we positioning portfolios?

Mead: Yeah, it's a great point and I think the most important takeaway is that with interest rates having moved already, again, 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 ten year treasuries, around 3%, Commonwealth government bonds in the mid threes in the ten year part of the curve, three and a half percent priced in the cash rate.

All these things suggest it's time to remove any structural underweight to bonds. And so if there are any investors out there that are still underweight bonds, now's the time to think about moving back to target. At some point moving above target.

We do think there's still this disconnect between risky assets and the bond market. It's arguably 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 21, the property market is only just started to roll over now.

Equity markets are a little bit more price, but nothing dramatic. 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 again, as we keep reiterating the bond market has been priced for this for a while. When it comes to credit assets, we think there's some attractive opportunities there, a little defensive in terms of we want to make sure that the underlying cash flows are very robust.

But when you think about in the market, since we last spoke a major Australian bank issuing tier two debt north of 6%, these are now very attractive opportunities for portfolio construction.

Garth: Thanks Rob, and thanks for joining us. If you've got any questions or would like any more information, please visit our website at pimco.com.au

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