RBA surprises by not cutting rates

The Reserve Bank of Australia (RBA) delivered a hawkish surprise in early July, by leaving the cash rate unchanged. The Bank remains concerned about global growth and the wide uncertainty bands around the outlook. Interestingly, it has chosen to wait for firmer evidence of an economic slowdown in the economy before cutting, rather than prejudging the outlook as negative purely because of uncertainty. Officials also view the latest inflation data as an upside surprise relative to expectations, even though many market participants interpreted the print as dovish.

We had expected the RBA would cut at either the July or August meetings, but not both.
A useful description of the RBA’s behaviour is a "Taylor rule", under which rates are set to a long-term neutral rate plus the size of the output gap (the deviation of output from supply-side potential). Our best real-time gauges now suggest the output gap is about 0.3% of gross domestic product (GDP), while the neutral rate sits at 3.6%. On that basis, the optimal cash rate is around 3.9%, slightly above the current rate.

Australian real-time output gap

Australian real unit labour costs and output gap

Australian 10-year bond yield and neutral rate

RBA cash rate and "Taylor rule" prescription

Many in the market believe the RBA is considering substantial cuts. At time of writing, money-market pricing implies about 75 basis points of easing by year-end. However, we disagree. If anything, post-‘Liberation Day’ data indicate the economy is resilient, and that the RBA should tone down its dovishness. We think there is scope for short-term yields to rise, especially relative to longer-term bond yields and we are therefore positioned for further flattening of the yield curve.