The Reserve Bank of Australia’s hawkish turn
In line with market expectations, the Reserve Bank of Australia (RBA) hiked its Overnight Cash Rate (OCR) for the first time in over a decade at its 3rd May monetary policy meeting. The hike was more hawkish than expected, as was the forward guidance that a “further lift in interest rates over the period ahead” will be necessary “to ensure that inflation in Australia returns to target over time”.
Recognition of economic strength:
The RBA hiked the OCR rate by 25bps to 0.35%. It also increased the interest rate on Exchange Settlement balances from 0.00% to 0.25% and confirmed it would not reinvest the proceeds of maturing government bonds purchased under its Quantitative Easing program.
The rapid central bank pivot was triggered by the realization that “the economy has proven to be resilient and inflation has picked up more quickly, and to a higher level, than was expected”. The RBA also updated its unemployment, GDP and inflation forecasts, with the former now expected to fall faster than previously anticipated to 3.75% by the end of 2022 while the latter is now expected to be significantly higher than previously expected, rising to 6% by the end of 2022, even accounting for higher base rates.
In the subsequent press conference, Governor Lowe acknowledged that rate hikes have occurred earlier than anticipated and are likely to move faster than expected. He confirmed that the RBA had no set path for rates, but would be guided by the data. However, the technical calculations used for the central bank’s economic forecasts do assume that base rates would be at 1.75% by the end of 2022 and 2.50% by the end of 2023. Addressing concerns about Quantitative Tightening, the Governor confirmed that the RBA would not be selling down their holdings of government bonds, rather letting them mature. Finally, in answering “why a 25bps hike to 0.35%”, which no analyst was expecting, Governor Lowe stated that 25bps is a standard move and the board “wanted to get back to business as usual”.
Although investors had already priced in an aggressive rate hiking cycle, the more assertive than expected central bank actions and higher than expected inflation forecast, pushed yields sharply higher with the 10-year government bond hitting an 8-year high, while the AUD appreciated versus the USD.
The RBA confirmed that “given both the progress towards full employment and the evidence on prices and wages, some withdrawal of the extraordinary monetary support provided through the pandemic is appropriate.” With base rates now on a clear upward path, the key questions remain about how fast and far rates will have to rise to help the central bank ensure inflation returns to target, while balancing the ongoing global and local economic uncertainties.
This rate hike is likely to be welcomed by AUD cash investors, although actual time deposit and repo rates will depend on how much commercial banks are willing to pass through. With quantitative tightening only occurring gradually and the Term Funding Facility not scheduled to roll off until Jun-2023, interbank liquidity remains ample, suggesting banks may not pass the full hike to cash investors. Meanwhile, with further rate hikes being likely, we believe investors should continue to segment and ladder their cash investments to optimize the balance between risk and return opportunities.