Why now is the time to go overweight on bonds

The Reserve Bank of Australia's latest interest rate increase was in response to stubbornly high inflation and an extraordinarily tight labour market. 

However, central banks have been increasing interest rates around the world for more than a year now. Developments in the global bond market appear to suggest the effects of those hikes are finally filtering through the system. 

While it doesn't mean that central banks are guaranteed a soft landing, a strong disinflationary trend and slowing economic growth signal that the rate-hiking cycle is done for most monetary authorities.

And with the end of rate hikes comes the start of bond market outperformance. 

In this month's Trading Floor update, I discuss why now is the time to take your bond position from neutral to overweight. 

Edited transcript

Orazio: Hi, and welcome to this month's trade floor update. Today, I’m joined by portfolio manager Aaditya Thakur.

AT, thanks for joining us again today. Now, as expected, the RBA did deliver a Melbourne Cup Day rate hike to increase the cash rate to 4.35%. What's behind this decision and has it changed our view?

Thakur: Yes, well with the RBA having paused earlier and at a lower level than other central banks, there was always the risk that they'd need to fine-tune monetary policy. And if we look at the last four months where they have been on hold, we've had small upside surprises in growth, inflation, house prices and even the unemployment rate has ticked a little bit below what they were forecasting.

So that really just pushed their inflation forecast to the top of their 2 to 3% target band and just left them with no room to move. They had to take out a little bit of insurance and increase their assuredness that they would get inflation back to 2 to 3%.

Now, what was interesting in their statement was that they were more equivocal and data-dependent about the need for a follow-up hike, and the market took that as a little bit dovish actually, and rates rallied both after the meeting and overnight. And I think that's tacit acknowledgement that the global picture is actually changing quite quickly and the window for follow-up hikes from the RBA is going to be quite narrow.

Orazio: Now AT, we've seen over recent months volatility pick up across pretty much all asset classes and you did mention that the global backdrop or the picture, as you put it, is changing. What do we make of it all?

Thakur: Yes, if you think about the narrative that's been driving markets over Q3 and Q2, it's one about economic resilience and also concerns around the supply of US treasuries.

And on both accounts, we've seen some good news. Last week the US Treasury had their quarterly re-funding announcement and supply concerns were not as bad as feared.

And secondly, we're seeing more and more evidence that growth is now slowing around the world. If you look across Europe and the UK, growth is particularly weak. China seems mired in their structural issues with their growth model. Even in the US, which had a stellar Q3 GDP print, there's a sense of payback there with growth normalising back to around potential, or maybe slightly below potential, for Q4.

So on top of this, over the last month, we've also had a tick-up in unemployment rates in Canada, New Zealand, the US and parts of Europe. There is this increasing sense that those monetary policy lags are finally fading and that growth is slowing and the disinflation process is continuing. So I think when you take that, put that all together, it's the reason why bonds have suddenly come back in favour.

And we've seen US treasuries, ten year rates fall from 5% down to almost four and a half per cent very quickly over the last week.

Orazio: Now, one final question. In light of everything you’ve said AT, how should investors be positioning portfolios?

Thakur: If you think about the cycle, you're getting more information that growth is slowing, that the disinflation process continues. There's more evidence that central banks globally, RBA notwithstanding, are done in their hiking cycle.

So this is really a point in the cycle where bonds start to outperform other asset classes, including cash. So I think, we've been advocating for investors over the last 3 to 4 months that if you are neutral or underweight bonds to get to a more neutral stance. I think now we can advocate for taking that positioning overweight and really thinking about lowering your exposure to risk assets, going up in quality and increasing liquidity in portfolios. I think this is a time to start going overweight bonds.

Orazio: Thanks AT. As always really appreciate your insights.

Now whilst the economic outlook is uncertain, we think there is good news for fixed-income investors. As we know, the starting yields in fixed income are a good predictor of future returns. And with high-quality core bond funds yielding close to 6%, we think the fixed-income asset class offers something for everyone. Whether you're looking to hedge against a further economic slowdown or looking to add resilient and attractive income to your broader portfolio.

As always, if you have any further questions or would like additional information, please reach out to your PIMCO account manager.