There was one main topic of discussion among the bond traders, sovereign and corporate issuers and institutional investors who gathered at Commonwealth Bank’s Darling Harbour headquarters on Monday for its annual global markets conference: how high can long-term bond rates go?
Naturally, one London-based hedge fund manager on the sidelines had the most confronting view, particularly for those borrowers who might have been hoping that interest rates had finally peaked.
The fundie outlined a scenario where 10-year bond rates reach 7 per cent – the rationale being that in the last major capital expenditure cycle in the 1990s, real interest rates reached 3.5 to 4 per cent.
A real interest rate measures the additional return above the prevailing inflation rate, and, given inflation rates have remained well above 2 per cent, the sum of real interest rates and inflation is suggestive of long-term global bond rates of between 6 and 7 per cent.
“Over the next four months we are probably more cautious about where things land before really deploying capital,” the hedge fund trader said.
There’s no reason for global capital expenditure, which relates not just to artificial intelligence but to the energy transition, to slow down.
The other observation is that with geopolitical and trade tensions running hot, the fall in goods prices that we have experienced in the past decade may come to an end, and that means a period of higher interest rates for the next five to 10 years.
These hedge fund managers are reluctant to speak to the media or publicly because of the conga-line of compliance in making their views known.
But there is no doubting their expanding presence in the fixed-income markets, where they are driving short-term price movements but also financing governments by investing in their bonds in the primary markets.
One of their challenges has been to convince bond issuers, such as the Australian federal and state governments, and corporate issuers, that they’re not just so-called fast money that will abandon them in their hour of need.
The hedge funds say they don’t all think and act in the same way, as different pods (units) within the same firms might deploy different strategies, and so they can provide much-needed market liquidity in times of stress.
Either way, they are absolutely a force in fixed income markets and are almost certainly behind some of the big sell-offs we’ve witnessed in global interest rate markets, as some so-called pods have been stopped out of big positions.
Another major theme in the global bond markets that surfaced during the CBA gathering was that the competition for capital among the so-called hyperscalers is heating up.
The likes of Alphabet, Amazon, Meta, Microsoft and Oracle are pumping out billions of dollars of debt to finance their artificial intelligence ambitions and building a presence in bond markets such as Australia to fulfil their enormous funding tasks.
They’re considered price-insensitive borrowers and aren’t going to slow down their issuance just because interest rates are increasing. This is because the return on their investments in cloud infrastructure vastly exceeds the cost of debt, and they cannot afford to slow down and risk falling behind in the AI arms race.
In fact, they might even be encouraged by the fact that higher interest rates and the meaningful turn in sentiment towards the neo-cloud sector that has pushed up their traded market interest rates to distressed levels only cements their dominance.
The net effect is that the hyperscalers are crowding out all other borrowers, and that is manifesting in higher borrowing costs for governments, corporates and even households.
The feeling at the event was that the AI borrowers are readying for another bond market funding blitz, so we should expect a lot more paper to be flying around, including in Australia.
This is going to present a challenge for central banks, including the Reserve Bank of Australia.
If the hyperscalers are not deterred by higher interest rates from raising funds in the bond markets and investing hundreds of billions of dollars, then central banks’ ability to use monetary policy to slow demand in the economy is imperilled.
In the long run, higher term premiums in bond markets – whether they’re caused by AI spending or higher energy prices – reduce the influence of monetary policy.
The theme among the large institutional investors at the event was that while AI is now a huge driver of their equity returns, they really have to be alert to the second-order effects.
If the enterprise values of Anthropic and OpenAI are around $US2 trillion and $US1.5 trillion, it implies that other large listed companies that were considered safe due to their moats or, industry dominance, are going to face a threat.
And so large institutional investors have to be alive not only to the AI opportunity but more widespread and destructive versions of the so-called SaaSpocalypse, which decimated the software sector.
The more immediate threat to equities is the fact that the competition it faces is from a bond market that is delivering attractive returns.
As NSW TCorp’s head of listed and unlisted asset management James Murray explained, a 10-year bond yield at 5.3 per cent combined with sub-investment grade credit spreads at about 3 per cent means corporate bonds are paying about 9 per cent.
Meanwhile, long-term risk-free Australian bond rates are paying investors 3 per cent above the inflation rate.
That’s an attractive return, yet he points out it hasn’t stopped many investors from reaching for yield by taking incremental risk in asset classes such as private credit.
“How prudent will that have looked in retrospect?” he asks.