Searching for a path lower

Yields have declined appreciably, and with two more central banks having cut interest rates, the global easing cycle appears underway. However, the path lower for the Fed and RBA looks more challenging. Our Chief Investment Office explains further. 

The global economy continues to move at two speeds. The US remains the outlier amongst developed markets, with GDP growth remaining reasonable. Conversely, growth in the euro area is anaemic, the UK and Japan have already encountered technical recessions, while Australia may yet narrowly avoid the same fate.

However, it is the direction of change across regions that is also important. In the euro area, growth is improving, unemployment is at a record low, and while the disinflation trend slowed last month, it remains intact. These conditions provided the European Central Bank (ECB) confidence to cut its policy rate by 25 basis points earlier this week.

For investors, it is worthwhile noting that the conditions under which the ECB cut interest rates were hardly conventional. Just as it was unusual for the ECB to commence lifting rates while growth was falling in 2022, so too was the move to cut rates while growth is accelerating.  Of course, these moves were not about the strength of growth, rather they were reflective of policymakers’ overwhelming need to use monetary policy to address inflation – typically a toxic mix for equity and bond correlations. Nonetheless, with inflation expected to be structurally higher in the decade ahead, investors may need to become accustomed to this nonconventional policy approach. Moreover, with correlations potentially not as reliable nor as strong moving forward, a more tactical approach to portfolio management will likely be required.

In the US, it appears the economic trajectory is finally turning also, although downwards in this instance. Q1 GDP growth was revised lower to 1.3 per cent last month, the disinflation trend was narrowly resuscitated by better-than-expected April CPI and PCE prints, while the jobs market is showing signs of slowly rebalancing – the ratio of job openings to available workers fell to a three-year low at the beginning of June. 

Labour demand is rebalancing

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Souces: BLS, Macrobound, ANZ CIO

Unlike Europe though, the path to rate cuts remains challenging. While employment and growth are moderating, they remain solid, and Fed speakers have indicated they will need several more months of labour market softness and further evidence of disinflation before considering easing.

In Australia, the path to lower rates looks more uncertain still. Inflation lifted for the second month running, edging up to 3.6 per cent in April, leaving no doubt that the disinflation trend has stalled. Just as worryingly, growth has continued to moderate, with the Q1 headline GDP print of 0.1 per cent taking annual growth to 1.1 per cent. Pandemic aside, this represents the slowest rate of growth since recession in the early-1990s. Moreover, the RBA remains amongst the most hawkish of central banks globally. On the same day the GDP figures were released, RBA Governor Bullock swiftly quashed hopes that the central bank will shift to prioritising growth over inflation. Responding to Senate questioning on the potential policy response if inflation remains sticky, “we won’t hesitate to move and raise interest rates again,” she said.

While the timing of rate cuts from the Fed and RBA is uncertain, for fixed income investors, market pricing is no longer as stretched. The first cut from the Fed is not fully priced till November, while a 25-basis point decrease is not expected from the RBA until July next year.

ANZ Research expects the Fed to commence easing from September and anticipates the RBA could still move the cash rate lower from November – though acknowledges this timing is increasingly uncertain.

As such, despite yields shifting materially lower over the past month, there remains room for further declines should conditions moderate more rapidly than the market currently expects.

The timing of rate cuts is important for equities too. Not only would rate cuts lower the risk-free rate, potentially increasing the relative attractiveness of equities to bonds, but more importantly would provide corporates and consumers some reprieve from what has been the second longest pause on record. 

The Fed is searching for a path lower

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Souces: Fed, Macrobound, ANZ CIO

Though the Q1 earnings growth of the S&P 500 was 8 per cent, the dynamic of lower volumes and higher prices paid brings some level of scepticism about the sustainability of these earnings if rates remain on hold.

Moreover, the resilience of markets to date must also be viewed within the context of the impact provided by other nonconventional policy measures – specifically, surplus liquidity provided by US Treasury funding decisions. As the chart below shows, this is estimated to have offset the Fed’s quantitative tightening program by more than $300bn over the past 18 months. In our view, this liquidity deployment is likely to continue in the leadup to the US election in November, providing a possible backstop for markets in the process and remains a key reason why we are at benchmark to equities. 

Easing by stealth – liquidity from TGA/RRP has overpowered Fed QT over last 18 months

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Source: Strategas, ANZ CIO

Nonetheless, we remain alert to the prevailing risks including a sharper than expected slowdown, a second wave of inflation and geopolitical tensions. Given the already long path trodden by investors over this tightening cycle, we continue to believe fixed income provides better risk-adjusted returns for investors and remain defensively positioned across portfolios as a result. 

What this means for our diversified portfolios

Earlier this year, we held the view that the market’s pricing for rate cuts seemed too aggressive. While last month’s inflation print increased the risks of further RBA tightening, with the market not pricing the first full rate cut until the second half of 2025, we no longer believe expectations are stretched.

This doesn’t dismiss the potential for further bond market volatility, but on a risk/reward basis we continue to favour fixed income to equities across portfolios.  While equity/bond correlations appear currently challenged, should risk assets suffer from a bout of sustained weakness we believe duration should eventually provide a good source of diversification again during periods of market stress or a recession.

As such, with yields trading at the upper end of their recent trading range last month, we took the opportunity to lengthen duration across portfolios, specifically via an increase to Australian fixed income.

With yields on high quality corporate and sovereign debt commensurate with those across the broader equity market, the decision was based primarily on the relative value of bonds at this point of the cycle.

Across portfolios we remain defensively positioned overall with a benchmark position in equities, overweights to domestic and global fixed income and a significant underweight to high yield credit.