The Accuracy of Forecasting Bond Market Rate Hikes – Jessica Rusit
In anticipation of further rate hikes from the Reserve Bank of Australia (RBA), bond markets are “pricing in” the current tightening cycle. However, to better position portfolios, it is useful to understand how accurately the market has predicted previous upswings. Here we look at what historical rate hike cycles can show us.
As recently as November last year, the RBA signaled that the conditions for a rate hike were “unlikely to be met until at least 2024”. As of this writing, there have been five rate hikes, following the RBA’s first pivot to tightening at its May meeting. Fixed income markets also revised future rates to reflect the outlook for higher RBA interest rates.
Media commentators and market economists will often talk about “what’s embedded” in bond markets. How accurate is this “reassessment” of the path of interest rates by market participants, and what lessons can bond investors learn from previous up cycles to better position their portfolios?
Typically, investors will favor floating rate bonds over fixed coupon bonds during an up cycle because the coupon on floating rate bonds adjusts upward as rates rise. On the other hand, fixed coupon bonds fix the rate at the time of investment, until the bond matures or when it is sold.
The market’s forward-looking views on rates, also called predicted rates, frame a path that participants expect the central bank to follow based on various factors such as inflation forecasts and what other central banks such as the US Federal Reserve are supposed to do. in the future.
Historically, the actual rate increases that result from the RBA, also known as realized, provide investors with insights into how accurately the market predicts future rate movements. When the RBA’s rate movements do not match what the fixed income market has priced in, then future cash rates are repriced to reflect the realized interest rate movement, the bond market as defined wide also being reassessed accordingly.
As such, if the RBA raises the cash rate below where markets were valuing, the yields earned on floating rate notes would decline as they adjust accordingly, while the yield on Fixed-coupon bonds would get stuck at the higher rate that the markets had predicted (wrongly!), along with capital gains as market yields adjust lower.
While anyone can guess how the current RBA tightening cycle plays out (even the RBA itself seems uncertain), by looking at historical rate moves forecasted and realized, we are able to better understand what could look like this current up cycle.
With this uncertainty, it pays to have a well-diversified portfolio, with an allocation to floating rate bonds, fixed coupon bonds and inflation-linked exposures to weather any interest rate swings.
We looked at historical tightening cycles to assess the accuracy of the market’s ability to predict rate hikes, or whether there were in fact periods of divergence. Did the market “over-predict” the magnitude of the hiking cycle?
The data point we used is the 1-year interest rate swap, an important benchmark in the interest rate markets used to price term deposits and mortgage rates. We compared the 1 year interest rate swap rate from today with what the market had “predicted” as the rate last year.
As shown in the graph below, the entire period from 1996 to the present has been used to have a larger data set. We have discussed periods of significant rate increases (circled in the table below) in this article, but data for the entire period has been used to form an opinion on the accuracy of market prices.
Market Expected Rate Pricing vs. RBA
The first period we look at is November 1999 when the RBA raised rates by 0.25% to a cash rate of 5.00% (before that the cash rate remained at 4.75% since December 1998). This was followed by four more rate increases, where the rate hit 6.25% (an eye watering from recent rate lows). At the time, there had been strong growth spurred by low interest rates, facilitating the rise of start-ups that would later see their significant downfall and become known as the dot.com bubble.
Markets had overpriced higher rates, relative to the rate hikes achieved by the RBA. The table below provides an overview in basis points (bps) of the market’s forecast rate hike.
The RBA’s next bull run began in November 2003, with a 25 basis point hike, bringing the cash rate to 5.00%. Previously, the rate had been 4.75% since mid-2002. Another rate hike of 25 basis points soon followed in December 2003, before another in March 2005, bringing the cash rate to 5.50%. After the invasion of Iraq, which shook consumer confidence, economies recovered with good employment figures and subdued inflation.
Rates for the period were again overpriced by the market, compared to rate increases made by the RBA. The table below gives an overview in basis points of the rate hike expected by the market.
In 2006, rate hikes began again, with the first hike in May 2006, where a 25 basis point increase took the cash rate to 5.75%. The rate had remained at 5.50% since early 2005 and set the stage for what would become known as the Global Financial Crisis (GFC), which occurred from mid-2007 to early 2009. The decline in Interest rates, unemployment and inflation made borrowing cheaper at a time of strong and stable economic growth.
Markets had further priced in higher rates than realized by the RBA, although noting the gap, this tightening cycle was lower than in previous periods. The table below gives an overview in basis points of the rate hike expected by the market (and correctly assessed during the February 6, 2008 rate hike).
Following the GFC, the RBA was quick to cut rates in a bid to stimulate the economy, dramatically reducing the official exchange rate from 7.25% in eight months to 3.00%. However, it was only six months later and the central bank was raising rates again. It was once again about the markets being overvalued by higher rates compared to the rate moves made by the RBA. It should also be noted that, as with previous tightening cycles, the gap is larger at the beginning of the cycle and narrows further into the period.
Referring to the first chart, the solid line through each circled tightening period identifies the overpricing by the markets in relation to the rate movements made by the RBA. On average over this period, the data shows that there are typically 75 basis points of expected moves priced in by the market, relative to rate moves made by the RBA.
Without drawing any conclusions about the current tightening cycle, it can be said that periods of prior rate hikes starting in 1996 generally indicate that the market is overvaluing higher rates than what will result from the RBA. It’s also worth mentioning that we believe portfolios should have a well-diversified profile and given that inflation and higher interest rates could lead to an economic downturn, this is more relevant than ever.
It should also be noted that here and in the US markets price rate cuts will begin mid to late next year, given the economic risks, perhaps both central banks suspend some of the hikes later and adopt a wait-and-see attitude approach
While some investors may have been hesitant to add longer dated fixed bonds given the rising rate environment, it should be noted that they currently offer an attractive entry point, trading at discounts significant compared to their face value. We would also expect capital to rise if we see a recession (all other things being equal) with investors looking for safer investments. We would consider it a core holding in any portfolio.
A diversified portfolio with a mix of floating rate, fixed coupon and inflation linked bonds will better protect fixed income portfolios no matter what.