The Point

Fixed interest: Check your ‘duration’ settings before inflation turns

Fixed interest investors should get their portfolio settings right now, before US inflation tops out and starts falling consistently in the second half, says Pendal’s Tim Hext.

Right now US inflation reports are resetting the mood of investment markets every month, says Tim, who runs government bond strategy at Pendal.

“By the second half of the year, we are going to get a much clearer picture and we are going to see that inflation hasn’t just topped out but is coming down,” he says.

“The big message is that investors have a bit of time on their hands now, but things will start to move quite quickly by the middle of the year. So investors should be getting their duration sorted.”

That means checking the duration of your fixed income investments and their sensitivity to interest rate changes.

“Investors should be getting back to at least where their model portfolios tells them they need to be in the medium-to-long term.”

Investors need two things right now: patience and protection

INVESTORS need two things in 2023 – protection and patience.

Yesterday’s Australian monthly CPI shows the Reserve Bank’s tightening – which started in the second quarter of 2022 – is starting to have an impact.

The monthly CPI indicator rose 7.4% for the year to January – an easing from 8.4% in December.

Monetary policy works with a lag – but it does work.

This can be observed through the two key components of the CPI number: new dwelling prices and rents.

Hard, fast rates cycle could mean it’s time for long-duration bonds

The RBA’s hawkish tone could mean a hard landing with a fast turnaround on rates later this year.

That means fixed interest investors should be eyeing longer-dated bonds, says Pendal’s Tim Hext.

In a Pendal webinar this week Tim reviewed the latest economic data with Commbank chief economist Stephen Halmarick and outlined how it affected investors.

With higher rates on their minds, Aussies have begun reining in spending in the past two weeks, says Halmarick, who has a real-time view of the spending habits of the bank’s 16 million customers.

That will be good news for the RBA. But it’s unlikely to change their hawkish approach to inflation in coming months, partly due to strong wage growth.

Still, Halmarick reckons the cycle will be short and rates could fall this year.

Tim Hext says it’s time to consider longer-dated bonds as insurance while locking in a decent income.

“Our advice to clients is if you’ve got quite short duration, you should be looking to lengthen that.

“With 10-year bonds around 4 per cent, we don’t think cash rates are going to be able to get that high. If they do, they’ll only be there very briefly.”

TIM HEXT: Mixed signals will remain into Christmas

After an extraordinary year, investors are hoping for clear air in 2023.

Will we get it?

Next year is when rate hikes fully kick in and the resilience of the real economy will be tested, says Pendal’s head of government bonds Tim Hext.

“Policy-makers are happy for the pain to continue until they see actual – not anticipated – inflation turns,” says Tim.

“Inflation is a lagging indicator – often by six to 12 months. But central banks view an inflation policy mistake as worse than a recession.

“Waiting for supply to solve the problem is proving too much. Demand destruction is required, even though it means people losing jobs and in some cases forced out of homes.”

That means clear air is unlikely until 2024 when a “normal” economy returns, says Tim.

TIM HEXT: Inflation will test Fed’s patience, but RBA has cards up its sleeve

US rates are headed for 4% or more after inflation remained high in August.

But the RBA may have more patience, says Pendal’s Tim Hext.

“We still expect goods deflation in the months ahead,” says Tim, who manages our government bond strategies.

“But US wage growth is spreading inflation wider into services. Services inflation is now the battleground.

“As always, Australian bonds will follow the US. But the RBA seems prepared to show a bit more patience due to factors such as wages and our floating-rate mortgage market.

“The RBA remain on course for 3% cash rates by year end (either 2.85% or 3.1%).

“Credit and equity markets were hit by the high inflation numbers, but for now look to be range-trading rather than breaking down.”

TIM HEXT: Interest rate pain probably won’t get too bad despite tough talk

Despite hawkish words from central bankers, cash rates are likely to sit around 3% next year, says our head of government bond strategies Tim Hext.

“One cannot blame them for hawkish comments on inflation, including talk of bringing on the pain,” says Tim.

“After all, their lack of forward-looking policy failed to pick up inflation soon enough in 2021.”

July’s rally — now a distant memory — comes down to the idea that inflation will fall and then stabilise around 4% in the next year.

That’s still too high, meaning rate cuts would be unlikely. But hikes would then stop around neutral and central banks would feel they had time on their side.

If Australia’s central bankers exhibit any patience our cash rates are likely to sit at 3% in 2023, says Tim.

Falling global inflation should allow our central bankers more confidence that we are not in some 1970s style spiral.

“For now, bonds have once again entered the buy zone. I’ll avoid predictions on equities. But I make the observation the landing in the US may not be as hard as many are predicting.”