The path of interest rates in 2025

Investors are reminded constantly that interest rates are a moveable feast. The Reserve Bank sets the overnight cash rate and the interest rate market exists with the primary aim of predicting what the path for that rate will be over time. Anyone with a mortgage knows that the RBA actions will directly hit their back pocket, the impact for investors is a little more obscure.

Because the markets are constantly pre-empting the actual cash rate, fixed income pricing reflects expectations as well as the current market. Investors with fixed rate coupons see no change in returns when the RBA make rate decisions but may see valuation changes, as happened so devastatingly in early 2022 when the RBA began hiking rates.

Traditional advice has been to hold a portion of fixed rate bonds in your portfolio to hedge the day when equity returns are zero. This classic textbook approach has not been terribly useful for the last 30 or so years – the chart below from Bloomberg data shows how rarely bonds are able to offset a negative year in equity.

Chart 1 - Australian bond and equity returns

Source – Bloomberg; ASX 200 Total Return Index and All Maturities Bond Index.

Over those 30 years, the worst two years for bond returns were also negative years for equity returns. The payoff was terrific during the GFC for bonds, but only compensated for half the losses in equity. Only twice in 30 years have bonds offset equity losses.

The holders of fixed rate bonds also must cope with volatility. Whilst lower than equity, it can still have a material effect on the value of their portfolio from an asset they see as defensive. 2025 is almost certain to bring us another year of conjecture both about the rate set by our RBA as well as the economic policies of a new US government. The old market adage that the market is always right has a kernel of truth, but in reality, the market is quite bad at picking when interest rates will move and how far when they do. The chart below shows how the market has changed its mind on where rates are headed.

Chart 2 - Australian Interest Rate Market over time

Source Bloomberg L.P.

The chart above shows how much the expectations have changed, not only from a year ago, but also from just a week ago. A year ago, the market was convinced interest rates were sure to drop almost immediately (as can be seen by the lower dotted green line) and every week we see expectations change (as per the brown and solid green line only one week apart).

Most investors want stability in their defensive asset class and floating rather than fixed rate increases that stability significantly. While some great rates traders will get their market guesses correct, in a floating rate instrument, the asset price remains close to par and the return generated changes with the cash rate.

A fixed rate investment with a relatively short maturity is a tremendous way of locking in returns for a given period and being able to reprice and reset returns regularly. Unlike a fixed rate index linked investment, those fixed rate bonds will mature whereas the index constantly renews itself and the underlying bonds are reinvested automatically no matter the prevailing rate.

So fixed rate investments do not necessarily bring portfolio volatility as long as they are all held to maturity. Fixed Income funds are open ended meaning maturing bonds are immediately replaced with longer dated bonds no matter what the prevailing rate is.

There is never a time when markets feel stable and the road to successful investing seems easy. In 2025 there is no difference, although market consensus will often deliver very firm views. An example of this is the market’s predictions for the path of the overnight cash rate as shown in Chart 3.

Chart 3 - Australian Cash Rate Expectations

Source Bloomberg L.P.

The chart shows a very strong pricing indication that interest rates will be 0.85% lower by December 2025. This is already “priced in” and reflected in valuations. Many market economists are predicting this easing cycle to begin in February after the RBA’s first meeting of 2025.

If investors are worried that their returns might begin to suffer if they are linked to the cash (floating) rate it is important to note that this movement lower is already priced into bond markets. Recent history tells us that other markets tend to do well as rates reduce unless there is fear of a collapse in the economy. Planning for collapse is a very hard way to maximise wealth.

Floating or short tenor fixed rate exposure tends to deliver positive returns no matter what the interest rate players are doing. Adding sensible credit exposure is a far more efficient way of building wealth for most investors than trying their hand at picking outright interest rate directions.

In 2025 we remain comfortably invested in credit with a mixture of higher yield shorter maturity fixed rate investments, supplemented by floating rate. if the borrower cash.