Philip Brown
Inflation keeps the RBA cautious, but the case for rate cuts is building
When the RBA meets at the November board meeting, there will be a new set of forecasts created that will likely include a higher forecast for the unemployment rate. The previous forecast was that the unemployment rate would slowly rise from 4.4% to 4.8% by end of 2028. The reality is that we’ve gone from 4.4% to 4.7% in only three months.
For bond markets, this means that the risk of an elongated Australian rate rise cycle is dropping. While the near-term may yet see a further RBA rate move, the previous expectations had been for a cash rate as high as 5.06% at the peak (pricing on 28 September for the cash rate to be 5.06% in August 2027). Now, following the unemployment data, the cash rate peak is expected to be 4.88% in May 2027. Importantly, this is still higher than the current cash rate of 4.60%. If there were to be a continuation of the current run of weak data then the market might come to the conclusion that the RBA will be actively cutting rates in 2027, rather than simply not raising them. In such a circumstance, there is plenty of scope for bond yields to fall much further from here.
The domestic threads are suggesting that the economy has an inflation problem, but that the RBA rate rises are largely working to slow the economy. Inflation hasn’t yet started to fall, but the changes in the labour market are clear. If this keeps up, the RBA might have to raise rates more, depending on the inflation data, but the chance of an elongated peak in the cash rate is falling. If the RBA does move to a cash rate of 4.85%, from the current 4.60%, then the trend of weakening in the labour market is only likely to intensify.
The impact of higher yields on bond returns and bond portfolio selection
The recent sell-off in bonds has taken bond yields much higher. Unusually, this sell-off has been led by the longer end of the curve at times. Overall, this has seen the longer end of the curve rise by more than it normally would at this stage of a cycle. This is particularly true of the longer bonds in the 7Y sector and longer.
For bond owners, higher yields can improve prospective returns, particularly for new purchases. More return is always better, all else equal. But in bonds, there are a few unusual and complicated features that mean some bond investors don’t appreciate just how beneficial higher yields are. Higher yields are not better than lower yields in a linear way; higher yields are better than lower yields in an exponential way.
Investors confident that yields are about to turn lower, and those who have longer investment horizons might want to consider bonds in the 10Y zone. Those who are a little more cautious should probably consider shorter bonds in the 5Y-7Y range.
Government debt and AI emerge as key credit risks
There are numerous headlines about rising credit risk in government debt, but it’s not always easy to disentangle what is credit risk from what is simply supply and demand moving yields higher. We believe that the moves higher in the US yields are mostly about supply and demand for capital, rather than a true market reaction to increasing sovereign default risk. Fiscal pressures have increased the vulnerability of some sovereign borrowers to adverse market developments.
Unusually compared to other parts of the globe, Australia’s budget forecasts tend to be conservative, with low commodity prices and strong reversion to the mean. A result of that conservatism is that the net debt forecasts almost always have a slight upward tilt. Every Budget since 2019/20 has forecast rising net debt to GDP growth at a rate equal to or greater than current forecasts, yet the ratio has not risen as anticipated. At present, Australia is in the middle of the pack, but the troublesome names are the US, France, Japan and the UK.
The cancellation of IPOs in the AI space in Australia has been one manifestation of the risk that the AI boom is overdone, but it’s not the only one. The equity prices of some of the larger companies in the US have been falling too.
It’s important to differentiate between AI as a technology and the current AI technology leaders. While AI is a phenomenal tool, it is far from clear how best to use that tool in a commercial and profitable way. The companies that figure that out, and the AI providers that provide the AI best tailored to that end, will be the final successes.
While risks may be concentrated in the AI-linked spaces, there will be spillovers everywhere in the event of a large credit spread widening. But at the same time, it can be hard to know when that cycle will start. If you hunker down too early, you can miss a lot of extra yield by holding too conservative a position too early. Investment is not usually about the complete avoidance of risk; it is about taking considered and appropriate levels of risk in an informed way.
In this environment, shorter-dated credit may help manage exposure to widening spreads while retaining some exposure to credit risk. Although we expect a widening in credit spreads in coming months, we do not expect there will be a widespread rash of defaults. In this circumstance, shorter credit duration may mitigate price sensitivity, although issuer credit quality remains critical.
A longer bond that experiences a widening in credit spreads may remain below its previous price for an extended period. A shorter bond that offers the same initial yield will both fall by a smaller amount in a credit widening and be pulled back to par more quickly over time. Australian-based credits which are not particularly exposed to AI risk, but are of shorter tenor and floating rate, appear to be the best credit options, at present.
Positioning for the next phase of the bond market cycle
We believe we’re approaching the end of the current cycle and the time is right to start thinking about what bond positions will be best for when the cycle actually turns. A turn in the cycle likely comes with a reduction in overall yields, but a widening in credit spreads. Notably, we don’t anticipate widespread defaults; we expect it is more likely that there will be widening in spreads without a material run of losses.
A balanced approach could include having lower credit duration but longer outright duration means selecting credit bonds that are comparatively short, but comparatively high yielding and then pairing these with longer, safer bonds.
Inflation-linked bond exposure may provide some protection against an unexpected rise in inflation. The risk of a material rise in the inflation rate, even amongst a general economic slowdown, remains high. It’s also important to focus on diversification.
By Philip Brown, Head of Research
