ABEWeekly 27102021

20th October 2021 

Market Update  

 

“Know where you stand before you do anything in business.” – Amanda Rose 

 

What a difference a week makes. The language being used by the RBA of late has once again kept the market guessing on the future of interest rates and as a result caused a steepening of the yield curve. One very important reason why the RBA is expected to be slow to begin the tightening cycle is the recent change in policy approach. After having missed the 2.5% target for core inflation since 2014, the previous approach of being pre-emptive has been replaced with the need to “play safe” and achieve the target before tightening. In the words of Governor Lowe, The RBA will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. “It won’t be enough for inflation to just sneak across the 2 per cent line for a quarter or two. We want to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2–3 per cent band again.” 

To emphasise its commitment to hold rates steady until 2024 the RBA has committed to purchase the government bond that matures in April 2024 at the cash rate of 0.1%. With the market now expecting a cash rate of around 1.4% by April 2024 this purchase commitment is just academic. However, just as the 2-3% inflation target cannot be adjusted, the RBA can’t walk away from this target suggesting that interest rates are likely to remain stable in the short term. 

Given the current increasing concentration in risk assets its worth revisiting just why fixed income remains an important part of any portfolio. Here we look at two considerations. The correlation and risk/reward of fixed income to other asset classes. 

Using Morningstar Direct data for the last five year and two fixed income indices – The Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays US Treasury Index – and comparing it to private equity and hedge fund returns, we see that fixed income is the only asset to demonstrate a low to negative correlation to risk assets. In this period, the range of correlations for traditional fixed income ranges from -0.40 to 0.00. This range suggests that fixed income is either not correlated (0.00) or negatively correlated (-0.40) relative to traditional risk assets. This underscores the importance of using fixed income as a diversification tool and why it should form part of any portfolio. 

     

Another benefit of fixed income is its modest risk profile which allows for efficient returns per unit of risk. While we acknowledge that potential returns for fixed income may appear to be limited in the current market environment, investors should consider whether designating some capital to fixed income is an efficient allocation considering the modest risk profile of the asset class. Looking at the table below, it’s quite evident just how efficient and effective an investment in fixed income is, easily outperforming equities.
 

 

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