Policy normalisation presents "tremendous opportunity" for income investors

Welcome to this month's trade floor update. It would have been fair to say that we were probably set for a number of interest rate increases this year with markets already pricing in the RBA and the Fed to hike. Fast forward to where we are now, a lot's changed. There are significant events taking place in Europe and driving uncertainty.

In this March 2022 Trading Floor Update, I discuss the latest market and policy developments impacting the investment environment.

What's going on in the global economy and in markets?

It's a turbulent time to say the least, but I think the most important takeaway for investors and the bond market is that some of this normalisation of policy is still somewhat inevitable. We've always thought that the extreme uncertainty that we were in during that phase meant that the speed and destination of this policy normalisation were uncertain. I think that's already showing up in terms of the adjustments to market pricing. 

The other important factor is that there are some other issues that we need to grapple with in terms of inflation - what is the inflationary impulse going to look like going forward? We are hoping that we're seeing the beginning of the end in terms of the Omicron variant, but again, we still don't know. We also know that central banks are moving from a Quantitative Easing style backdrop to potentially Quantitative Tightening, which has liquidity implications for markets. All of these things generate even more uncertainty. 

So from an investment point of view, you want to be pretty close to your structural targets rather than take any very significant risks.

What are the expectations for central bank policy this year?

I think there's still going be some normalisation, and again the geopolitical backdrop makes that less certain, but there will be a path to this normalisation. I think the really important takeaway is that this new neutral concept still holds. 

We still think that rates getting back to a 2% range, maybe into the low 2% in most developed economies, will feel like policy is genuinely tight. When we look across markets at the moment, some of those markets are already priced for that rate movement, even priced for more than that. Even with some level of uncertainty in the backdrop, in places like New Zealand, their rates have already been pricing more than 3% as a policy rate. 

That represents value to us. Other jurisdictions still have further to go in terms of seeing that normalisation.

Looking at the portfolio, how should investors be thinking about bonds today? 

As we've talked about before, bonds do multiple things in a portfolio context. Core bonds, especially the very high quality US Treasuries, European bonds, Australian Commonwealth, government bonds, all act as a natural, safe-haven asset - that's never going to change. We'll see that during bouts of volatility. During these times we will see the flight to quality, and that will stay with us. This obviously provides a tremendous benefit in terms of portfolio diversification.

On the other extreme of the bond market, we have income generation. Again, as credit spreads widen (and they're widening already), it's partly reflecting that move from a very liquid QE environment where low interest rates had implied that all asset prices were elevated. Some of the credit spread repricing is already taking place. In fact, in our own market, we saw Australian bank bonds (five-year bonds, senior debt) already with a 3% yield only a couple of days ago. These factors represent tremendous opportunities for income generation.

Finally, there's always going to be the illiquid private sector, especially in the structured credit space where we see tremendous value opportunity to generate income, even under really stressed environments. That's part of our role to understand how they perform under extreme stress.

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