Investment Matters

Bond markets bubble away

Mount Etna or “Montebello”, is Europe’s most active volcano, sitting on the east coast of Sicily.

It is slightly baffling that just 20km downhill from this bubbling force of immense destruction, sits a small local village, Nicolosi, a town of some 7,000 people.

A pact has existed between villagers of Nicolosi and the mountain for hundreds of years.

Its periodic outbursts have provided the village with mineral-rich soil, from which dozens of vineyards and orchards have sprung, not to mention a burgeoning tourism trade.

In return, its inhabitants live under the constant threat that one day, once again, the great mountain may choose to press the ‘reset’ button.

It’s easy to draw parallels between the people of Nicolosi and the investor in today’s climate.

The low-interest-rate environment of the last decade has led to a growth in asset prices, prosperity and wealth (albeit with some uneven outcomes).

Yet, investors have remained vigilant. For in the background, the very source of this prosperity continues to bubble away.

Friday reminded us of the importance of constructing portfolios while keeping the market’s bubbling mountain firmly in sight.

An explosion in bond rates

Last Friday we were reminded of the great mountain up the hill: with an eruption in short term interest rates.

Wednesday’s consumer price index (CPI) print showed inflation is running hotter than expected, and now sits within the Reserve Bank’s target band of 2.0%-2.5%.

Since the onset of the pandemic, the Reserve Bank has been committed to keeping short term rates low – intervening in the market suppressing the interest rate on the 3-year government bond at 0.1%. This was, in our view at the time, as well as in hindsight, an inspired piece of public policy, taking medium term (3yr) pressure completely away from household and corporate balance sheets whilst they endured a pandemic. But sometimes even the best policies are hard to reverse in the face of markets.

With fierce selling pressure – the market forced the Reserve Bank’s hand, which was unable to anchor the short end of the interest rate curve. Wisely they only resisted for a short time.

We can see this below, with the target yield on the April 2024 government bond shooting up more than 0.6%

An eruption in short term interest rates

Yieldbroker

Source: RBA, Yieldbroker

What was the market signalling?

With inflation now at target levels, there is an expectation that the overnight cash rate (the primary price-setting mechanism for short-term interest rates) will rise sooner than the RBA’s forecast of 2024. Perhaps as early as next year.

As the RBA met on Tuesday, Governor Phil Lowe was quick to temper expectations – continuing to distinguish between the rampant inflation we have seen abroad and Australia’s experience.

Meanwhile, interest rates continue to bubble away.

While crisis-era monetary policy has successfully steered us away from catastrophe –the events of Friday showed that without intervention, bond rates would likely sit at significantly higher levels.

This is crucial as bond prices function as ‘gravity’ for asset prices.

Sustained inflation may trigger further rises or a need for other forms of intervention. Ultimately, this will determine the path forward for asset prices.

As noted by MST Marquee:

“At the start of the pandemic the RBA pulled out a range of new tools from its policy tool-box. It has now put yield-curve control back into its tool box and we suspect it will refrain from using it again. It is clear that controlling the price of money is difficult for a small open economy central bank. The credibility repercussions are considerable in our view”

Implications

There are several directions in which inflation and monetary policy could head from here.

We won’t claim the ability to forecast this with any degree of certainty. 

In fact, we are similarly sceptical of others’ ability to do so. This includes the Reserve Bank.

While oft-quoted, the words of Mark Twain continue to resonate in this environment: 

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.“

Client portfolios are positioned with an acknowledgement that the future may look very different to the present.

This could span a spectrum of possibilities including a continued rise in interest rates and a period of post-war like financial repression.

What remains key to us is an appreciation of history, a healthy degree of scepticism and maintaining the same level of vigilance as the villagers of Nicolosi.