The Point

What the Reserve Bank’s 0.5% rate rise means for investors

After this week’s higher-than-expected rate rise, will we see a cash rate close to 3% by the end of 2022?

“The cash rate has been held too low for too long and the RBA is behind the curve,” says Pendal’s head of cash strategies Steve Campbell.

“They are moving more quickly to get closer to neutral. I view 50 basis points next month as more probable than 25.”

Are markets right about a cash rate closer to 3% by year’s end? “Market pricing is aggressive, but at the moment I wouldn’t rule anything out,” Steve says.

Markets are looking for another 3% of rate hikes in the next 12 months — but is the economy ready?

“The RBA tried to imply the economy would be resilient. But the tide is now going out.

“The first 1.5% of hikes will see belt-tightening, but probably no more. However the next 1.5% could see actual stress, especially in housing.

“This is an experiment the RBA hasn’t undertaken for more than a decade — and risks of a policy error are rising.”

Michael Blayney: Three investing rules for turbulent times

Emotion can overwhelm strategy when markets are volatile. Pendal’s multi-asset chief Michael Blayney has three simple rules to remember in times like these:

1. Don’t Panic: A well thought-out and documented philosophy and process is crucial to any active decision making during volatility. This helps you stay disciplined despite the noise. It’s easy to get swayed by emotion, or worse still, enter a crisis at a risk level that wasn’t right for you to begin with.
2. Look for opportunities, but at least rebalance: Disciplined rebalancing adds to returns and reduces risk over time, compared to letting a portfolio run.
3. Diversification Matters: Diversified investors know there’s always going to be some part of their portfolio that’s not working as well as others. Then the cycle turns and they need that part of the portfolio. That cycle can take a decade so an investor must be able to cope emotionally with an underperforming asset for a period. Always include enough liquidity (cash) for your short-term needs. You never want to be a forced seller.

What this week’s rate rise means for cash investors

The cash rate now looks like it will be closer to 1.75% by the end of 2022 after this week’s jump to 0.35%.

“It’s better times ahead for cash investors, though the speed of the move has not been without some pain,” says our head of cash strategies Steve Campbell.

Six-month yields are now likely to sit closer to 1.65%, up from 1.48%, says Steve.

“Those sitting in term deposits may enjoy having their deposits valued at par — but they are accruing at a much lower rate than other opportunities in the market.”

Investors should be wary of short-dated TDs.

“First and foremost cash should be there to provide liquidity while preserving capital. TDs are great at preserving capital. But liquidity? It’s almost quicker to sell a house than wait for TDs to mature.

“I expect we’ll see more volatility, even by cash fund standards in the coming months.

“Short-dated, highly liquid assets will quickly reflect the changes that the RBA will deliver in the coming months. It’s why I think our Pendal Stable Cash Plus Fund is well placed in this environment.”

Inverted yield curve: what it means (and it’s not what you think)

Longer-dated bonds usually pay higher interest rates to compensate for the increased risk over time.

But right now short-term interest rates are moving closer to — and even higher than — long-term rates.

This “yield curve inversion” is a very important signal since it usually means a recession is imminent.

But that’s not the case this time, argues Oliver Ge, an assistant portfolio manager with our Income and Fixed Interest team.

With a strong global economy, low unemployment and benign equity market conditions, analysts have been looking for an alternative explanation for the inversion.

The inversion may be explained by expectations that current inflationary pressures are only short term, says Oliver.

“Short-dated bond yields are higher because they carry a premium to their longer-dated counterparts to compensate investors for bearing higher near-term inflation risk.

“That’s what’s driving the inversion.”

Why bonds are worth considering even as rates rise

Most investors understand that when rates go up, bonds go down.

But what if bonds had the potential to provide an investment return during central interest rate hiking cycles?

It’s possible says Oliver Ge, a portfolio manager with Pendal’s Income and Fixed Interest team.

“The key is that it depends on how much is priced into the bond market at the point central banks start lifting rates.

“Looking at history, an investor who buys bonds at the moment of the first rate hike in a cycle and sells at the last rate hike actually gets quite a substantial return.”

Since the 90s there have four rate hiking cycles in Australia, each averaging an increase of 2.25 per cent to the RBA’s policy rate Oliver says. The annualised bond return over the same period was more than 4 per cent.

“The compelling story is don’t ignore bonds when rates are rising — they can still give you mid-single digit returns. That’s quite significant in a market where equities are negative.”

Look to government bonds instead of term deposits

Ultra-loose monetary policy is creating exceptions to risk and reward – and bringing opportunities for better returns, says Pendal’s Oliver Ge.

Investors who choose the safety of a government bond held to maturity are now offered better returns than a nominally higher-risk bank term deposit.

“The big banks are offering about 0.25 per cent on a one-year term deposit — $25 on a $10,000 investment.

“A one-year Australian government bond is paying 1 per cent — four times as much money.” State government bonds offer more — as high as 1.6 per cent for West Australian semi-government bonds.

The anomaly exists because the RBA is providing very cheap funding to the banks, meaning they can keep deposit rates artificially low without affecting the financing of their lending businesses.

By contrast, government bonds are issued into a competitive global market and rates are set by investor demand.

It’s likely to stay this way as long as banks have access to cheap funding.

“This is a genuine opportunity to get a lot more juice with the same or better safety – assuming you hold to maturity.”