The economy and the cash rate reach the low point in the cycle

Determining exactly when an economy reaches a low point in the cycle will be difficult (many market commentators were surprised by yesterday’s rate cut by the RBA to 2.75%). You would expect to see less frequent cash rate cuts by the RBA and professionals in the market would take into account the RBA’s monthly minute statements which reveal how the board came to make its decision on holding, cutting or raising rates. When the economy reaches the low point in the cycle, fixed rate bonds should have largely served their role. They helped maintain income when interest rates were falling and the bonds’ prices should have increased, offsetting underperforming equities or property. The low point signals that the likely next step would be an increase in interest rates.

1.1. Sell fixed rate bonds and buy floating rate notes

It’s difficult to predict a turning market but generally you would seek to change your preference from fixed rate bonds to floating rate notes. The fixed rate bonds should have outperformed with prices rising over the contracting economy part of the cycle. So it is time to sell fixed rate bonds at their high point and buy floating rate notes (FRNs), theoretically at a low price point given recent low demand. Any increases in interest rates will be captured by FRN coupons (given their link to an underlying benchmark – usually the bank bill swap rate in Australia) as the RBA starts to increase rates to slow down a growing economy. The FRNs should also then improve in price as demand rises.

2.2 Continue to protect income – do not sell all your fixed rate bonds

Optimum portfolio allocation means investors should continue to hold fixed rate bonds throughout the cycle to protect against the unexpected. For example, you might consider a cycle had hit the low point but in reality it had further to play out or an unexpected natural disaster meant another contraction. So keep some fixed rate bonds in your portfolio or, if you are a new investor, consider buying some fixed rate bonds for downside protection. The prices of these bonds may fall but investors will usually be repaid $100 face value at first call or maturity and depending on where interest rates were when the bonds were first issued, may offer attractive running yields.

2.3 Add inflation linked bonds

Run away growth can lead to an inflation spiral. In slowing, or bottoming economies, governments are under pressure to stimulate economic activity through direct or monetary policy intervention. If the government gets this wrong, overstimulates, or stimulates for too long, upward inflationary pressures can result. While investors would not have experienced high inflation for some time as the economy had been contracting, at the low point in the economic cycle it would be good to add inflation linked bonds (ILBs) to the portfolio. Buying at the low point (with the possibility of buying at a discount) makes sense before the risk of inflation heightens. ILBs can also be an excellent investment in a low growth economy. Their known set margin above the Consumer Price Index (CPI) can be attractive when interest rates are low for long periods.

2.4 Add risk

Companies are less likely to default in a growing economy when government, business and consumers are spending. This is a good time to add higher risk issuers and securities to your portfolio.

2.5 Redeem term deposits (or stick with short terms) and buy FRNs and ILBs

When you expect an economy to start a growth phase, you should hold your cash in short dated term deposits or buy floating rate note debt as an alternative, as increases to the coupon will be reflected through the higher expectations in BBSW. This is not the time to lock in for longer terms.

Click here to read Investment and trading strategies Part 1 – when an economy starts to contract. For more information, please call your local dealer.