The Case for Duration at the Top of the Yield Cycle

With inflation, global conflict and rising government debt dominating headlines, it’s worth taking stock of what has happened in the bond market this year.

Inflation has sat above target for several years and shows little sign of returning inside the band on its own. Headline CPI rose 3.5% over the year to July, down from 3.8% in June, but trimmed mean inflation was unchanged at 3.6%. Progress on the underlying measure has stalled, and a growing consensus holds that policy settings need to be more restrictive to finish the job.

That backdrop has been in place all year, but sentiment has shifted sharply over the past three months. The 10-year Commonwealth government bond yield has moved from roughly 4.75% in June to 5.40% today — its highest level since 2011. Short-dated rates have followed, with the 3-year bond at ~5.00% and 6-month BBSW at ~5.04%.

Members of the RBA’s Monetary Policy Board have also made public comments signalling a willingness to hike to bring inflation back to target. With the cash rate held at 4.35% in August, markets now price roughly an 85% chance of a 25bp increase to 4.60% at the 29 September meeting, and a reasonable probability of one further hike before year-end — a terminal rate of 4.60%–4.85%.

The question is how much tightening the domestic economy can absorb. GDP grew 0.4% in the June quarter and 2.1% through the year, productivity growth is effectively zero, and unemployment has drifted up to 4.5%. These are not the data points that usually accompany rate hikes. But with underlying inflation stuck at 3.6%, the Board looks likely to move regardless.

A further 25–50bp may well be the catalyst that pushes inflation back into the 2–3% band. It is equally arguable that it tips growth negative and delivers a technical recession.

Is the curve overdone?

That raises the more interesting question: are the forward rate expectations embedded in the bond market too aggressive?

Six-month BBSW at 5.04% sits close to 70bp above cash. Strip out the bank credit spread and it implies the cash rate averaging near 4.80% over the next six months — consistent with two hikes delivered and a bias toward a third. Further out, 10- and 20-year yields are broadly consistent with a cash rate in the low-to-mid 5s being sustained for the next decade.

Two caveats are worth stating plainly. First, part of the long end is term premium, not rate expectations — investors demanding more compensation to fund widening deficits and heavier issuance. Term premium does not mean-revert when the RBA cuts, so a portion of the current yield may prove sticky. Second, the market is not pricing “no cuts for a decade” so much as pricing a wide distribution of outcomes whose average sits high.

Even allowing for both, the implied path embeds a fairly demanding assumption: that the economy absorbs higher rates without recession and without needing any loosening over the coming years. The more plausible sequence, in our view, is that the RBA hikes into year-end, gets the inflation outcome it needs at the cost of growth and employment, and is left with a stagnant economy in 2027–28 requiring support.

We have seen versions of this before — credit spreads widening after a credit event, as in early 2023, or the bond market testing central bank resolve by pushing long yields higher, only for them to snap back within 6–12 months. The BBB Australian bond index below illustrates how cyclical yields have been post-Covid, and why fixed rate bonds bought near the top of the yield cycle have historically delivered strong total returns. There is a reasonable argument that we are close to that point now.

Where the opportunity sits

For investors who share that view, high-grade fixed rate bonds trading below par provide income while they wait and potential capital upside if long term yields decline. Two examples:

Alphabet (Google) is among the largest companies in the world, with a dominant market position, an exceptionally strong balance sheet and a diversified revenue base. A AA+ rated bond at a 7% yield to maturity is a rare combination of credit quality and outright income. In a rate-cutting or recessionary environment it should perform strongly on two fronts: flight-to-quality flows into high-grade names, and the price sensitivity that comes with holding a long-dated bond below par. The longer the maturity, the more of that yield decline converts to capital gain.

ANZ will appeal to investors who prefer domestic exposure. A major bank, heavily regulated and strongly capitalised, ANZ reported FY25 cash profit of $6.9bn before significant items. As with Alphabet, falling long-term yields and a flight to quality in a rate-cutting environment would support the price.

If the thesis is wrong and yields grind higher from here, the mark-to-market impact on long-duration holdings is material — the offset is that both bonds pay a solid yield to maturity while investors wait.