Wednesday 27 July 2022 by Jessica Rusit FY23-market-outlook-and-the-opportunities-for-bonds General,Market stats

FY23 market outlook and the opportunities for bonds

Investors have been on a wild ride this year, from escalating inflation concerns to faster rate hikes, increased equity volatility and heightened recession fears. There’s a lot going on in markets right now, and it’s likely to get even more interesting. Here we provide a market update and discuss how bonds can alleviate some concerns for investors.


It has been a perfect storm for markets this year. While there was never any doubt it would prove difficult for central banks to smoothly unwind unprecedented stimulus measures, other factors have added to its complexity.

There has been a lot to digest as an investor. Here we look at current market conditions, rates outlook and the strong case for bonds.

Market update

Market movements this year have mostly been driven by central bank rate hikes, which are as a result of escalating inflation. Where major central banks had originally thought increasing inflation was ‘transitory’, this has not turned out to be the case, and as such taming inflation became their number one priority.

The European Central Bank (ECB) is the most recent central bank (at time of writing) to hike rates, surprising markets by raising rates by 50 basis points (bps), despite guiding to a 25bps increase for some time. Inflation in the Eurozone increased further to 8.6% in June, with hopes the rate increases will help bring it back to their 2% target.

While Eurozone inflation might sound on the higher side, the US Federal Reserve (Fed) is tasked with chasing inflation that has reached 9.1% for June, the highest since November 1981. This was up from 8.6% in May and above the 8.8% market consensus.

The Fed meets later this week, where it is widely anticipated to deliver a hike of at least 75bps, and at most 100bps, given inflation seems to have not peaked yet as was previously predicted. This would be the fourth rate hike this tightening cycle and the second one in the region of 75bps.

The outcome is likely to influence the Reserve Bank of Australia’s (RBA) own monetary policy, which its set to meet next week for August. Australia’s 2Q CPI data showed headline inflation accelerated to 6.1% over the last 12 months, up from 5.1% the prior quarter. Following this release, the market is pricing in just over seven rate hikes for the year.

Moving sooner on the rate hiking front was the Reserve Bank of New Zealand (RBNZ), which delivered its sixth straight interest rate hike at its July meeting, this one by 50bps. This takes its official cash rate to 2.5%, a level not seen since March 2016.

The chart below illustrates the increase in inflation across the US, New Zealand and Australia over a year, with the RBA faced with a lesser challenge than some peers.


With rates moving higher, and set to move even higher again, central banks are hoping pent up savings accumulated over the COVID-19 pandemic will be sufficient to avoid an economic hard landing. Recently RBA Deputy Governor Michelle Bullock gave a speech reiterating that household sector balance sheets are in a ‘fairly good position’ to withstand increasing rates. However, markets are providing ominous signs on this.

Recent consumer and business sentiment reports have pointed to a negative shift in outlooks. Westpac’s monthly Consumer Sentiment Index for July shows a clear downward trend in consumer sentiment, recording its eighth consecutive monthly drop and now at levels in line with historical economic downturns (recessions of the early 1980s and early 1990s, GFC, COVID-19). This is illustrated in the chart below:


While the index in previous months seemed to indicate consumers were more concerned by inflation than rising interest rates, the most recent survey indicates that, while inflation remains a concern, the RBA hikes are also starting to impact confidence as well.

This overall picture is confirmed through the CBA’s Household Spending Intention Index for June which shows that, while spending continues to rise, we can see the start of a shift within spending categories towards non-discretionary items, while retail, home buying and entertainment are going backwards.

Another often referenced indicator for recession risk is the inverted yield curve, which has predicted seven of the past eight recessions. The inverted yield curve refers to the yield on the longer-dated 10-year US Treasury bond dropping below the yield on offer from the shorter-dated 2-year US Treasury bond. Currently the 2-year US Treasury bond yield is ~24bps higher than that of the 10-year US Treasury bond yield, which would point to a possible upcoming recession. While this has historically been the case, with central bank actions such as QE distorting yield curves, it can’t be relied upon as accurate going forward.

A promising sign is the tight labour markets both in Australia and other major economies, as shown in the chart below, for both the US, New Zealand and Australia. In fact, Australia’s unemployment rate for June dropped to 3.5%, the lowest level of unemployment since 1974. With job-vacancies at historic high levels, there is currently almost one vacant job for every person unemployed. The story is similar in the US, with two job openings for every unemployed person as at the end of May.


While there remains a strong labour market, this hasn’t translated to pressure on wages, with the Wages Price Index for the March quarter at 2.4% year on year. This is short of the RBA’s forecasts of 4%, although we may see an uptick with new awards negotiated and an increase in public sector wages for the September quarter.

Bonds are the new black…again

While many investors may feel the best place to ride out the uncertainty is from the sideline, current conditions have made bonds an even more attractive investment option than ever. So much so, that even a notable equity investing firm has referred to bonds as ‘back on the investment radar’.

With markets pricing for faster rate hikes, investors are able to lock-in higher returns offered by a steeper yield curve, without having to sacrifice credit quality. While a few years ago investors would need to ‘reach for yield’, investors can now achieve similar returns (or even better) in investment grade positions.

The chart below illustrates the significant move higher in yields since the beginning of this year in both the US and Australia, as more aggressive rate hikes are priced in, offering more attractive returns.


While term deposit rates will also benefit from higher rates, coming off such a low base, it’s likely they won’t be more compelling until further into the rate hiking cycle.

Along with attractive returns, bonds also provide a regular income stream, which not all other asset classes offer. Furthermore, unlike discretionary dividends paid on shares, the coupon payment on a bond is a contractual obligation that a company must meet.

While fixed coupon bonds will lock-in the return offered (and in current conditions provide possible capital upside if and when yields do eventually tighten), floating rate notes will adjust each periodic coupon payment against the 3month Bank Bill Swap Rate (BBSW). As such, the periodic coupon payment will increase, providing a higher income stream, with an uplift in the 3month BBSW. We continue to believe that a balanced and well-constructed portfolio should include a mixture of both fixed, floating rate and inflation linked bonds.

With inflation a key concern for investors, inflation linked bonds offer protection by keeping cashflows paid to investors in step with the rate of inflation. This is an important consideration for investors looking to protect their spending power against destructive inflation.

Unlike equities, bonds have a specific repayment date when the issuer must repay full principal back to bondholders at a known capital value. As such, if an investor is comfortable with the individual credit exposure, then they should be comfortable looking through any price movement, knowing the amount that will be repaid at maturity.


While it’s been an action-packed first half to the year, there’s likely to be even more to unfold in the latter half. It’s yet to be seen if the number of hikes priced in do eventuate, but whatever the case, we can expect more rate rises to come. Expect more noise around inflation reads, with inflation set to peak later this year, and increasing concerns around the possibility of a recession. Will pent up savings accumulated during the pandemic be enough to avoid an economic hard landing? Whatever the outcome, a balanced bond portfolio will provide both the income stream, capital protection and diversification to weather the storm.