By Philip Brown, Head of Research, FIIG Securities
The RBA has raised rates three times in this cycle, taking the cash rate back to the previous high of 4.35%.
At present, the RBA is sitting back waiting to see how the data develops before deciding on the next steps. There are the seeds of higher inflation coming down the pipe because of the recent rise in petrol prices, but also a countervailing force from the recent rate rises which can be expected to slow inflation.
The RBA doesn’t want to raise rates unnecessarily but also doesn’t want to let inflation become entrenched.
The general economic commentariat splits into two camps: those who think that there will be another rate rise in 2026 and those who think the RBA is done and the next move will be cut sometime in 2027. We can see merit in both positions, though do see a further rate rise as slightly more likely than the current market expectation.
How bond markets have reacted to 2026
Despite the direct short-term cash market suggesting that the RBA has only one more rate rise, the longer-term bond market is behaving more like it normally does when the RBA is mid-cycle.
Since the most recent peak on 15 May, market expectation for the cash rate has shifted significantly. At one point, markets were pricing two rises or a 0.50% hike. This has changed dramatically. The market is now only expecting a 0.125% rise. After pricing a peak towards the end of 2026, the cash market is expecting a small chance of rate cuts beginning at the start of 2027.
Much of the data has been slightly better so the market might be pricing the start of the rate cut cycle a trifle too early. There remains a risk of a rate rise across the balance of 2026 and perhaps one that is slightly larger than currently priced by the market. But as we head into 2027, rate cuts are going to be the far more likely.
Also read: Inflation’s Comeback Puts Bonds On Notice, And Equities In The Lead
Despite the cash market pricing an end to the RBA rate hiking cycle in 2026, the bond market looks more like a mid-cycle market.
When the RBA began raising rates in 2022, bond yields had already reacted and had been rising ever since 2021. This is because bond yields try to anticipate where the RBA is going in future, not where it is now. So, bond yields moved well ahead of the RBA cash rate. This applies at the other end of the cycle too. When the bond market believes the RBA is nearing the end of a hiking cycle, bond yields will stop rising, even if the RBA continues to raise rates. This is what happened in 2023 when bond yields fell despite the RBA delivering the last few rate rises.
So, even though there may be an additional hike or two, the bond market is already anticipating the next rate cut cycle. Because of this, towards the end of an RBA rate rise cycle it is quite common for the bond yield to be lower than the cash rate. In effect, this is the bond market saying that the cash rate is above the long-term average and so over a medium or long-term period, say five years for example, the average cash rate will be lower than the current cash rate. In effect, this line of reasoning suggests that when the RBA rate is at a peak, the five-year bond yield should be lower than the prevailing cash rate.
This is emphatically not what is happening now. Despite the cash market being quite convinced the RBA has at most one more rate rise, the bond yields (particularly the 10-year bond) are still significantly higher than the cash rate. If the cash rate is not going to rise this suggests that the current 10-year bond is providing excellent returns compared to a normal cycle. Now there is extra duration risk in a longer bond, and we would never advise any client ever to put all of their investments into long-duration bonds at one time or in one go.
However, we think that now is a good time to start accumulating longer duration because we don’t believe the RBA will raise rates more than once more. If so, then the question really becomes: “When is the next rate cut cycle going to begin?”.
Whenever that rate cut cycle is anticipated by the market, long-term bonds will start to look very attractive and are likely to increase in price significantly. In fact, bond yields are likely to start falling (and bond prices rising) before the RBA begins to cut rates in anticipation of the coming rate cut cycle. That is why the two year, three year and five-year bonds in Australia have already rallied a little bit down from their peak.
It is possible that the RBA hikes again in 2026 and if so, that would likely signal that it is time to start preparing for the end of the cycle. For bond investors that means starting to accumulate duration in a more aggressive way.
Overall, we think the RBA rate rise cycle is drawing to a close. That makes now the time to start thinking about allocating into more duration. Clients who wait for the RBA to cut rates will likely have missed the best time to buy fixed rate bonds, potentially by several months.
