Central bankers don't make for good gymnasts

The task ahead for central bankers is a difficult one, delicately poised between persistently high inflation, resilient labour markets and a never-before-seen monetary policy response – both past and present.

Economics 101 tells us a rapid level of demand destruction will likely trigger higher unemployment and sharp downward adjustments in consumer spending and economic growth, with further downside risk of recession. This is the balancing act central bankers currently find themselves in, aptly described as a "tight spot" by Ulysses Everett McGill in one of my favourite films, O Brother Where Art Though.

Accordingly, most of my time is spent thinking about how we can best prepare client portfolios for such a downside scenario. Don’t get me wrong, I hope the landing is soft. In my book, central bankers don't have enough credits in the bank for me to be confident. Their credibility is not what it once was. Judging from fixed income performance year to date, it seems I am not the only one in that camp.

Central bankers are now unenviably tasked with creating the right amount of demand destruction to the point of slowing down inflation without sending economies into recession. The recent UK Gilts crisis showed us that no amount of jawboning about “no more central bank put” is likely to prevail when financial stability is at risk. Should such a tipping point be reached, it will be difficult not to return to the well-trodden path of intervention. Possibly even accepting a higher rate of inflation.

But the long kiss goodnight must eventually come to an end.

Where Is the Value in Credit Markets?

We will then compare riskier asset returns to those benchmarks to identify where we see value. Naturally, we must be compensated with a commensurate premium for the additional layers of risk we are adding to the risk-free rate. Such risks might include credit risk, liquidity risk or default risk. In that context, risk-free rates seem very attractive right now.

Globally, sovereign yields have seen nothing short of vicious moves since rates started increasing. In the last 12 months, the US 10-Year government bond yield has increased over 210 basis points to 3.93%, while the 2-Year has risen an eye-watering 340 basis points to 4.63%. Meanwhile, the Australian 10-Year has increased 165 basis points to 3.78% while our 2-Year has risen 242 basis points to 3.50%. The magnitude of these moves should not be ignored. The 2-Year, somewhat acting like a wild child, tells us the market expects an average benchmark rate of 4.63% over the next two years. 

However, current levels of fixed rates on high-grade paper are too attractive to ignore. We continue to see upside risks to market pricing suggesting a terminal domestic cash rate of 4.10% and as such, will continue to accumulate duration should yields move higher.