ABE Weekly: When it comes to debt, it pays to be the creditor

Australian Bond Exchange Weekly Update

Friday 9th June 2023

Key Points

The RBA hiked the cash rate again on Tuesday, raising it 25 basis points to 4.1%, signaling to markets they will do whatever is necessary to curb this sticky inflation
Investors and commentators are jumping on the “bondwagon” as a new sense of hype emerges around lower-risk fixed income investments with coupon rates above 5%.
As the mortgage cliff fast approaches, the International Monetary Fund warns of an imminent global economic slowdown, and recent data from China shows even they are not immune.
High interest rates, high inflation, slow economic growth and a tight labor market is “pretty darn good” for fixed income investors, according to Larry Fink from BlackRock

Global Cash Rates & Inflation*

The RBA Cash Rate was hiked 25bps on Tuesday to 4.1% to fight an annual inflation rate of 7%. The next RBA meeting is on Tuesday 4th July, when the next cash rate decision will be made.
The BOE Cash Rate is 4.5%, as the central bank chases an inflation rate of 8.7%. The UK may need to continue to raise rates to curb inflation at the next meeting, set for Thursday 22nd June

The US cash rate is between 5-5.25% and inflation 4.9%, as Federal Reserve cash rate hikes bring inflation down. The US’ next rate decision is next Tuesday 13th – Wednesday 14th June.
The ECB Cash Rate (deposit facility) is at 3.25% and inflation is forecasted at 6.1% in the 12 months to May, down from 7% in the year to April. The EU’s next decision is Thursday June 15th.

RBA hikes cash rate to 4.1% in a serious bid to tame inflation

This week, the Reserve Bank of Australia (RBA) increased the cash rate by 25 basis points to 4.1%, sending a clear message that the central bank will do what’s needed to get inflation back to target.

“Inflation in Australia has passed its peak, but at 7 per cent is still too high and it will be some time yet before it is back in the target range,” RBA Governor Philip Lowe said.

“Some further tightening of monetary policy may be required, but that will depend upon how the economy and inflation evolve.”

According to Co-founder of BlackRock Larry Fink, the central banks’ target range of 2-3% is unrealistic.

“Will the central banks around the world, if we got inflation down to 3.5 per cent, call it a day?” Fink said to the Australian Financial Review. “I don’t know,” he continued, “but right now, it’s hard for me to see why and how inflation is going to break 4 per cent.”

Dubbed by some as “paranoid”, Fink has been a loud supporter of the passive investment revolution and despite the noise has been taking advantage of the above-average yields of bonds.

However, it is not by pure luck that BlackRock is the best-performing financial services stock in the S&P 500, and Fink’s move to fixed income has been followed by a noticeable market shift from highly volatile equities to lower-risk investments.

When it comes to debt, it pays to be the creditor

Both market analysts and commentators are starting to see Fink’s logic, and across a range of financial publications there has been a new sense of hype around fixed income investments.

This is especially the case with bonds and other debt securities, where investors can capitalise on high interest rates stoked by cash rate rises, to generate returns for lower risk.

Recently, Christopher Joye from Coolabah Capital spoke with LiveWire about being “nimble” in this investing environment and looking for opportunities where bonds are undervalued.

“We see a lot of discontinuity between the yields in our liquid asset classes and the yields in liquid, high-grade bonds,” he said. “Senior-ranking major bank bonds are paying almost 5% per annum. The major banks’ Tier 2 bonds are paying 6.3% per annum. And these yields will only rise further as the RBA increases its cash rate.”

He also discussed the importance of investments that do not rely on the contentious housing market, where rising interest rates have sent mortgage payments skyrocketing.

Australia Bond Exchange CEO, Bradley McCosker agrees, “The longer-term challenge is far grimmer for mortgage holders,” he said, “unless there are other policy measures taken outside of that under the remit of the RBA, higher rates are on the horizon.”

Further, both a shortfall in supply and a sharp increase in housing prices, will likely be compounded by the mortgage cliff’s arrival later this year, as fixed rate mortgage debt (around 2%) switches over to variable rates (around 6%).

In fact, RBA data shows only one third of fully fixed owner-occupier debtors will be able to afford the minimum scheduled payment for three months or more, if they were to immediately roll off to the average new variable rate.

According to the IMF, the Australian property market has the second highest risk level of all developed countries’ housing markets, prompting property investors to look at alternative markets.

Property investors get into debt, and fixed income investors become creditors of corporate or government debt. In this kind of high interest rate environment, it pays to be the creditor.

Slow global growth and sticky inflation persists, even China is not immune

The World Bank’s Global Economic Prospects report published Monday, forecasted that global growth will drop to a thirty-year low for the rest of the decade, as rich economies struggle with growth in productivity, trade, labor and investment. Even China is not immune, reporting a 7.5% drop in exports growth in May, despite an 8% jump in April.

The International Monetary Fund (IMF) World Economic Outlook Report released in April backs these claims, with a firm stance on the likelihood of an impending global recession.

Commenting on banking sector turmoil, rising interest rates and sticky inflation, the prospect of a “hard landing” has risen sharply with the potential for financial sector stress

The IMF’s recent inability to accurately predict economic growth in countries like the UK, could suggest the above information is incorrect, however the inability to forecast accurately is more likely due to the unusual economic situation we’re in.

A lack of economic stability, coupled with historically low unemployment across major economies has also caused some central banks to admit they underestimated how strong the current cycle of inflation would be.

Amidst high interest rates, slow growth and high inflation (often called “stagflation”) some commentators are suggesting we’re entering an inflationary period not seen since the oil shocks of the 1970s.

According to some market commentators, we could even be headed for déjà vu, as last week it was announced there would be a significant reduction in global oil supply. Agreed to by the Organisation of the Petroleum Exporting Countries (OPEC), this is just another factor that could impact central banks’ rate decisions, as it is the lack of supply is driving up inflation.

This economic dilemma of “stagflation”, could be pretty darn good for fixed income

Although central banks have been aggressively raising the cash rate to curb inflation, public policies like the Inflation Reduction Act in the US (which is said to have almost no impact on inflation) and the recent 5.75% increase in award wages in Australia, will see significant injections of liquidity into the economy.

If more money is pumped into economy, and wages rise to match inflation, there is a risk that inflation will remain high above target, and this could encourage more rate hikes from central banks.

This economic dilemma, however, is offering an attractive buying opportunity for investors stepping into the fixed income space, as yields on offer are the highest they’ve been in decades.

As Larry Fink maintains, “A large portion of your portfolio can now be in bonds and have less risk.”

“This is a net positive, it’s not a net negative,” he continued, “I’m not trying to suggest it’s perfect for the entire society. But overall, it’s pretty darn good.”

What’s coming up:

Next Tuesday 13th – Wednesday 14th June, the Federal Reserve will make their decision as to whether they will raise the cash rate of 5-5.25%, when inflation is below 4.9%.
On Tuesday 13th June, the Westpac Consumer Sentiment Report and NAB Business Confidence reports are out, which will likely show the impact of rising interest rates.
On Thursday 15th June, the ABS will release data on unemployment rates, which if raised could signal the “softening” of the labour market that the RBA is looking for.
Next Thursday 15th June, the European Central Bank will also make their cash rate decision. The deposit rate is currently 3.25% and inflation is at 6.1%, which suggests a hike.

*Data accurate as at 9.6.2023

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