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As we look ahead into 2024, the macro-economic environment presents a number of concerns for investors. While we don't have the benefit of a crystal ball to know with certainty what lies ahead, we do have the yield curve and numerous data points to help us analyse the picture and to appropriately position portfolios.

Where are we now? An economic balancing act

After the vast COVID-19 excesses, where governments and central banks provided extraordinary levels of fiscal and monetary support to economies, central banks have had to shift their attention to battling persistent inflation.

In our view, if we aren’t already there, we feel we are very close to peak cash rates. While it has been expected for some time, the domestic economy is now starting to cool.

Due to the lagged effect of interest rate rises, we believe a credit default cycle will eventuate taking a toll on corporates and households burdened by substantial debt.

This is particularly the case for the many ultra-low fixed rate mortgages which are starting to transition to variable rate loans, resulting in mortgagees copping the full force of 13 rate rises in an instant.

For context, in Australia a $1,000,000 mortgage fixed at the COVID-19 lows of 1.99% p.a. for a 30-year term would cost borrowers $3,691 in repayments per month. If that were to roll onto today’s standard variable rate of 8.80% p.a., the monthly repayments would more than double to $7,903, setting the scene for widespread mortgage stress, compounding cost of living pressures already felt from inflation.

While each economic slowdown since the Global Financial Crisis has been averted through central bank and government intervention, given inflation continues to linger, if central banks were to rapidly cut rates and provide quantitative easing to stimulate markets again, the embers of inflation would likely be fanned back into an inferno.

This puts both governments and central banks in a precarious position given the apparent trade-off between extinguishing inflation and keeping the economy out of a recession.

Three potential paths ahead

At a high level, when it comes to the range of potential outcomes for central banks, there are only three broad scenarios to consider – rates remain on hold, rates are cut, or rates rise.

Below we explore the implications for each outcome for investors.

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1. Interest Rates Remain on Hold

If interest rates stay on hold for an extended period of time, this suggests the interest rate rises so far are sufficient and that inflation is being seen to continue an orderly retreat toward an acceptable level and that the economy is appearing to operate with a degree of stability.

Taking the 10-year Australian Government bond as an example, with yields now at their highest levels seen in 15 years, they now represent a meaningful source of income and liquidity for investors. As inflation moderates, its erosive effect on bond income and value will diminish, meaning investors will also be better off in real terms.

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2. Interest Rates Are Cut

The potential for an economic downturn following rapid rate rises could see central banks back-track on interest rates, setting the scene for once-in-a-decade returns for bond investors.

Interest rate cuts are nirvana for government bond investors as they not only receive the regular government-backed income, but they also benefit from the bond becoming more valuable due to its relative attractiveness compared to newer bonds issued after the rate cut, or other investment options such as cash or term deposits.

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3. Interest Rates Rise

Should another market shock take place, such as the energy crisis experienced in 2022 following Russia’s invasion of Ukraine, there is potential for further interest rate rises to quell any resulting inflation.

While this would be a challenging environment for investors across all asset classes, given the 13 rate rises implemented by the RBA since November 2021, we would not anticipate numerous additional rises in response – particularly given the rate rises already implemented are still filtering through the economy.

Our view

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While time will tell whether the RBA’s official cash rate rise in November 2023 was the last in the cycle, our view is that we are at or near the peak in cash rates. Peak cash rates is a very exciting prospect for bond investors, particularly now that bond yields have been restored from the very low levels seen since the Global Financial Crisis. Bonds are arguably in better shape now than they have been in a number of years.

If history is a guide, cash rates tend to remain on hold after the peak for an average of 8 months and while this is certainly not an exact science, based on what we currently know about the economic outlook and market pricing, we anticipate a period of cash rate cuts toward the end of 2024.

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