Global drivers are likely to exert a higher influence for Australian rates in the short term. Going into 2023, investors need to remain agile and have dry powder1 assets to deploy.
2022 saw the emergence of 70’s style inflation across the globe from both demand and supply side factors, leading central banks to embark on an intense policy tightening cycle. The geopolitical risks earlier in the year, led to a sharp increase in energy prices, incessant upside surprises in inflation numbers, and the emergence of tail risk scenarios threatening financial market stability closer to Q3 2022. All of this culminated in a turbulent period for almost all asset classes. Rising interest rates and widening credit spreads, pressured fixed income total returns, while expected impact on corporate margins from rising costs and wages as well as slowing economic growth, led equities to struggle as well.
Some of these factors saw a reversal in Q4, as US and global inflation numbers showed signs of peaking or slowing down overall. Drastic downside energy scenarios seemed to have been avoided for Europe and optimism about China’s re-opening narrative emerged. This has led to markets pricing in a shallower recession in the US and Euro area than initially expected, and a bounce back in asset performance (Figure 1) and a consolidation was seen in medium and longer tenor rates (Figure 2).
Figure 1: Most assets still down for the year, but a reversal is starting to build momentum from Q4
Figure 2: The relentless rise in yields has hit a pause recently
In Australia the Reserve Bank of Australia (RBA) shifted to smaller rate hikes earlier than other Developed Market central banks, and raised its cash rate by 25bps to 3.10% in its December 2022 meeting. It noted that tightening remains open and not on a pre-set course, highlighting the balance between strong domestic demand, tight labor markets and that of uncertainties over the timing and extent of slowdown in household spending ahead. Inflation remains high, with Year-on-Year Consumer Price Index at 7.3% in the September quarter - the highest inflation rate since 1990! However, recent monthly release numbers for October, show signs that it may have peaked falling to 6.9%.
Global drivers are likely to exert a higher influence for Australian rates in the short term, and risks do exist. These include 1) the fact that the market is expecting an increase in gross ACGB supply in Q1 2023, 2) the cessation of the RBA's bond purchase program coming to effect on the intermediate tenors, and 3) the slower pace of hiking by the RBA posing greater risks of inflation getting entrenched and more data driven moves later.
Going into 2023, investors need to remain agile and have dry powder in cash/high quality liquid assets to deploy, looking for signs to emerge, pointing to a meaningful lowering of inflation that is closer to target, enabling risk assets to find a bottom. Australian investors looking for a stable source of income, which complements cash and domestic fixed income in a portfolio may consider high quality FRNs. These are issued predominantly by Australian banks whose fundamentals remain strong from the margin benefits due to the sharp increase in interest rates. The floating coupon FRNs pay, set at a margin over the bank bill swap rate (BBSW), has historically followed movements in cash rate very closely. With markets expecting the cash rate to stabilize at cycle highs of 3.7% to 3.8% in Q2/Q3 20222 this could provide a cushion against spread margin volatility, and with limited duration risk this is a compelling high yielding, low volatility asset.
1 “Dry powder” is a term that refers to the amount of cash reserves or liquid assets available for use. They are usually kept on hand to cover future obligations that may or may not be foreseen.
2 Bloomberg Policy Rate Estimate. As of 13 December 2022.
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