If the pace of monetary tightening in the U.S. is any sort of leading indicator for policy tightening in the rest of the world, including Australia, then in Australian parlance, it will be “like watching grass grow.”
The Federal Reserve first uttered the word “taper” way back in May 2013. At that time, the Fed stated its intention to begin reducing its bond purchases, pulling back from the quantitative easing program it had designed to keep interest rates low and stimulate growth. It has taken four-plus years for the Fed to raise rates four times, in 25-basis-point increments, and now, finally, the Fed is about to begin normalising its balance sheet. This exceptionally gradual tightening path has occurred despite U.S. policy rates having reached close to zero in 2008, the Fed’s balance sheet growing to over $4 trillion and the U.S. unemployment rate falling to 4.2%.
By contrast, the Reserve Bank of Australia (RBA) is one of the few developed-market central banks to undertake a full interest rate cycle since the global financial crisis (GFC). When the GFC began, the RBA cash rate target was a lofty 7.25%. The rate was then cut to an “emergency level” of 3% in 2009 before being lifted back to 4.75% by late 2010. This hiking cycle proved to be very short-lived, with rates then cut all the way down to 1.5% in August 2016, where they have remained.
Rising rates in Australia: a direct impact
PIMCO’s estimate of the neutral policy rate (the level that neither stimulates growth nor slows it) is 3% for Australia – what we call the New Neutral because it is likely to remain lower than in the past. A neutral rate of 3% would put the 10-year bond yield at around 3.75%. The reason our neutral rate expectation is lower than the RBA’s 3.5% is that we see the potential for stress to materialise for mortgage holders earlier and at much lower rate levels. Approximately 85% of Australian mortgages are floating-rate, and the balance are typically fixed for only two to three years before they reset to higher rates. In the U.S., by comparison, less than 10% of mortgages are floating-rate.
The transmission mechanism for monetary policy is therefore much more direct in Australia: Mortgage rates are quickly impacted by changes in RBA policy settings. Partly as a result, unlike many other central banks, the RBA did not find it necessary to cut rates to zero or expand its balance sheet in an effort to stimulate economic growth. The transmission mechanism should be similarly effective if and when rates rise, especially as Australian households have accumulated more debt at current low interest rates. The direct transmission mechanism is why we believe that the RBA will, like the Fed, take a very gradual path in raising interest rates.
What will rising rates mean for bonds?
When interest rates are expected to rise, investors are often concerned about how bonds will perform. However, bond markets, like all financial markets, are forward-looking in their pricing, and as a result have already started to price in expectations of higher interest rates in the future. If these forward interest rates as priced by the market today were realised, then Australian bonds would still outperform cash.
Based on PIMCO’s analysis, even if the RBA were to reach PIMCO’s estimated neutral rate of 3% by the end of 2020, which is considerably faster than we forecast, the expected returns from cash and Australian bonds would be almost identical.
All this implies that even as rates rise, investors can look to bonds for the benefits they have typically provided, especially low or negative correlations with risk assets like equities. In addition, many Australian portfolios are currently underweight bonds, so when interest rates move up toward the neutral level, we should expect a robust rebalancing from equities back into bonds. By PIMCO’s estimate, this could equate to over $100 billion in bond purchases by Australian investors alone. This expected flow into the bond market could further limit the potential for significantly higher interest rates into the future.
Until then, Australian investors could consider which assets are most likely to generate returns after inflation and invest their portfolios accordingly, rather than watch the grass grow.
For more, please see our long-term outlook for Australia.
Robert Mead is co-head of Asia-Pacific portfolio management at PIMCO in Sydney and a contributor to the PIMCO blog.
A version of this article appeared in the Australian Financial Review on 2 October 2017.