“If opportunity does knock, build a door” – Milton Berle
Well, we all knew it was inevitable, Westpac now expect that the RBA will begin its tightening cycle in the first quarter of 2023 with a 0.15% lift in the cash rate. That is expected to be followed by two more increases in 2023 of 0.25% each lifting the cash rate by year’s end to 0.75%. That said the RBA will keep a close eye on inflation, expected to remain between 2-3%, and will also be very measured in its tightening cycle given the prominent levels of household debt. Using those broad guidelines, Westpac are pencilling in two further 0.25% rate increases in 2024 lifting the terminal cash rate to 1.25% by November 2024. On the back of this we will start to experience a further steepening of the yield curve in the next two years.
For everyone that has a mortgage, APRA guidelines will instruct lenders to ‘stress test’ the ability of loan applicants to make repayments if their mortgage rate increases from around 2% to over 4%. In effect, if the mortgage rate were to increase by more than 2.5% lenders would be uncomfortable with potential risks of mortgage stress for some borrowers. The reality is the RBA is very aware of the sensitives at hand (see chart below) so, despite current forecasts of marginal increases to interest rates, these can at the very worst be delayed.
The US are setting up for a similar outlook. Westpac is already forecasting that the FOMC will begin its tightening cycle in December 2022 and raise the Federal Funds Rate to 0.875% by June 2023. It seems reasonable to expect a resting neutral Federal Funds Rate will be higher than the RBA’s 1.25% – given the much-reduced sensitivity of the US household sector to the US official interest rate. (The neutral rate of interest is the interest rate that supports the economy at full employment/maximum output while keeping inflation constant.)
So, it looks like the most favourable solution/investment, from a fixed income perspective, will be, to have a diversified portfolio of both fixed and floating rate bonds available via The Bond Exchange, for both wholesale and retail investors. It is important to point out yet again, that Australian investors are massively underweight fixed income and overly exposed to risky and very volatile assets. Recent statistics suggest that SMSF’s on average, hold less that 2% in fixed income, with the rest in either shares or property. This is fine when these asset classes are performing but we have seen what happens when “risk off” mentality hits markets. The beauty of bonds is that you know your income stream up front (companies can change dividend payout ratios) your capital is protected, and you know at maturity you will receive the face value, normally $100.
One last point is that the debt levels worldwide over the past 18 months have increased at an unprecedent speed and level resulting in a world that is much more leveraged than ever before. This means a slight increase in funding cost (or unwinding of the massive QE programs) will have a far greater impact and no one at this stage knows what the breaking point will be. We have already seen a massive steeping in the yield over the past six months and the long end has had a sell off with yield peaking at over 2% back in March from a low of 0.70% late last year.
The chart below gives a clear indication of what households are thinking on the future of interest rates – there has been a surge to 40% as a percentage of total outstanding loans suggesting, not surprisingly that there is a concern amongst the public on what is to come potentially.
- As part of our feature this week I thought we would look at how one of the world’s most successful investors does it, and by that I am referring to Warren Buffet. Buffett follows the Benjamin Graham school of value investing, which looks for securities whose prices are unjustifiably low based on their intrinsic worth. There is not a universally accepted way to determine intrinsic worth, but it is most often estimated by analysing a company’s fundamentals. Like bargain hunters, the value investor searches for stocks/bonds believed to be undervalued by the market, or stocks/bonds that are valuable but not recognized by most other buyers.
ABE Bonds of interest
High demand for SSAs and other safe investments as credit spreads tightening.
There has been significant demand in the above names. We continue to build interest in these names and others.
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