The Reserve Bank of Australia: moving ahead of the curve?
At their monetary policy meeting on June 7, the RBA surprised the market by raising the Overnight Cash Rate by 50bps to 0.85%1. This is the second rate hike in the current cycle, following a 25bps move in early May, as the central bank noted that “inflation in Australia has increased significantly” and “is likely to be higher than was expected a month ago”. The size of the rate hike also affirms the RBA’s desire to get ahead of the inflation fighting curve – which, until recently it was perceived as significantly behind.
Balancing “resilient” domestic economy versus “clouded” international outlook:
The hawkish rate hike lifted base rates back to their highest level in almost three years, erasing all the emergency Covid inspired rate cuts in 2020. Concurrently, the RBA increased the interest rate on Exchange Settlement balances by 0.50% to 0.75%2. While the accompanying note did not mention the RBA’s large quantitative easing bond holdings, recent statements confirmed the central bank intends to allow them to mature rather than pursue quantitative tightening.
Australian inflation is published quarterly, with the last reading on April 27 showing headline Consumer Price Index hitting at 22-year high of 5.1%y/y3, although this is lower than price increases witnessed in other advanced economies. Nevertheless, the RBA decided not to wait until the next print, noting that higher electricity prices, supply chain disruptions and the Russia / Ukraine’s conflict meant that inflation was “higher than earlier expected” and is “expected to increase further”.
The strength and resilience of the domestic economy, with first quarter Gross Domestic Product increasing by a stronger than expected 0.8%q/q (3.9%y/y)4, while unemployment rate fell to a 48-year low of 3.9%5 gave the RBA confidence to hike. However, the central bank did caution that a fall in house prices, slow wage growth momentum and a squeeze on household incomes warranted monitoring as they contemplated future rate hikes.
Hawkish reactions and expectations:
Prior to the monetary policy meeting, the market was split on the outcome, with the majority of economists calling for a smaller hike – as investors contemplated a central bank which was previously focused on a “slow and steady” normalization of rates. Following the RBA’s announcement, bond yields moved sharply higher (with the 2-year jumping 0.17% to a decade high of 2.75% while the 10-year rose 0.07% to 3.55%6), as investors reassessed the risk of more rapid, front loaded rate hikes. Meanwhile, market consensus on the terminal rate remains aggressive at 3.50% compared with the RBA’s previous suggestion that the neutral rate was around 2.50%7.
While the RBA concluded that “the resilience of the economy and the higher inflation mean that this extraordinary support is no longer needed”, it committed to a data dependent stance in determining the size and timing of future rate hikes. Nevertheless, with an unusually high number of monetary policy meetings per year, the central bank has ample opportunity to normalize rates. In our opinion, this implies more frequent and larger hikes are now likely.
For AUD cash investors, confirmation that the RBA has joined the Federal Reserve and other central banks in front loading larger rate hikes to combat inflation is positive news. Following the rate hike, time deposit and repo rates will likely reset higher – although high inter-bank liquidity suggests commercial banks may not pass through the entire hike to depositors. Finally, with the market pricing in faster and larger rate hikes while the RBA emphasizes its data dependent stance, market volatility is likely to remain elevated. We believe investors should take a cautious approach to cash management, ensuring sufficient segmentation and diversification to optimize the risk and return opportunities.
Diversification does not guarantee investment returns and does not eliminate the risk of loss. Yields are not guaranteed. Positive yield does not imply positive return.
6 Source: Bloomberg, data as of 7 June 2022
7 Source: Bloomberg, RBA, J.P. Morgan Asset Management, data as of 7 June 2022