In anticipation of further rate increases from the Reserve Bank of Australia (RBA), fixed income markets are ‘pricing in’ the current tightening cycle. However, to better position portfolios, it’s worth understanding how accurate the market has been at predicting prior hiking periods. Here we look at what historical rate hiking cycles can show us.
Background
As recently as November last year, the RBA was signalling conditions for rate hikes were “unlikely to be met until at least 2024”. At the time of writing there have been five rate increases, following the RBA’s first pivot to tightening at its May meeting. Fixed income markets have also repriced future rates to reflect the higher interest rate outlook from the RBA.
Media commentators and market economists will often talk about ‘what’s priced in’ to bond markets. How accurate is this ‘repricing’ of the forward path of interest rates by market participants and what lessons can fixed income investors learn from previous hiking cycles to better position their portfolios?
Typically, investors will favour floating rate notes over fixed coupon bonds during a hiking cycle as the coupon on floating rate notes adjusts upwards as rates increase. On the other hand, fixed coupon bonds lock-in in the rate at time of investing, until the bond’s maturity or when it is sold.
The market’s forward-looking rates views, also known as predicted rates, frame a path that participants expect the central bank to follow based on a variety of factors such as inflation forecasts and what other central banks such as the US Federal Reserve are expected to do in the future.
Historically, the actual rate increases that eventuate from the RBA, also known as realised, provide investors with guidance as to how accurate the market is in predicting future rate moves. Where the RBA’s rate moves don’t match what the fixed income market has priced-in, then accordingly, future cash rates are repriced to reflect the realised interest rate move, with the wider bond market also repricing accordingly.
As such, if the RBA increases the cash rate to a lower level than where markets were pricing, the returns achieved on floating rate notes would decrease as they adjust accordingly, whereas the return on fixed coupon bonds would remain locked in at the higher rate that markets had predicted (incorrectly!), as well as likely gaining in capital terms as market yields adjust lower.
While it’s anyone’s guess as to how the RBA’s current tightening cycle plays out (even the RBA itself seems unsure), by looking at historical predicted and realised rate moves, we’re able to better understand what this current hiking cycle could look like.
With this uncertainty, it pays to have a well-diversified portfolio, with an allocation to floating rate notes, fixed coupon bonds and inflation linked exposures to weather any interest rate moves.
Tightening cycles
We have observed historical tightening cycles to gauge the accuracy of the market’s ability to predict rate increases, or if in fact there were periods of discrepancy. Did the market ‘over predict’ the extent of the hiking cycle?
The data point we have used is the 1-year interest rate swap, an important benchmark in the interest rate markets used to price term deposits and home loan rates. We compared the 1-year interest rate swap rate from today, with what the market ‘predicted’ the rate to be the year before.
As shown in the chart below, the entire period from 1996 to now has been used to have a larger data set. We have discussed the significant rate hiking periods (circled in the chart below) in this article, but data across the entire period has been used to form a view on the accuracy of market pricing.
Market predicted rate pricing versus RBA realised
The first period we review is November 1999, where the RBA increased rates by 0.25% to a cash rate of 5.00% (prior to this the cash rate remained at 4.75% since December 1998). This was followed by another four rate increases, where the rate reached 6.25% (eye-watering when compared to recent rate lows). At the time, there had been strong growth spurred by low interest rates, facilitating the rise of start-up companies which would later see their significant fall and become known as the dot.com bubble.
Markets had over-priced higher rates, compared to realised rate increases from the RBA. The table below provides a snapshot in basis points (bps) of how much higher the market had predicted rates to be.
The RBA’s next hiking period began in November 2003, with a 25bps increase, taking the cash rate to 5.00%. Prior to then, the rate had been 4.75% since mid-2002. Another 25bps rate increase quickly followed in December 2003, before a later one in March 2005, taking the cash rate to 5.50%. Following the invasion in Iraq, dragging on consumer confidence, economies recovered with strong employment figures and contained inflation.
Rates for the period were once again over-priced by the market, compared to realised rate increases from the RBA. The table below provides a snapshot in bps of how much higher the market had expected rates to be.
In 2006 rate hikes began again, with the first increase in May 2006, where a 25bps increase took the cash rate to 5.75%. The rate had remained at 5.50% since early 2005 and set the scene for what would become the global financial crisis (GFC), which occurred from mid-2007 to early 2009. Lower interest rates, unemployment and inflation made it cheaper to borrow, at a time of strong and stable economic growth.
Markets had furthermore priced-in higher rates than what was realised by the RBA, although noting the discrepancy this tightening cycle was less than in earlier periods. The table below provides a snapshot in bps of how much higher the market had predicted rates to be (and priced correctly at the 6 Feb 2008 rate hike).
Following the GFC, the RBA was quick to cut rates in an effort to stimulate the economy, slashing the official cash rate from 7.25% in eight months to 3.00%. However, it was only six months later and the central bank was increasing rates again. It was once again a matter of the markets over-pricing in higher rates compared to realised rate moves from the RBA. It’s also worth noting, similar to earlier tightening cycles, the discrepancy is larger at the beginning of the cycle and narrows further into the period.
Referring back to the first chart, the solid line across each circled tightening period identifies the over-pricing by the markets compared to the realised rate moves from the RBA. On average over this timeframe, the data shows there is generally 75bps of predicted moves priced in by the market, compared to realised rate moves from the RBA.
Implications
While not making conclusions regarding the current tightening cycle, it can be said that generally previous periods of rate increases from 1996, point to the market overpricing higher rates than what is to eventuate from the RBA. It’s also worth commenting we believe portfolios should have a well-diversified profile and given higher inflation and higher interest rates could see an economic slowdown eventuate, it is more relevant than ever.
It’s also worth noting that both here and in the US markets are pricing rates cuts to start from the middle to late of next year, given the economic risks maybe both central banks hold off on some of the later hikes priced and adopt a wait and see approach.
While some investors may have shied away from adding longer dated fixed bonds given the rate hiking environment, it’s worth noting they currently provide an attractive entry point, trading at significant discounts to face value. We would also expect capital upside should we see a recession play-out (all else being equal) with investors seeking safer investments. We would consider these to be a core holding in any portfolio.
A diversified portfolio with a mix of floating rate, fixed coupon and inflation linked bonds will better protect fixed income portfolios whatever may eventuate.