Despite more hawkish comments by the Reserve Bank of Australia (RBA), which would suggest that the cash rate is more likely to increase at some stage in the next six months, bonds rose over the quarter outperforming cash.

Outlook

Longer dated bond yields have risen sharply since the start of the year on the expectation that the stimulus measures will ultimately prove inflationary. This may well prove to be the case but, at the present time, inflation remains well contained. The inflation rate for the year ending 30 June of  1.50% remains well within the RBA target range of  2-3%p.a. Nevertheless consumer price index data is backward looking and so the RBA, when assessing the appropriateness of the current cash rate, needs to consider inflationary expectations.  Clearly if the RBA is considering changing its neutral bias to one of tightening then it believes inflationary expectations are rising.  This is a valid estimation should aggregate demand continue to improve as expected. The global recovery, however, remains somewhat more fragile than domestic conditions suggest. This may temper inflationary expectations until this uncertainty begins to dissipate.

Conclusion

We recommend a marginal overweight exposure to cash and marginal underweight exposure to fixed interest.