In brief

• Following a five-month hiatus, the Reserve Bank of Australia (RBA) decided to raise the Overnight Cash Rate (OCR) by 25bps to a 12-year high of 4.35%.


• Recent, stronger than expected economic activity and more persistent inflation than expected were key drivers for the rate hike.


• Money market and bond yields, which had recently increased in anticipation of a rate hike, declined as investors remain uncertain if this represents the peak in rates or additional hikes may be necessary.

At its monetary policy meeting on the 7 November, the Reserve Bank of Australia (RBA) decided to raise the Overnight Cash Rate (OCR) by 25bps to a 12-year high of 4.35% (Exhibit 1). The rate hike, which follows a five-month hiatus was widely anticipated by economists following stronger than expected economic data. In the accompanying statement, the RBA noting that inflation “is still too high and is proving more persistent than expected a few months ago” and “judged an increase in interest rates was warranted… to be more assured that inflation would return to target in a reasonable timeframe”.

Exhibit 1: The RBA has hiked rates for the thirteenth time; pushing short end rates higher and the curve steeper

Source: Bloomberg, J.P. Morgan Asset Management, data as of 7 November 2023. BBSW: Bank Bill Swap rate

Slow progress on inflation

The RBA paused its rate hiking cycle in July, hoping it could engineer a soft landing – by curbing inflation while avoiding unnecessarily triggering a recession. With the central bank’s extremely shallow glide path for CPI to return to target (2-3% by the end of 2025), this indicates its desire to retain as many of the employment gains of the past few years as possible. Initially, this strategy appeared to have been successful as the combination of higher interest rates and cost-of-living pressures dampening consumer and business confidence, as well as triggering a period of “below trend growth” - necessary to reduce inflation.

However, this choice implied a very narrow path for the RBA to achieve their goal and an asymmetric inflation risk profile – which the Board recognized in their October minutes - having “a low tolerance for a slower return of inflation to target than currently expected”. With subsequent economic data stronger than anticipated and the latest quarterly inflation print slowing by less than expected (Exhibit 2) the central bank was forced to acknowledge that “progress” on reducing inflation “looks to be slower than earlier expected” – necessitating a resumption of hikes.

Nevertheless, the RBA still believes that previous interest rate hikes are working to balance supply and demand with the impact of recent rate hikes continuing to flow through the economy. The central bank’s latest forecast now expected inflation to slow to 3.5% by the end of 2024, but still reach the top of its 2-3% target range by the end of 2025. Meanwhile, it expects unemployment to only rise gradually to around 4.25%.

Exhibit 2: Inflation has fallen from Dec 22 peak, but the pace of decline has been slow, while unemployment remains close to record lows

Source: Bloomberg, J.P. Morgan Asset Management, data as of 7 November 2023.

Market Reaction and Fund Positioning

Ahead of the announcement the AUD had strengthened and bond yields had risen in anticipation of a rate hike – although given the central banks hesitancy, markets were only pricing a 70% probability of an increase. Following the announcement, the AUD weakened slightly and bond yields declined as investors remain uncertain if this represents the peak in rates or additional hikes may be necessary.

Outlook

Overseeing her first-rate hike as head of the RBA, Governor Bullock confirmed that “the board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome”. Although their latest inflation and labor market forecasts is stronger – suggesting “”the risk of inflation remaining higher for longer has increased”, the central bank still reasoned that “significant uncertainties around the outlook” still exist. The RBA also pivoted from their previous stance that “some further tightening of monetary policy may be required”, to a more nuanced “further tightening of monetary policy… will depend upon the data and the evolving assessment of risk”.

For AUD cash investors, the latest rate increase should be welcome news – with interest rates on cash investments increasing to a new cycle high. In addition, with the yield curve still upward sloping, investors with longer investment horizons may enjoy additional yield pick-up. Nevertheless, given uncertain market conditions and increased volatility, segmenting cash across a broader array of money market and ultra-short strategies continue to present opportunity in achieving a diversified and cautious stance.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

This information is generic in nature provided to illustrate macro trends based on current market conditions that are subject to change from time to time. This generic information does not take into account any investor’s specific circumstances or objectives and should not be construed as offer, research or investment advice.

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