Tim Hext: what to expect as rate hike cycle begins

The US Federal Reserve is expected to start raising rates next month. Pendal’s TIM HEXT explains how the rate hike cycle is likely to play out in Australia

The March 16 US Federal Reserve meeting is now a month away.

A tightening is a given. Market pricing suggests 50bp to get things started and then 25bp every meeting this year (there are another six).

If correct this would mean it will take less than a year to get back to almost 2.5%. It took three years in the last hiking cycle (Dec15-Dec18).

Obviously 7.5% inflation focuses a central banker’s mind and stopping to see if hikes are working along the way is not on the cards.

The US Fed has often done this as Greenspan showed in the 2004 to 2006 relentless hiking cycle.

This is partly because the US largely has a long-dated fixed rate mortgage market, so cash rates have less importance.

Overall, financial conditions are more influenced by long-term interest rates which may or may not go up with rate hikes.

In the 2004 to 2006 cycle cash rates went from 1% to 5% but 10-year bonds from only 4% to 5%.

What about us?

Australia is very different.

Rate hikes are passed on almost instantly. Traditionally, floating rates make up 80% of the market, though recently that fell to 50%.

However most of the wall of fixed rates from last year will roll off in 2023, offering only limited respite.

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Therefore the RBA is more likely to move more cautiously.

Like my local bus service, rate moves tend to come in twos.

This year that should be August and September and then November and December. This at least gives a little time to see the impact on housing and confidence.

The next CPI, due in late April, will again be strong but with an election and post-election uncertainty (hung parliament anyone?) the RBA will likely wait till after the Q2 CPI in July.

Strangely enough that CPI could offer some inflation respite. Goods prices will be tapering by then and a childcare subsidy will knock 0.3% off headline CPI.

What comes next

Attention now turns to the terminal rate — in other words how high do cash rates need to go to slow the economy enough to bring inflation back to target and GDP growth back to capacity.

Nirvana for the RBA would be inflation at 2.5%, GDP growth at 3% and wages growth at 3.5%.

I wrote about this in our last quarterly report, but it’s fair to say a zero real rate and 2.5% inflation rate leads to 2.5% as a reasonable estimate.

A lot would need to go right before we get there but this decade feels different to the last, mainly due to fiscal policy being unleashed.

Finally, asset owners should start thinking about where they get back into fixed interest markets.

Bonds are a defensive instrument but the last few years it has been hard to avoid the awkward fact that they were expensive on any long-term measures.

Back above 2.5% though this changes and we expect some rebalancing back into bonds for long-term asset owners, especially those managing retirement incomes.

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.

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