The silver lining for investors from the latest rate rise

Despite mixed commentary on the RBA decision, the good news for investors is the availability of attractive interest rates on high-grade fixed income.Despite mixed commentary on the RBA decision, the good news for investors is the availability of attractive interest rates on high-grade fixed income. 

Opinion

Despite mixed commentary on the RBA decision, the good news for investors is the availability of attractive interest rates on high-grade fixed income.

Christopher JoyeColumnist

Nov 10, 2023 – 10.48am

The Aussie dollar slumped and bond yields fell in lockstep following the Reserve Bank of Australia’s begrudging decision to raise its cash rate from 4.1 per cent to 4.35 per cent, still just a sliver above its estimate of the “neutral” rate around 3.8 per cent.

The counter-intuitive reaction of the exchange rate and long-term yields to what should have been a hawkish move after another inflation surprise was explained by governor Michele Bullock’s decision to dovishly downgrade her commitment to future hikes.

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Key media commentators have speculated that this might have been motivated by a desire “not to offend Treasurer Jim Chalmers”, which paradoxically only serves to demonstrate how politically compromised Martin Place could be.

Commentators who had indicated that the RBA would not lift rates in November alleged the decision could be explained by the RBA’s attempt to “very deliberately … draw some lines in the sand” to show that it would not be “bullied or “advised” by Chalmers.

According to another telling, “Treasurer Jim Chalmers’ clumsy attempt to influence monetary policy backfired spectacularly because it left … Bullock little choice but to raise interest rates in a defiant display of independence”.

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Remember, Chalmers had declared that the September-quarter inflation data did not satisfy the RBA’s “materiality test” apropos the need to raise its inflation forecasts and delay the return to the central bank’s 2 to 3 per cent target band. This was universally viewed as an attempt by Chalmers to jawbone the RBA into keeping rates unchanged in November.

A senior columnist further asserted that Chalmers’ Treasury secretary, Stephen Kennedy, who sits on the RBA board, had “all but announced he will be voting for a pause”.

Inflation update

The problem with the spin since the RBA’s hike is that, in practice, it had no objective choice irrespective of the politics. Following the inflation release, markets immediately imputed a near-certain 80 per cent probability of the RBA moving in November, notably before Chalmers’ interventions. And almost every economist in the land promptly shifted to this perspective.

In its statement, the RBA conceded that “the board has received updated information on inflation, the labour market, economic activity and the revised set of forecasts [where] the weight of this information [suggested] that the risk of inflation remaining higher for longer [had] increased”, with “stronger-than-expected [GDP growth] over the first half of the year”, higher-than-anticipated underlying inflation (“including across a broad range of services”), a lower-than-predicted peak in unemployment of 4.25 per cent, and what it has described as bewildering appreciation in house prices.

Crucially, the RBA’s forecast for the peak in unemployment is now below its estimate of the non-accelerating inflation rate of unemployment, which was last reported at circa 4½ per cent. This implies that policy remains too loose.

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More substantively, the RBA could no longer credibly claim that it would return inflation to somewhere inside its target 2 to 3 per cent band by 2025, which it had previously characterised as a slow normalisation in price pressures.

The upside surprise to the September-quarter inflation data meant that the RBA was now forecasting that inflation would be “at the top” of the band in 2025 compared to its prior projection that sat inside it. Put differently, the RBA would not return inflation to the mid-point of its target band until 2026, which is an absurdly long horizon for meeting its legislated price stability target.

Instead of clearly communicating the need for tighter policy, Bullock purveyed bizarrely dovish testimony to parliament after the inflation print, which only served to confuse markets and economists. This has been compounded by the very odd dilution of the RBA’s commitment to future increases.

Watered down

Whereas the RBA had previously asserted that “some further tightening of monetary policy may be required” after its October meeting, November’s statement was watered down to the question of “whether further tightening of monetary policy is required”.

The RBA has therefore hinted that this could be the last increase in the cycle, immediately undermining the impact of the November hike as demonstrated by the ensuing price action. Bond markets are assuming that this is likely one-and-done, revising down estimates for the RBA’s terminal cash rate to 4.44 per cent (a smidge above the current rate).

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After the decision on Tuesday, one market participant said: “Don’t read what they say, watch what they do – she didn’t know she was hiking today.” With brisk wages data to come, this trader argued that the RBA’s “dovish hike is silly [and] going to cause property to move higher”, concluding Martin Place had “totally wasted this opportunity”.

A long-time veteran of the RBA board, Warwick McKibbin, whose wife Renée Fry-McKibbin was a co-author of the government’s review of the central bank, told The Australian Financial Review that the cash rate needed to rise to 5 per cent to quash excess demand. This would bring the recalcitrant RBA into line with policy rates in countries such as New Zealand (5.5 per cent), the US (5.25-5.50 per cent), Britain (5.25 per cent) and Canada (5.0 per cent).

“If you look at us relative to inflation, and then look at us relative to other central banks, we’re quite a substantial way behind the curve,” McKibbin said.

When all is said and done, the data will ultimately dictate the central bank’s future path. So we eagerly await the latest wages and employment prints next week.

One of the reasons the RBA looks so sluggish compared to global peers is that the cash buffers Aussie households built up during the pandemic – care of our internationally tough lockdowns and generous government handouts – are among the biggest in the world. This savings pile will not be exhausted until late next year, and presents additional latent demand and inflation pressure, potentially elongating the RBA’s hiking cycle.

Higher borrowing rates are demonstrably bad news for over-leveraged sectors such as commercial real estate and non-bank lenders that finance sub-prime borrowers with high risks of default. Local and global commercial real estate prices continue to slump. And delinquencies on non-bank loans to businesses and households are rising sharply.

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Silver lining

The silver lining for investors is the availability of attractive interest rates on high-grade bonds, as highlighted by a torrent of new supply this week. Westpac priced a $1.25 billion Aussie dollar Tier 2 bond that paid 7.2 per cent annual interest, which reportedly attracted bids from Australia’s savviest super funds. This deal offered 30-40 basis points in extra annual interest over our fair value estimates.

In the same session, Westpac launched a $US750 million Tier 2 bond, which hedged back to Aussie dollars and paid an annual interest rate of 7.5 per cent. This security provided 70 basis points in extra interest above the Aussie bond curve and was 10-15 basis points cheap compared to our US fair value estimates.

Smart bond issuers like the major banks always pay investors healthy new issue concessions to ensure these securities perform, which is not a practice that is always emulated by smaller rivals in the domestic market.

NAB followed suit with $5.25 billion of three-year and five-year senior bond issues on Thursday that also carried handsome concessions.

We await with bated breath to see where Westpac prices its forthcoming $1.5 billion hybrid issue given a current five-year secondary curve for major bank securities at about 300 basis points over the quarterly bank bill swap rate (or an all-in running yield of 7.4 per cent).

In fixed-income markets right now, it is not hard to earn yields as high as 8.5 per cent from liquid, high-grade bonds that have returned north of 15 per cent over the past 12 months after fees. That makes it very tough for other asset classes until their yields climb to competitive levels above these hurdle rates.

Christopher Joye is a contributing editor who has previously worked at Goldman Sachs and the RBA. He is a portfolio manager with Coolabah Capital, which invests in fixed-income securities including those discussed in his column. Connect with Christopher on Twitter.

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