As we embark on a new financial year, it’s timely to hear from FIIG’s Head of Research, Philip Brown on the Macro Outlook. Here Philip provides his insights for the year ahead, and how to best position fixed income portfolios.
The Macro Outlook in Australia, as seen by FIIG Research, is one of transition. There are big decisions and possibly divergent paths.
The war against inflation seems to be drawing to a close, and the new challenge in the coming years is likely to be stimulating growth. The Reserve Bank of Australia (RBA), however, seems to be quite late to pivot to a new understanding of the economic challenges of 2026 and 2027 and remains very focused on fighting inflation.
We expect the RBA is likely to change two key principles in their understanding of the economy relatively soon. First, the RBA is forecasting recent rate cuts and wage rises to trigger a major rise in the consumption side of the economy, but these instead seem to be showing as a rise in the savings rate. Second, the RBA continues to view the labour market as relatively strong and liable to trigger wages growth and inflation. After witnessing the economy over the last few years fail to deliver wages growth, we place much less emphasis on this risk.
FIIG Research expects a much slower, but much more elongated, RBA rate easing cycle that continues, slowly, into 2026 and possibly beyond.
For bond investors, that suggests owning longer-dated fixed-rate bonds is the clear strategy, but there are material risks there, too. The biggest risk is that the US Government’s approach to debt and deficit is putting strain on global funding markets. We’ve already seen small wobbles in the US Government’s ability to fund itself. Globally, interest rate curves are steepening, with the US 10-year and US 30-year bonds rising in yield noticeably, even as the Federal Open Markets Committee (FOMC) has cut rates.
The US Government is also starting to crowd out other forms of borrowing. An obvious example is the high US 30-year bond rate putting pressure on 30-year mortgage rates, but the pressure is more widespread than that. The recently passed Big Beautiful Bill may well stimulate the economy in the short term, but the roots of a more long-term problem are clearly evident as the cost of funding these repeated bouts of stimulus hits home.
The risk of a major dislocation in US bond markets is real, though not high, but would cause a major rise in 10-year and 30-year bond yields. To balance these risks while also positioning for an elongated rate easing cycle, FIIG continues to suggest taking duration risk in the front and mid sections of the curve, with 5-year and 7-year bonds the recommended option. Credit risk is relatively well-behaved at present, but with so much risk in the system overall, it’s important to remain vigilant on diversification to manage overall portfolio risk.
As we move further into the RBA’s easing cycle, bond portfolios can assist in maintaining better returns when other asset classes can sometimes come under more pressure.
It’s likely that the combination of RBA cuts and US borrowing pressure will mean interest rate curves will remain steep or get even steeper in coming months. Steep interest rate curves provide good opportunities for bond investors to achieve short-term returns much higher than the quoted yields. FIIG investors have achieved average returns of around 9% for two consecutive years, mostly by buying bonds which yield in the mid 6% range in part because of the steepness of the curve.
This demonstrates that the overall return for a portfolio can be much higher than the yield, consistently, for those who rotate their portfolio at opportune times and take advantage of the shape of the curve. This effect is already present, but will become even more noticeable if the curve steepens more, as we expect it will. A diversified and well-constructed bond portfolio will continue to offer investors a steady income no matter what the year ahead brings.
To read the full Mid-Year Macro Outlook please click here.