RBA's Gradual Rate-Cut Cycle: Navigating Fixed-Income Opportunities in a Flattening Yield Curve

The Reserve Bank of Australia's (RBA) decision to hold the cash rate at 3.85% in July 2025, despite market expectations of an immediate cut, underscores a pivotal shift in monetary policy strategy. By prioritizing data confirmation over preemptive easing, the RBA has set the stage for a prolonged, gradual rate-cut cycle. This approach creates asymmetric opportunities in fixed-income markets, particularly for investors positioned to capitalize on flattening yield curves and extended duration exposure. For mortgage-backed securities (MBS) and bond portfolios, the delayed August cut and stretched timeline—potentially extending to November 2025 or beyond—present a nuanced landscape of risks and rewards.

The RBA's Forward Guidance: Timing and Depth of Cuts

The RBA's July hold was a strategic move to await the June quarter inflation data (due July 30), which will determine whether trimmed mean inflation has settled near the 2.5% midpoint of its 2-3% target. If confirmed, an August 2025 cut becomes highly probable, with the terminal rate forecasted at 2.85% by late 2026 (per Westpac's analysis). This path implies four 25-basis-point reductions by mid-2026, stretching the easing cycle well into 2026. Key considerations for investors include:

1. Global Risks: The RBA's caution reflects heightened uncertainty around U.S.-China trade policies, which could disrupt global demand and delay rate cuts. However, the bank's flexibility to act decisively on “material developments” keeps the door open for accelerated easing if geopolitical risks ease.
2. Labor Market Tightness: While headline inflation has moderated, wage growth and low unemployment (~4%) remain concerns. This creates a “soft ceiling” for rate cuts, as the RBA must balance inflation control with labor market resilience.

Yield Curve Dynamics: Flattening and Optimal Duration

The gradual easing path is already reshaping the Australian yield curve. reveals a flattening trend, with long-dated yields compressing faster than short-term rates. For fixed-income investors, this creates two key opportunities:

1. Extend Duration in Longer-Dated Bonds

• Why: As the RBA's terminal rate approaches 2.85%, the convexity benefits of longer-dated bonds (e.g., 10-year government securities) will amplify returns. Flattening curves reduce the risk of capital losses from rising rates, while extended duration positions profit from yield declines.
• Risk Mitigation: Focus on real yield differentials. The Australian 10-year breakeven inflation rate (~1.8%) suggests nominal bonds offer better value than inflation-linked securities, given subdued inflation expectations.

2. Leverage Mortgage-Backed Securities (MBS)

• Why: Prepayment risk in MBS typically rises as rates fall, but the RBA's stretched easing timeline reduces this concern. With mortgage rates already at multi-year lows, refinancing activity remains muted, stabilizing cash flows for MBS investors.
• Optimal Play: Target agency MBS with durations of 5–7 years, which balance yield pickup and liquidity. Avoid adjustable-rate mortgages (ARMs), as their embedded options could dilute returns in a flattening curve.

Cautionary Notes: Risks in Short-Term Paper

While long-dated bonds and MBS offer compelling opportunities, short-term instruments face headwinds:- Volatility: The 2-year bond yield is particularly sensitive to RBA policy shifts. A delayed August cut or unexpected hawkish tilt could spike short-term rates, compressing returns.- Roll-Down Risk: Short-duration portfolios (e.g., 1–3 year corporate bonds) may underperform as yields converge toward lower terminal rates.

shows this pattern during prior easing cycles.

Portfolio Strategy: Positioning for the Terminal Rate

Westpac's 2.85% terminal rate forecast is a critical anchor for duration decisions. Investors should:

1. Ladder Maturities: Allocate 40% of fixed-income exposure to 5–7 year bonds/MBS and 30% to 10+ year securities. The remaining 30% can be in floating-rate notes to hedge against any near-term volatility.
2. Hedged Global Bonds: Diversify with high-quality global sovereign bonds (e.g., U.S. Treasuries or German Bunds), which benefit from global yield compression and provide diversification against domestic curve risks.

Conclusion: Patience and Precision in a Flattening Market

The RBA's delayed August cut and stretched easing timeline are not merely technicalities—they define a strategic era for fixed-income investors. By prioritizing duration extension in long-dated bonds and quality MBS while avoiding short-term paper, portfolios can navigate the flattening curve with resilience. However, vigilance toward global trade risks and labor market dynamics remains essential. As the saying goes: In a flattening yield curve, patience is the ultimate yield enhancer.