Floating Over the Correlated Sell-off

Global inflation pressures continue to persist, market confidence in central banks has eroded and the macroeconomic backdrop has turned more challenging for most asset classes with Floating Rate Notes outperforming most fixed income segments.

The typical role of government bonds as a defensive asset class within investor portfolios has come to question recently, as inflation has muddled long-term correlations, and we are seeing sell-offs across government bonds and other risk assets in tandem (see Figure 1). Financial conditions in Australia already have tightened close to 5 year highs, and the Reserve Bank of Australia (RBA) is just getting started. With duration risk within traditional government bonds expected to be poorly rewarded at this juncture, as investors rethink the need for much tighter policy settings, higher term premia and a terminal rate well above neutral – Floating Rate Notes (FRNs) could potentially benefit investors seeking a defensive fixed income option with less sensitivity to rising interest rates, capital stability and good income potential – now with the 3 month Bank Bill Swap Rate close to 1%.1 We discuss this further in our recent paper “Piloting Defensive Portfolios During the Powell Pivot ”.

Figure 1: A Correlated Sell-off

Australia Credit

Global inflation pressures continue to persist (see Figure 2) and market confidence in central bank’s projections as well as their ability to provide rate-guidance/assurance through communications have eroded, leading to increased instances of episodic volatility and underperformance across asset classes. The macroeconomic backdrop has turned more challenging as well, as the Russia-Ukraine conflict is now turning into a prolonged war of attrition without any clear endgame - with increased chances of an energy supply disruption hitting Europe, in addition to the recent price shock.

Figure 2: Citi Global Inflation Surprise Index – Last 10 Years

Future Performance

Amid a strong labour market, rebounding economic activity and an upside surprise in domestic inflation data which had crossed 5%, the RBA was quick to pivot from its ‘hold’ stance and increased its cash rate by 25bp to 0.35% on 3 May, its first hike since 2010. Since the RBA has started the hiking cycle a bit later than other developed market peers, markets are aggressively pricing in around 230 bps worth of hikes till the end of this year (see Figure 3). We believe that the RBA would continuously hike till the cash rate reaches a pre-covid level of 1.50%, and then reassess – based on economic data trends, and the ability of the economy as well as the AUD$10 trillion residential real estate sector to absorb more.

Domestic as well as global market sentiment is likely to remain volatile in the near term given uncertainty around inflation and its path, as well as the expected downside growth risk from China (as it continues to follow a strict ‘zero-COVID’ approach) and Europe (as its ability to substitute Russian gas faces hurdles, requiring outages/rationing).

Figure 3: Market Expectations for the Cash Rate Have Risen


In summary, Australian FRNs managed to avoid the majority of the recent correlated sell off in assets (see Figure 1). FRNs have historically performed well in periods of rising interest rates and with markets expecting rates to continue to rise (see Figure 3), investors seeking a defensive fixed income option with capital stability and less sensitivity to rising rates could benefit from an increased allocation to FRNs in their overall portfolios.

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