Positioning for reluctant but necessary rate hikes

The Reserve Bank of Australia (RBA) has hiked rates 25bps to 3.85% in early February. In its February Statement on Monetary Policy (SoMP), the bank has cut its growth forecasts and incorporated a delay in inflation returning towards the mid-point of the target 2-3% band (from an upwardly revised base). Initially, the bond market interpreted comments about “inflation being elevated for some time” as hawkish. However, in reality, the RBA was merely explaining its decision to hike rates, to the surprise of some in the community. After all, according to its latest forecasts incorporating current market pricing for the path of rates, the economic growth would slow to a sub-trend pace risking higher unemployment, an outcome that policy makers would feel uncomfortable with, even if deemed necessary.

In the press conference, Governor Bullock did not rule out the possibility of more hikes, suggesting that the same cautious observation employed in the cutting cycle was a good model for the hiking cycle too.

We think that the Bank is likely to hike again. Indeed, our models suggest that with a neutral rate around 3.7% and the output gap around 0.7% of gross domestic product (GDP), there is room for more hikes, with a credible Taylor rule currently pointing to a 4.4% cash rate. However, we doubt that the Bank will ultimately hike this far, because there is some tightening of financial conditions coming through, notably through the exchange rate, and there could be more to come if rates rise further, credit growth slows, the government restrains spending, or financial markets become more volatile. Indeed, our financial conditions index points to growth slowing to the high 2's on an annualised basis. Also, our real time domestic demand tracker is pointing to similar growth outcomes. If the RBA only hikes one more time, bonds look a little cheap, already pricing in more hikes than this.

Figure 1: RBA cash rate model

Chart 2: Australian real GDP and financial conditions index

Chart 3: Australian real domestic demand and activity tracker

Chart 4: Australian 10-year bond yield and neutral rate

Chart 5: Australian sector preferences according to yield curve regime

In the wake of the RBA’s cash rate decision, short term rates have risen faster than long-term bond yields, causing the yield curve to bear flatten. In this environment, history suggests that resources stocks fare best relative to defensives and domestic exposures. Although, if the curve were to bull flatten, there would also be scope of real estate stocks to add value. We think that both resources and real estate are worthwhile exposures to have at present, noting that we are navigating an inflection point in the shape of the yield curve in the coming months.

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