This market has changed and changed again... here's how to navigate it

As we all know, it has been an incredibly volatile period for bonds over the past two years. On occasion, investors have been wrong-footed and even the professionals aren't immune. 

Roy Keenan, Co-Head of Australian Fixed Income at Yarra Capital Management, readily admits that a recently changed view on US bonds has created some frustration, but he believes that continuing to focus on the shape of the yield curve will benefit investors. 

Keenan explains how his team adapted their portfolio strategies based on changing interest rate expectations. In response to the flat yield curve, they focused on steepening strategies, with expectations that the curve could continue to steepen in the future. 

"We felt that the curve was far too flat for the environment that we were looking into the future".

Keenan goes on to explain that steepening strategies were applied across Yarra Capital's fixed income portfolios, and he still thinks "the yield curve can steepen further - and that's more long rates selling off and the front end of the yield curve being held by central banks nearly being close to finishing".

In this Expert Insights, Keenan shares his view on the global and local economic outlooks, why inflation and employment are all that matter for interest rates, and the supply and demand dynamics in the bond markets.

Edited Transcript

Chris Conway: Roy, thanks for chatting with Livewire Markets today. What's your outlook on the Australian and the global economy as well?

Roy Keenan: Yeah, it's really interesting. It's pretty tough today with what's going on in the Middle East, but I think the biggest focus for us has been on where we are in the cycle. 

Prior to the Middle East taking place, we were getting very constructive on the cycle. 

In some of the countries in the developed world, such as Mexico and Indonesia, we were seeing really good signs of growth and an upswing in industrial production. So that was giving us a lot of confidence around where we were in the cycle.

For Australia, I think it's going to be about inflation and how quickly that comes down. For us, it's been surprising on the downside and what's really been interesting about that is bonds haven't reacted to that. Consumers have held up well, but pressure will remain in the second half of the year.

In the US, it's been quite a surprise that economic growth has held up so well. Everyone has been anticipating a recession that we haven't had and it's interesting to see some of the reasons why that growth has held up really well. Fiscal spending and financial conditions are easing a fair bit, and the outlook for the US looks pretty good at the moment.

Chris Conway: Last time we had a chat, I think your outlook on the interest rate cycle was maybe one more. Where are you at now in terms of your thinking on the interest rates here in Australia?

Roy Keenan:

Well, a new governor is in place, so I think it's ultimately down to two things: employment and inflation. We would not be surprised in the coming months, especially if inflation prints a little bit higher than expected - which is likely - that we might see one more (and has since occurred post the interview).

So we haven't changed in that view. I think it also comes back to the governor trying to show hawkishness in displaying that she's not going to be a dove for her tenure. The RBA is probably going to be close to finished.

Chris Conway: Aside from the governor and employment, are there any other factors that go into the mix when determining your outlook for interest rates?

Roy Keenan: Supply and demand is one thing. I mentioned the US before, and we changed our view on bonds. We've been overweight bonds for probably 12 to 15 months. And what was quite interesting, probably a couple of months ago now, we changed our view when the US Treasury announced how many bonds were going to be issued into the marketplace, especially long bonds. 

That changed our outlook and, in some ways, we've been disappointed because our view was that rates would be lower because inflation was going to continue to surprise on the downside. 

So it's frustrating for us, that trade, but in some ways now I think it just means that interest rates are getting close to their peak and it's providing opportunities for us.

Chris Conway: Roy, you talked a little bit already about changing your view. Let's talk about the practical elements of how that manifests in the portfolio. What are you focusing on now? What are some of the trades that you've been doing? How has the portfolio construction changed in the last three to six months?

Roy Keenan: Once we realised that rates weren't going to rally and we were seeing supply come to finance the US fiscal supply, we looked at yield curves. 

And back in that period, the yield curve was flat. And by "flat", what I mean is there was no difference in interest rates between the three-year bond and the 10-year bond. We felt that the curve was far too flat for the environment that we were looking into.

Across all our portfolios, we put in some steepening strategies, which has worked for us. We still think the yield curve can steepen further, and that's more long rates selling off and the front end of the yield curve being held by central banks nearly being close to finish.

The other thing that a higher interest rate environment does from a credit point of view is, if it's high for longer - which is probably the environment we're in now - it focuses you on understanding what that means for companies with a lot of leverage or who have asset revaluation processes going on at the moment. Are they expecting rates to start to fall or are they going to be staying a lot higher? Understanding how that impacts the credit for those companies and their intentions for the future is really important for our construction.

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The Yarra Enhanced Income Fund seeks to deliver higher returns to investors than traditional cash management and fixed income investments. Learn more via the Fund profile below, or by visiting Yarra Capital Management's website.

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Yarra Enhanced Income Fund

Australian Fixed Income

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