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Wednesday 10 May 2023 by FIIG Research General

Recalibration – bond markets rally off the back of growth outlook

A lot has happened in financial markets over the recent months that has compounded concerns about the growth outlook, resulting in a sizeable rally in bond yields and a large shift in market expectations for future central bank interest rate decisions. With this also, investors should consider their asset allocation, as they re-evaluate their portfolio construct and returns on offer.


Bond markets do not wait for central banks to signal a turn in their monetary policy – they look ahead and price accordingly.

A large move in government bond yields directly impacts the yield on offer on fixed rate corporate bonds (assuming unchanged credit spreads). Yields have fallen and prices have increased on both government and corporate bonds.

In this note we attempt to ‘mark-to-market’ i.e. shine a light on where corporate bonds are now trading, allowing investors to recalibrate their expectations. The old ‘6-7%’ is now closer to ‘5-6%’ on Aussie investment grade bonds, in line with moves in government bonds and term deposit rates.

With this shift, investors chasing certain yield targets may need to reconsider their asset allocation, where bonds can still offer higher returns compared to more conservative asset classes, also noting that fixed rate bonds allow investors to lock in returns and provide the same stable income stream even during periods of lower rates.

The Hangover

On the back of Silicon Valley Bank (SVB), Signature Bank of New York and Credit Suisse developments (covered here), we have seen a rush of bank deposits out of smaller US banks (4.3% decline in deposits since March) into larger US banks. However, and more importantly, we have also seen an acceleration in the decline of aggregate US bank deposits – around 3% since February 2023 - on account of elevated Fed Funds rates, directly impacting the attractiveness of short-term government bonds and money market funds compared with bank deposit rates, as shown in the chart below.

The problem is that short-term treasuries and money market funds do not have direct transmission to funding the broader economy, unlike banks. The withdrawal of deposits has the market concerned about the trajectory of future credit growth, given developed market economies are almost entirely reliant on credit expansion for economic growth.

This is just the latest factor to compound already soggy expectations of future economic growth. Markets rely on a number of leading economic indicators to get a gauge on the direction of future growth. The Conference Board Leading Economic Index (LEI) for the US includes factors such as average weekly hours worked, weekly initial claims for unemployment insurance new orders, building permits and the shape of the yield curve etc. This composite indicator has a strong track record in anticipating growth slowdowns, and subsequent interest rate cuts from the US Federal Reserve (Fed), as can be seen in the following chart.

The recent speed and slope of the fall in the LEI is greater than during the GFC period, while the Fed Funds rate hike profile into a slowing LEI looks eerily similar to that of the GFC. The very mention of the term ‘GFC’ should see investors scrambling for fixed rate bonds, and that is exactly what we have seen with 2-year US government bonds rallying more than 100 basis points (bp) since the beginning of March – despite the Fed raising its base rate a further 25bp at its March meeting (and again this month).

Also noteworthy (and closer to home) is that we have seen multiple banks cutting their term deposit rates. Macquarie has cut its 1-year term deposit rate from 4.90% to 4.50% in March– almost the equivalent to two interest rate cuts from the Reserve Bank of Australia (RBA). This came ahead of the RBA’s pause in interest rates in April, showing once again that central banks are potentially ‘behind the curve’ yet again. Macquarie is not alone, with more than 10 banks cutting TD rates over the recent months.

As a result we are seeing lower bond yields and falling term deposit rates ahead of any central bank rate cuts.

Hang on, what about inflation?

Global inflation prints remain well above stated targets, however these largely reflect what was happening in the economy 6-12 months ago. Central banks are still regularly opining on inflation, but there is evidence that the market is simply not concerned with inflation anymore – or rather, the concerns about future insipid growth now outweigh the concerns about inflation. It is not hard to see why – while the spike in inflation was steep, the decline has been a near mirror image (so far), as illustrated in the following chart.

Two of the main culprits for the surging inflation prints were commodity prices and supply chain issues, both of which have reverted materially in 2023 and will provide a disinflationary impulse in upcoming inflation prints, as shown in the below chart.

While it is too early to say that inflation was transitory (still something of a dirty word within financial markets), the inflation-focused part of the bond market is already pricing a return to normal levels of inflation as indicated by 2-year US CPI Swaps and Break evens (the difference between nominal and inflation-linked bond yields) between 2.5-2.6%, at time of writing.


The call to action here is not to take a strong view either way, but to ensure that your portfolio is sufficiently diversified. Given the dynamics of 2022, the likelihood is that the average investor portfolio is skewed to asset classes now exposed to lower rates. We think now is the time to take a more balanced approach to your bond portfolio across fixed and floating-rate bonds, such that it has the capacity to fulfil its role as a defensive part of your broader asset allocation if the conditions forecasted by the Leading Economic Indicator come to fruition (yields falling on fixed rate bonds will lead to higher bond prices, while other risky assets are losing value).

The other important thing to remember is that falling bond yields and cuts to term deposit rates mean that you should expect lower yields on corporate bonds now – that is consistent with all the other moving parts of the broader cash and bond markets. What you were able to pick up for 6-7% is now priced around the 5-6% level. With the yield on the Bloomberg AusBond Credit 0+ index sitting below 4.5% now - compared with 5.3% around 6 months ago - a recalibration is in order.