After three years of rate hikes, many economists forecast the downward trend in regional inflation would allow Asia-Pacific (APAC) central banks to declare victory and swiftly cut base rates back toward previous lows. However, while APAC central banks appear very keen to cut rates from multi-decade highs to help stabilize growth, a combination of structural changes, financial risks and a higher for longer Federal Reserve mean their ability to do so is limited – with significant implications for cash investors.

Local versus global inflation

Historically APAC inflation is typically a local issue –dominated by food and fuel – which generally have a much higher weighting in the basket than Western countries. However, the recent period of higher inflation was global in nature – with similar factors affecting multiple countries – although APAC inflation (Exhibit 1A) peaked at much lower levels than in Western markets.

Since cresting in 2022, we have seen inflation trend down across the APAC region. How much was due to central bank tightening and how much due to fading price pressures is debatable – but the decline has recently pushed real interest rates into positive territory (Exhibit 1B).

Divergence challenges

Over the past three years, APAC central bank’s monetary policies have converged with US Federal Reserve monetary policy - hiking base rates aggressively to fulfil their inflation targeting mandates and ensure investor confidence in local financial markets.

Notably, APAC central banks were among the first to hike, with rates generally peaking in mid-2023 at multi-decade highs. Higher base rates raise the cost of funding and have a negative impact on interest rates sensitive sectors like housing and consumption – putting downward pressure on growth. Therefore, in theory, central banks should start cutting rates before inflation hits target to avoid real rates becoming overly restrictive and potentially triggering an undesirable recession.

However, unlike during previous hiking cycles, APAC central banks are struggling to diverge from global monetary policies. Despite weaker domestic growth, muted consumer confidence and sluggish property markets, investors have not witnessed a subsequent sharp decline in base rates, with three regional central banks actually hiking further.

A lack of confidence that inflation is really contained; a Federal Reserve which is likely to keep rates higher for longer and most importantly long memories of the Asian Financial Crisis are the key reasons for this reticence to cut. While lower rates would support domestic growth, they also risk currency weakness (despite base rates at record highs, APAC currencies have declined year-to-date versus the USD and remain close to decade lows), increased market volatility and potential capital outflows.

Positive cash returns

The sharp increase in central bank base rates has pushed market drive short tenor interest rates higher across the region (Exhibit 3A). Meanwhile yield curves (Exhibit 3B), which had flattened as investors anticipate rate cuts, have recently re-steepened. While we believe APAC central bank base rates have probably peaked, sticky service inflation, increased geo-political risks and a higher for longer Federal Reserve suggest rates will remain elevated for the foreseeable future.

Conclusions

For APAC cash investors these higher yields and upward sloping curves offer attractive investment opportunities with returns at decade highs. But with many central banks switching from a coherent policy framework to data dependence – interest rates have become significantly more volatile as economists focus on a few key data points. Therefore, we recommend investors continue to focus on the key goals of cash investment, liquidity, and security by ensuring good diversification and segmentation to achieve competitive returns.