US rate hikes: what they mean for Australian investors

The US Federal Reserve has raised interest rates for the first time since 2018. Pendal’s head of government bond strategies TIM HEXT explains what it means

THE US Federal Reserve raised rates by 0.25% this morning, as expected.

However the Fed’s forecast for future rates were also raised, slightly catching the markets by surprise.

It was viewed as a ‘hawkish hike’, as we expected. You cannot begin a hiking cycle downplaying its impact – you need overall conditions to tighten.

A couple of interesting points.

The Fed is forecasting (via their dot plots) rates to be 1.9% by the end of this year – this means seven hikes in the next seven meetings.

They then expect 2.8% by the end of 2023. But by the end of 2024 they expect 2.4%.  Neutral rates are generally considered to be around 2%, although that too is dynamic.

The Fed expects inflation to be 4.3% at year end and then 2.7% in 2023 and 2.3% in 2024.

This will be achieved through not only tighter policy but base effects (high numbers from a year ago drop out of year-on-year numbers) and of course reopening of supply chains.

We think these estimates are reasonable, though we agree with the Fed that surprises may be more to the upside. Markets believe inflation will average 2.8% for the next ten years, so are less convinced.

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In the Q&A with Chair Powell there was a lot of criticism about the rapid change of course.

As recently as November the message was that the Fed could be patient as inflation pressures were largely transitory. I am paraphrasing, but Powell’s response was that the situation was rapidly evolving.

As we mentioned numerous times recently it seems the inflation impact of events in the Ukraine has outweighed the risk-off or growth impact in the Fed’s mind.

Where does this leave the RBA?

As recently as this week the RBA minutes from the March meeting were maintaining the line, or as some would say fiction, that “while inflation had picked up, members agreed it was too early to conclude that it was sustainably within the target band.”

Sounds like the Fed in November. 

The Q1 CPI in Australia will be released on April 27. Headline is likely to be 1.4% or 4.3% Y/Y.

We think the RBA rhetoric will change in May to be that “inflation appears to be sustainably within the 2-3% band” paving the way for a June hike.

They will likely go 0.4% first off taking the official cash rate to 0.5%. We would then expect hikes in August and November (after the next two CPIs) to finish the year at 1% cash.

There is a chance the RBA tries to cling on a little longer and the first hike is August, but either way rates finish the year at 1%.

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In the medium term it is interesting that curves are now flat in the US — that is, five year rates in the US are now flat to the 10-year rate at around 2.15%.

This suggests markets believe the Fed in that rates will peak in 2023 before levelling out of even coming back down.

This normally happens later in a hiking cycle but in these days of high transparency markets are far more forward looking.

Implications for Investment Markets

Equities seem to have taken the Fed actions in their stride, maybe also encouraged by the oil price tapering.

Economies remain strong and earnings healthy, although no doubt talk of slowdowns will build with the rate hikes. The Fed did downgrade their GDP forecast for 2022.

Australian 10-year bonds are now around or just above 2.5%.

As mentioned before this is not necessarily cheap but I am prepared to say bonds are no longer expensive and that balanced portfolios should be reducing underweights.

Bonds are still a defensive instrument and if the hiking cycle eventually produces a recession, as seven out of the last 10 hiking cycles in the US have, investors will need them in their portfolios.

Finally, cash is back and is short-priced odds to be the top-performing asset class in 2022 (ignoring some commodities). 

While mortgage holders will suffer from higher rates, for every $3 of debt there is $2 of domestic savings (the other $1 borrowed from offshore).

Cash rates will remain below inflation for a long time yet, eating away at purchasing power, but there may at least be some relief for savers.

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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