Fed Cuts, RBA Holds: What Diverging Policies Mean for Australian Bonds
The Federal Reserve's recent decision to initiate its easing cycle through a bold 50 basis point cut marks a pivotal moment for investors and the broader market. This move not only represents a significant shift in monetary policy but also reflects the Fed's revised year-end projections, which have been lowered by 75 basis points for 2024 and 2025, positioning the expected interest rate closer to a neutral level of approximately 3% by early 2026. Such proactive measures underscore the Fed's commitment to steering the economy toward a soft landing while acknowledging the inherent delays in the transmission of monetary policy.
In contrast, the Reserve Bank of Australia (RBA) has chosen to maintain the cash rate at 4.35%. In our view, these divergent monetary strategies are creating attractive opportunities for Australian bond investors.
What does the Fed’s rate cut mean for investors?
The Fed's long-awaited policy shift carries significant implications for markets, and it is worth highlighting three key considerations for investors:
- The Fed’s focus has changed: The Fed has two key goals mandated by Congress: promoting stable prices and promoting maximum employment. For the past two years, with inflation running hot, it has managed risk in relation to prices. Now that inflation has come down close to the Fed’s 2% target, wage growth is slowing and the labour market is starting to cool. So the Fed’s focus now is on ensuring job creation continues at a healthy pace. While it may remain patient in the face of positive economic data, any signs of negative data—especially concerning employment—are likely to trigger more aggressive cuts.
- The Fed projections are not a guarantee: The Fed’s projections for interest rates (also known as the dot plot) are updated quarterly and, as a result, can change as the facts change. Current market pricing and Fed projections suggest a return to neutral rates at around 3% by early 2026. However, there is potential for the market to start pricing in additional rate cuts beyond that neutral rate, particularly if economic data worsens. This scenario reinforces the role of bonds as a strong diversification anchor in investment portfolios, providing stability amid uncertainty in the event of a potential downturn.
- Money will be on the move: With U.S. interest rates declining, we can expect a substantial redeployment of money from cash and money market funds into investments further along the risk spectrum, including bonds, credit and riskier assets, such as equities.
Considering these factors, we maintain a positive outlook on duration and are positioned for further yield curve steepening. In the absence of a significant data shock, we expect volatility to remain relatively contained.
The RBA's hawkish stance creates attractive opportunities in domestic bonds
The RBA has opted to keep rates on hold, leaving investors wondering when it will join the global easing trend. Most economists now predict that the RBA will initiate a shallow easing cycle in February next year. This timeline aligns with our view that the macro cycle in Australia has lagged the U.S. by approximately six to nine months. By February, we anticipate an improvement in inflation and a further loosening of the labour market, setting the stage for a dovish pivot by the RBA.
For domestic investors, there is a silver lining. The RBA's relatively hawkish stance compared to other central banks means that bond yields in Australia have not fallen as much as those offshore. Currently high quality core bond portfolios are yielding between 4% to 6% depending on the risk profile, which represents a compelling opportunity for investors to lock in attractive yields.
From a portfolio positioning perspective, one of our highest conviction trades remains holding a long duration position in Australian and New Zealand bonds relative to offshore markets.
Following the Fed’s policy pivot, changes are in store for investors
Although the RBA has yet to join the easing party, Australian banks have already begun to lower term deposit interest rates. This has significant implications for Australian savers who rely on this steady income.
Now is a good time to consider moving out of cash and into income-generating bond funds. With high quality bond portfolios yielding 4% to 6% or above depending on the risk profile, we believe there is a window of opportunity to secure elevated levels of yield, potentially benefit from capital gains, and hedge against anticipated economic weakness.
Find out more about how to access today’s attractive opportunities in bonds here.
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