Interest rates play a crucial part in supporting the returns for investment portfolios. For many investors, interest paying investments will make up 30% to 50% of their portfolio. So, what is the outlook for this crucial component of our portfolios?

Current Economic Landscape

RBA's Current Position: The Reserve Bank of Australia (RBA) kept interest rates on hold at 3.6% at the December 2025 board meeting. Governor Michele Bullock emphasized that setting rates is becoming increasingly difficult. She signalled that a rate hike is more likely than a cut, though economists are divided.

Challenges for the RBA:

• Inflation remains high, creating discomfort for the RBA.
• The board fears past rate decisions may have been wrong and is cautious about future moves.
• Monetary policy decisions rely on backward-looking data, adding complexity.

Market Movements:

• Australian bond yields have surged in recent weeks, with the three-year yield up 74 basis points to 4.05%, and the 10-year yield near 4.75%, close to 15 year highs.
• Similar trends are seen globally, including in Japan, Britain, Germany, and the US.

Implications for Retirees and Investors

1. Income Planning

• Higher Interest Rates: If rates rise, term deposits and cash accounts may offer better returns, which is positive for retirees relying on fixed income.
• Bond Market Volatility: Rising yields mean falling bond prices. If you hold long-duration bonds, higher rates mean we should expect capital value declines. Shorter-duration or floating-rate bonds help to diversify these risks.

2. Investment Strategy

• Shares Under Pressure: Higher rates often weigh on share markets, especially growth stocks. Retirees should review equity exposure and ensure diversification.
• Defensive Assets: While markets remain strong, trimming growth to top up reserves by adding to defensive income producing investments is a proven strategy to ride through market cycles.

3. Inflation Risk

Persistent inflation erodes purchasing power. Continuing to own growth assets is important long-term, even though values can fall in the short-term.

4. Global Factors

Ray Dalio, founder of hedge fund Bridgewater Associates, argues the world faces a collision of three cycles:

• Debt/Money Cycle: Governments have excessive debt, but can't raise taxes or cut benefits.
• Domestic Political Cycle: Wealth inequality is driving political polarization.
• Geopolitical Cycle: Security and self-reliance now outweigh economic priorities.

This creates a scenario where countries and central banks are "stuck" between competing priorities. This creates uncertainty about the direction of interest rates. Importantly, diversification is critical to achieving good investment outcomes and managing risk over time.