After a period where we’ve seen some of the lowest interest rates in history, investors are now starting to take a closer look at what rising bond yields are telling us.
Over the past few months, the yield on both US and Australian Government bonds has been rising sharply. As it stands the yield on the 10-year US Treasury is sitting at 1.6%, with recent highs around 1.75%, and Its Australian counterpart is currently at 1.66%.
Contrast that to what we are hearing from the central banks and their message that the current low level of interest rates will continue for the next three years and there is clearly a disconnect taking place.
The theory around why rates are rising suggests that markets believe inflation is set to rise earlier than expected as the economy recovers post-COVID. We are starting to see numerous states in the US opening up while across Australia it is nearly business as usual, with the exception of the international borders remaining closed. As I have said previously, I do not think we can assume that the path of post-pandemic recovery will be a smooth, linear progression upwards. The new country lockdowns in several nations in the Euro bloc bear testimony to this and emphasizes the need for ensuring that central bank stimulus measures are not withdrawn too early and threaten this economic recovery.
One of the reasons bond yields are rising and the central banks are not following suit in potentially preempting some monetary tightening, is that they are not only waiting for inflation but also encouraging it. Both RBA Governor Philip Lowe and FOMC Chairman Jerome Powell have made it clear that the goal is to stimulate jobs growth and the broader economy. They are prepared to let inflation run above the
2 -3% target band if it means that they are able to create jobs, and more importantly, wages growth. Without wages growth, we will likely not see much inflation so the prospect of “full employment” needs to actually put more cash into workers pockets to enable an increase in spending and thus economic expansion.
Seeing long bond yields rise does suggest that the economy is turning things around. We’ve seen this first hand in Australia based on the latest jobs data. The ABS recently revealed that the unemployment rate had fallen to 5.8%, which is the lowest level we’ve seen since the COVID shutdowns began. To put it in context at that time the jobless rate was 5.2%.
2020 was rough for many Australians and we saw unemployment hit a 22-year high of 7.5 per cent in July as more than one million Australians were officially unemployed for the first time ever.
Interestingly, we have also recently seen that new job postings are now tracking 32.9% above their pre-COVID level. Clearly, low-interest rates have done their job and the economy has very much turned the corner.
With jobs returning, equities back at near record-high levels, and property prices rising at the fastest level in nearly two decades, it’s fair to assume that inflation might be coming back, although I think it may be further down the track than markets seem to be assuming.
However, it’s important to note that inflation is not necessarily a bad thing.
In fact, if you’re invested in growth assets such as property, then you stand to benefit over the coming years. As we see central banks print more money and potentially create inflation, then the value of real assets rises rapidly.
Similarly, the Federal Government will also be wanting to see inflation rising in an orderly manner as this would indicate that they have been able to stimulate the economy and employment without creating unwanted excesses. This might also be the only way they will be able to efficiently pay down the mountains of debt that have been created over the past 12 months through these pandemic stimulus measures.
Investing in 2021
Despite all the positive signs, there is still a great deal of uncertainty ahead and investors will need to be compensated for that uncertainty.
From an Australian expat viewpoint, the AUD has strengthened substantially
since its nadir in March 2020. However, if you already own AUD based assets or you’re buying more property in Australia or buying equities priced in Australian dollars, then it’s a good thing to have a rising AUD as this will ultimately deliver some tailwinds in terms of longer-term growth and income delivery.
In terms of how we are looking to manage our client growth portfolios, we went from overweight cash (USD) last year to benchmark, and increased equities from underweight to benchmark at the same time. We’re also overweight equities compared to bonds and little exposure to duration over this period.
Our belief is that equities should deliver better results, however, some people are getting a bit ahead of themselves in the likes of the ‘recovery’ stocks such as airlines, hotels etc. A lot of recovery profits are being priced in so there might not be as much value there at current levels as people anticipate.
There is no doubt we will see rising interest rates at some point, but it is also important to consider that the central banks won’t be tempted to jump too early as they have done previously.
It’s also worth noting that rising rates aren’t necessarily bad for property and real growth assets in the longer term. Interest rates rise when the economic expansion requires them to do so. In the event of unacceptable overheating in the Australian property market, we’ve also seen other measures such as APRA’s macro prudential controls being used extremely effectively in the past so this is also something we could certainly see more of. One would assume that this process will be more tempered in its approach as the previous introduction in 2017 had a detrimental effect on the Australian economy when it created the sluggishness that was still evident prior to the COVID-19 pandemic last year.
While bond yields have been rising, I don’t expect central banks will jump too early to try to pre-empt any economic overheating and will remain patient. That’s what they’ve been telling us for months now and I suspect they will hold course for the time being until there is evidence of wages growth above 3.5% and inflation remaining in the 2 – 3% target band for some time.