Beyond Bulls & Bears

Fixed Income

Australia and Higher US Interest Rates

With the US Federal Reserve having just raised short-term interest rates, many Australian investors find themselves in an unfamiliar environment in which their domestic monetary policy is diverging from that of the world’s largest economy. Andrew Canobi of our Australian Fixed Income team reveals the segments of the market he believes may be most impacted by this divergence and discusses the investment strategies the he is using to help prepare his team’s portfolios accordingly.

With the US Federal Reserve (Fed) raising short-term interest rates from an effective rate of zero, a major regime shift in global capital markets is ahead for 2016—even for those of us an ocean away in Australia. Market watchers have long anticipated a rise in US interest rates, but the reality of a world confronted with higher interest rates may present a significant test for many investors.

Australian bonds have historically had a reasonably high correlation to movements in US yields, and a rising-rate environment will likely challenge traditional Australian bond investors with long duration1 exposures, especially since the starting point for fixed income is one where the current yield structure offers little income, with prevailing yields near record low levels. This means there is little “buffer” to offset any negative capital movement from rising yields. The potential bond portfolio losses from a rise in yields are further exacerbated by the market’s high levels of sensitivity to changes in interest rates.

Additionally, strategies that largely rely on credit of one form or another are likely to continue to face challenges in 2016, with risks associated with mergers and acquisitions rising, and commodity prices remaining under pressure. We believe that investment approaches that protect against these risks through shorter but dynamic duration management and judicious credit security selection may still deliver attractive returns above cash.

Whilst we do not necessarily expect a savage sell-off in Australian bonds as the Fed tightens interest rates, the implications of this environment for riskier areas of fixed income, particularly high-yield debt, are significant, in our view. Just as investors have pursued a search for yield in these sectors as a result of a zero interest-rate environment, the riskier areas of credit markets may face challenges as interest rates rise and the relative attractiveness of high-yield debt declines. To help preserve capital, investors may want to consider rebalancing away from their traditional fixed income strategies toward ones which allow them to invest in a wide variety of securities and strategies that seek to counteract specific types of risk.

A key reason behind the Fed’s decision to raise interest rates is the likelihood that inflationary pressures will begin to reverse direction in 2016 from their recent downward trajectory. In the United States, inflation is currently below the Fed’s informal target of 2% due to transitory factors, notably lower energy prices and currency strength. We believe these could fade as we move into 2016, and headline inflation will likely move higher. In Australia, the decline in the Aussie dollar similarly is likely to result in some upward pressure on prices returning. A market that adjusts its expectation for inflation upward is typically one that faces upward pressure on yields.

More Australian Easing Down the Road?

Meanwhile, whether we have seen the low in Australian bond yields will likely be determined by what’s happening in the domestic economy as well as actions from the Reserve Bank of Australia (RBA). We could see the RBA act on its easing bias and lower the cash rate, which is the interest rate the RBA charges on overnight loans to commercial banks. In this context, we believe investors should avoid traditional benchmark-aware approaches that are typically long duration in nature and therefore more exposed to rising interest rates.

As we consider the Australian economy overall, several headwinds remain that we believe justify the RBA’s current easing bias even if the hurdles to cutting rates—such as the potential for increased speculative housing lending—remain high. Income growth is very weak, household debt levels remain high and home sales—one of the brighter spots in recent years—are slowing. We can envisage the RBA remaining on hold, but unless domestic conditions improve, the alternate scenario is one where it is dragged back to the easing table as the year progresses.

For all the hopes around a transition from mining activity to other areas to diversify the economy, Australia remains highly dependent on China’s demand for commodities. We remain of the view that China is effecting a managed transition from a construction- and investment-led boom to a services- and consumption-based economy, but it will likely be challenging for Australia to benefit from China’s transformation.

The comments, opinions and analyses are the personal views expressed by the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Changes in interest rates will affect the value of a portfolio and its yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a portfolio adjust to a rise in interest rates, the portfolio’s yield may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.

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1. Duration represents a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.