The recent sharp rise in bond rates may not be a big topic of conversation around the Sunday barbecue, but it has set pulses racing on financial markets amid talk of inflation and what that might mean for investors.
US 10-year government bond yields touched 1.61 per cent in early March after starting the year at 0.9 per cent.i Australian 10-year bonds followed suit, jumping from 0.97 per cent at the start of the year to a recent high of 1.81 per cent.ii
That may not seem like much, but to bond watchers it’s significant. Rates have since settled a little lower, but the market is still jittery.
Why are bond yields rising?
Bond yields have been rising due to concerns that global economic growth, and inflation, may bounce back faster and higher than previously expected.
While a return to more ‘normal’ business activity after the pandemic is a good thing, there are fears that massive government stimulus and central bank bond-buying programs may reinflate national economies too quickly.
The risk of inflation
Despite short-term interest rates languishing close to zero, a sharp rise in long-term interest rates indicates investors are readjusting their expectations of future inflation. Australia’s inflation rate currently sits at 0.9 per cent, half the long bond yield.
To quash inflation fears, Reserve Bank of Australia (RBA) Governor Philip Lowe recently repeated his intention to keep interest rates low until 2024. The RBA cut official rates to a record low of 0.1 per cent last year and launched a $200 billion program to buy government bonds with the aim of keeping yields on these bonds at record lows.iii
Governor Lowe said inflation (currently 0.9 per cent) would not be anywhere near the RBA’s target of between 2 and 3 per cent until annual wages growth rises above 3 per cent from 1.4 per cent now. This would require unemployment to fall closer to 4 per cent from the current 6.4 per cent.
In other words, there’s some arm wrestling going on between central banks and the market over whose view of inflation and interest rates will prevail, with no clear winner.
What does this mean for investors?
Bond prices have been falling because investors are concerned that rising inflation will erode the value of the yields on their existing bond holdings, so they sell.
For income investors, falling bond prices could mean capital losses as the value of their existing bond holdings is eroded by rising rates, but healthier income in future.
The prospect of higher interest rates also has implications for other investments.
Shares shaken but not stirred
In recent years, low-interest rates have sent investors flocking to shares for their dividend yields and capital growth. In 2020, US shares led the charge with the tech-heavy Nasdaq index up 43.6%.iv
It’s these high growth stocks that are most sensitive to rate change. As the debate over inflation raged, the so-called FAANG stocks – Facebook, Amazon, Apple, Netflix and Google – fell nearly 17 per cent from mid to late February and remain volatile.v
That doesn’t mean all shares are vulnerable. Instead, market analysts expect a shift to ‘value’ stocks. These include traditional industrial companies and banks which were sold off during the pandemic but stand to gain from economic recovery.
Property market resilient
Against expectations, the Australian residential property market has also performed strongly despite the pandemic, fuelled by low-interest rates.
National housing values rose 4 per cent in the year to February, while total returns including rental yields rose 7.6 per cent. But averages hide a patchy performance, with Darwin leading the pack (up 13.8 per cent) and Melbourne dragging up the rear (down 1.3 per cent).vi
There are concerns that ultra-low interest rates risk fuelling a house price bubble and worsening housing affordability. In answer to these fears, Governor Lowe said he was prepared to tighten lending standards quickly if the market gets out of hand.
Only time will tell who wins the tussle between those who think inflation is a threat and those who think it’s under control. As always, patient investors with a well-diversified portfolio are best placed to weather any short-term market fluctuations.
If you would like to discuss your overall investment strategy, please reach out to the Sherlock Wealth team here to help look at what’s right for you.
i Trading economics, viewed 11 March 2021, https://tradingeconomics.com/united-states/government-bond-yield
ii Trading economics, viewed 11 March 2021, https://tradingeconomics.com/australia/government-bond-yield
Treasury chief Steven Kennedy believes few countries have experienced what Australia has achieved in responding to last year’s recession – relatively good health outcomes, smaller economic impacts and now, rapid recovery.
“By any measure, Australian governments have struck the right balance,” Dr Kennedy told senators in Canberra.
“Our outcomes have been world leading, both in the health and the economic sphere.”
He said the economy has now recovered 85 per cent of the decline from its pre-COVID level of output.
“Growth will now begin to moderate as we move past the initial phase of the recovery,” he told a Senate estimates hearing on Wednesday.
“While the economy is recovering strongly, well supported by fiscal and monetary policy settings, we are well below our pre-pandemic economic growth path and it will take some time to fully recover.”
He said the peak in unemployment now appears to have passed following strong employment gains in recent months.
In the mid-year budget review released in December, Treasury had predicted the unemployment peaking at 7.5 per cent in the March quarter.
Instead, the unemployment rate has steadily fallen, dropping to 5.8 per cent in February.
“Nonetheless, while outcomes to date have tended to surprise on the upside, there is still significant spare capacity in the labour market,” Dr Kennedy said.
New figures show there remains strong demand to hire staff with job advertisements posted on the internet jumping by a further seven per cent in February to be 24.8 per cent over the year.
This is the 10th straight month job ads, as compiled by the National Skills Commission, have risen after striking a record low in April 2020 and the depths of last year’s recession.
Job ads grew in all eight broad occupational groups monitored by the commission and recruitment activity increased across all states and territories.
But Dr Kennedy expects the number of people defined as being in long-term unemployment – those who have been looking for but been without, paid work for a year or more – will jump in coming months.
“This reflects the flow-on impacts of the spike in unemployment at the onset of the crisis in March and April last year,” he said.
Meanwhile, Australia recorded its third consecutive goods trade surplus above $8 billion for the first time in history.
Preliminary trade figures show exports grew by two per cent in February, buoyed by a record $1.3 billion of cereals exports, which helped offset a 12 per cent decline in iron ore shipments to China.
Imports also grew by two per cent, led by a 24 per cent increase in road vehicle inbound shipments.
Colin Brinsden, AAP Economics and Business Correspondent
(Australian Associated Press)