Rate Expectations

If you consume enough financial media, you’ll notice that much time and space is spent wondering what central banks will do next with benchmark interest rates. But while this constant speculation fills a gap, it can serve as a distraction for long-term investors.

Underpinning the obsession in media about the utterances and actions of central bankers – like the US Federal Reserve, the Reserve Bank of Australia (RBA) and the Reserve Bank of New Zealand (RBNZ) – are a number of assumptions.

Leading or Following?

The first of these is that interest rate decisions by central banks lead the market, when in reality it is often the other way around.

The central banks tacitly admit that themselves when they say their future decisions are “data-dependent”.(*1)

That phrase implies that their current view on the correct level and likely course of official interest rates may change as new information comes to light about inflation, economic growth, unemployment and other variables.

In other words, the policymakers don’t have any more information or insight than the market itself. We are all working off the same signals, which means the central banks can be behind the market in coming to a conclusion about where rates should be set.

The Australian Experience

Think back to November 2020, about eight months after the pandemic was declared. The RBA cut its official cash rate to a record low of 0.1% – virtually zero – and lowered its target for three-year Australian government bonds to the same level.(*2)

Given the significant uncertainty surrounding the path and economic impact of the coronavirus at that point, the bank’s governor Philip Lowe said the RBA was not expecting to increase the cash rate “for at least three years” or until inflation was sustainably within the bank’s 2-3% target range.(*3)

But then things changed.

Soon after the RBA announcement, there was a breakthrough on the development of vaccines. By 2021, the economic recovery was stronger than expected.

And later that year and with market-set interest rates increasing, the bank had to abandon its policy target for the three-year government bond.

In other words, the market, responding to the same information, had essentially forced the RBA’s hand.(*4)

By this time, inflation was starting to pick up again as well. In some advanced economies, headline rates were above 4%.(*5)

But the view of the RBA governor, like those of other central bankers, was that this was likely to be a “transitory” phenomenon as increased demand was running up against pandemic-related supply constraints.(*6)

“The latest data and forecasts do not warrant an increase in the cash rate in 2022,” Dr Lowe said in November 2021. “The economy and inflation would have to turn out very differently from our central scenario for the board to consider an increase in interest rates next year.”

But this is precisely what happened. In the March quarter of 2022, Australia’s annual inflation rate rose to 5.1%. This result, a 20-year high, exceeded market expectations and was fuelled by the rising costs of building supplies, petrol and groceries.(*7)

Having abandoned its attempt to control the yield curve six months before, the RBA in May now walked away from its cash rate forecasts as well and raised the benchmark rate to 0.35% in the first policy tightening in more than a decade.(*8)

Rates continued to rise from that point as inflation ratcheted higher.

In making this decision, Governor Lowe described the central bank’s guidance that interest rates would not rise until 2024 as an “embarrassing” error and announced an official review into how the bank had got its forecasts so wrong.(*9)

The lesson for investors here is that central banks have no more information than the market itself and are just as data-dependent as anyone.

Which Interest Rate?

When the media talks about “interest rates” it usually means benchmark rates. In reality, there are thousands of rates.

These are set by buyers and sellers in the bond market and vary by the maturity, credit quality and currency of issuance. As we have seen, these rates move independently and often well ahead of central bank benchmarks.

Bond prices, and therefore yields, change every day based on changing economic conditions, risk appetites and information about individual issuers.

This means investors can build diversified fixed interest portfolios in which their exposure to key determinants of risk and return in bonds – duration, credit and currency – can vary according to their goals.

These goals include preserving capital, managing the volatility of your overall portfolio or seeking total return.

The point about bonds is there is information in today’s market about two components of their return – the yield or interest rate of the bond, plus the expected capital gain or loss based on today’s prices.

A third component – the future change in yield is not observable. So certainty, even with bonds, is not completely attainable.

Even so, we know more about future cash flows with bonds than we do with equities and we know that we can manage risk by diversifying.

Your exposure to term and credit, two of the sources of risk and return in bonds, can vary depending on your goal.

The Big Picture

So you can see that there is much more to investing in bonds than just following what central bankers are doing. As we have seen, they are as much in the dark as anybody else and can change their minds as the economic data changes.

While bonds had a bad start to 2022, certainly worse than anything we have seen for decades, that says nothing about likely future returns.(*10)

For many years now, people have been complaining about ultra-low interest rates from bonds. Well, now rates and expected returns are significantly higher.

And while you would have suffered a capital loss from bonds earlier this year, you have the opportunity to earn a higher income from bonds than previously and a chance to make a capital gain.

Though less volatile than stocks, bonds are nevertheless risky assets. And while this year’s poor returns from bonds is unusual, it is not unexpected.

Finally, we know that markets do a pretty good job of pricing risk. And with bond yields now significantly higher than they were a year ago, there is an opportunity for investors to use that information in prices to generate higher expected returns.(*11)

For investors for whom capital preservation is the prime consideration, there is the option of staying in short-term, high quality bonds.

As always with investment, it comes down to the goal.


(*1)‘Data Dependent Monetary Policy in an Evolving Economy’, Jerome Powell, Federal Reserve, 8 Oct 2019.

(*2)‘Reserve Bank Cuts Interest Rates to Record Low of 0.1%, ABC News, 3 Nov 2020.

(*3)Statement by Philip Lowe, Monetary Policy Decision, 3 Nov 2020.

(*4)‘Get Used to Bond Market Turmoil as RBA Seen Behind the Curve’, Bloomberg, 3 Nov 2021.

(*5)‘Euro Zone Inflation Hits 13-Year High Above 4%’, Europe News, 29 Oct 2021.

(*6)‘Recent Trends in Inflation’, RBA Governor Philip Lowe, Speech to ABE, 16 Nov 2021.

(*7)‘Consumer Price Index, Australia’, Australian Bureau of Statistics, 27 April 2022.

(*8)‘Australia’s Central Bank Hikes Interest Rates, Flags More to Come’, Reuters, 3 May 2022.

(*9)‘Lowe Admits Embarrassing Error on 2024 Rate Rise’, Australian Financial Review, 3 May 2022.

(*10)Dimensional Returns Program.

(*11)‘Bonds Demystified’, Bhanu Singh, Dimensional, 24 March, 2022.


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