Tim Hext: Federal Budget – the three things that matter most to the bond market

Here are the key takeaways from the Federal Budget and February’s inflation data, according to head of government bond strategies TIM HEXT

• Watch now, on demand: How to prepare for rate cuts in a shifting global economy
• Browse Pendal’s fixed interest funds

INTERESTED readers may want to pore over the many details of the Budget by themselves. But here are the three things that matter for the bond market.

1. Gross debt will hit $1 trillion by next year

There is nothing important about this milestone as such.

But with a $62 billion headline cash deficit and around $90 billion of maturing debt to refinance, the Australian Office of Financial Management will need to issue more than $150 billion next financial year.

This is $3 billion a week (as it takes Christmas and New Years off), which is double the pace of this financial year.

Can the market absorb these higher amounts? Of course they can.

And with arbitrage players buying bonds (then financing them with banks on repo) and selling futures in massive volumes, the government can fund itself easily. This is one way the US government is getting itself huge issuance volumes away.

However, term premiums will continue to go up and yield curves should steepen further.

2. Big government is here to stay

The government continues to spend any savings it finds.

The Budget forecasts are highly sensitive to employment predictions. Not only do workers pay taxes, but you also don’t need to pay them welfare. Therefore, a fall in the unemployment forecast from 4.5% to 4.25% helped make the government $36 billion better off over the next five years.

However, new spending and modest tax cuts used up $35 billion of this. As a result, government spending remains above 27% of Gross Domestic Product – the highest since the 1970s (Covid aside). And this is only Federal government – including the state governments only makes it bigger.

The following graph is courtesy of ANZ – a larger version can be seen here.

3. There is very little in the Budget to help productivity

This Budget was not supposed to happen, with only Cyclone Alfred stopping an April election.

One hopes that both parties are holding back their bold initiatives for the campaign proper, which will begin next week. However, a pessimist may also suggest that both are trying to be small targets, as in the modern age, reform is viewed as just too difficult.

The thinking is a small number of losers will make far more noise than a large number of beneficiaries from any reform.

In the meantime, productivity in Australia is hard to come by, at least over the last decade. There are few signs we will be able to boost it anytime soon, though we are doing better than our friends in New Zealand.

This matters for markets and should make investors cautious that we can sustain real returns (over inflation) around the 3-4% level.

Recent years have left investors confident that the good times will keep rolling, but expectations should be moderated – disappointment will not be too far behind.

Inflation

Today, we also received the February monthly CPI numbers. This compares levels with February last year.

Prices are up 2.4%, almost right on the RBA’s target. If a trimmed mean is applied to CPI (that is, removing the top 15% and bottom 15% on a weighted basis) this number is 2.7%.

This is good news for the RBA. While electricity subsidies are keeping headline inflation down (these run out next year), there is plenty of good news in the items.

Importantly, new dwelling prices are only up 1.6% over the past 12 months, having been above 10% in 2021 and 2022. Rents were 5.5% higher – still too high, but down from 8% peaks.

In fact, apart from excise-impacted alcohol and tobacco, the only pinch points of high inflation remain health, education and insurance.

Lower wage growth should help health and education fall, though structurally they will remain elevated. Insurance is only a small part of overall CPI but should follow – down moderating car repair and building costs.

The Q1 2025 CPI numbers, due out 30 April (RBA meets 18 May), should show trimmed mean inflation at 0.6%. Headline may be nearer 0.8% or 0.9%, but either way, it will provide the RBA with a very good reason for another cut.

If the polls are right in suggesting post-election mayhem and both parties try to woo the independents to form a government, we may not have a government by 18 May.

However, whoever does become prime minister will be handed a gift from the RBA.

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager