Since the world’s central banks began lifting interest rates in 2021 and 2022, financial markets have struggled: both equities and bonds have declined, borrowing has become much more expensive, and with the risk-free rate rising, the value of many real assets has fallen.
However, after as much as 400 to 500 basis points (or 4.00% to 5.00%) of interest rate hikes by many developed country central banks, it seems we have reached a point where we can ask the question – have interest rates now peaked?
In New Zealand, the Reserve Bank of New Zealand (RBNZ) has lifted the Official Cash Rate (OCR) by 500 basis points, to 5.50% and, at its June meeting, it signalled that that was likely the last of its interest rate hikes. Meanwhile, other central banks, such as the US Federal Reserve (the Fed), the Reserve Bank of Australia (RBA) and the European Central Bank (ECB) appear to have one or two more interest rate hikes left.
The rate hikes in New Zealand have seen the 10-year government bond yield trade from below 1% to nearly 5% - and as bond prices move inversely with yields, this has meant a significant hit to bond investments. It has been a similar story in the US, with its 10-year equivalent rising about 400 basis points in less than two years.
Although interest rate markets suggest that central banks are at the back end of their hiking cycles, we are mindful that things can change. Nevertheless, as we look at the cumulative effect of the rate hikes to-date, slowing inflation and a benign outlook for global growth, we are comfortable that bond yields have peaked, or are very close to doing so.
In New Zealand, we see several factors pointing to a peak in bond yields. Firstly, it is clear the economy is slowing. The local economy entered a recession in the first quarter of 2023, and as many households roll off low fixed rate mortgages, household budgets will continue to be pressured – and this will likely result in a further slowdown in consumer spending.
Furthermore, we are starting to see evidence that the labour market, which has been one of the big drivers of inflation, soften. At this stage, we are seeing it in the number of jobs advertised – a possible first sign that this market is starting to turn.
“At least here in New Zealand, we believe interest rates have peaked because the RBNZ have told us they have, and the data backs them up. Inflationary pressures are easing and the tightness in the labour market is being relieved by strong inbound migration. One of the risks to our view would be if we saw house prices starting to rise again, which would enable consumers to increase their spending. We also don’t see the increase in immigration as a medium-term inflationary threat, as we think this is a delayed COVID-19 reopening surge, rather than a new paradigm, but it is something to watch”, Iain Cox, Australasian Head of Fixed Interest & Cash.
Meanwhile, in the US, while the Fed may still have a couple of interest rate hikes in them, we believe most of the move higher in bond yields has already occurred and are close to a peak, thereby offering a more positive outlook for bond investors. Nevertheless, despite their recent ‘pause’, strong data during the last quarter means the Fed still has some headwinds.
“The Fed has a tough challenge ahead to get core inflation below 3%. Monetary policy is a blunt instrument and the easiest path to lower core inflation is via an increase in unemployment. A restrictive Fed monetary policy stance should ensure the long end of the yield curve will outperform in the short-term until the employment market weakens”, Ray Jack, Senior Credit Analyst.
So, against the backdrop of a possible peak in bond yields, what does it mean for investment markets?
We believe the outlook for high quality bonds is looking brighter for long term investors, and not just because we believe yields have peaked. Currently, bond yields are offering returns at or near levels not seen since before the global financial crisis. And another important point, with inflation on the decline, real yields – the yields that bonds offer after considering inflation – are also much higher.
In terms of the outlook for equities, rising interest rates weighed on markets through 2022, but with bond yields close to peaking, we believe their influence on company valuations should begin to subside. Going forward, equity markets are also more likely to be influenced by company earnings rather than changes in interest rates, although one factor we are tracking is how companies manage their higher interest costs – as company debt begins to roll over in the higher interest rate environment.
Wrapping this up, what doesn’t change is our approach to investing. Our portfolio managers continue to invest in high-quality companies with robust balance sheets. We believe by doing this, along with strong investment governance, we put our investors in the best place to be rewarded in the long term.