The first rate rise to hit in 2023, what ditching the 3-year yield-curve target means, and other hot takes on the RBA's decision

Glenn Freeman

Livewire Markets

The Reserve Bank of Australia today left the official interest rate of 0.1% unchanged but abandoned the Australian Commonwealth Government Bond yield curve target – marking the “beginning of the end” of emergency monetary policy settings.

Both had been largely priced-in by the market. Bond yields and the Australian dollar moved only slightly on the announcement.

Acknowledging underlying inflation had picked up faster than the bank anticipated, RBA governor Philip Lowe said inflation would likely remain inside its 2% to 3% target band for the next few years.

“The board is prepared to be patient, with the central forecast being for underlying inflation to be no higher than 2.5% at the end of 2023 and for only a gradual increase in wages growth,” Lowe said.

Notably absent from his statement was any mention of rates being lifted from 2024. As some of the below comments indicate, the RBA is likely to begin gradually increasing rates from 2023. 

This follows days of speculation, the market pricing in five hikes to the cash rate before the end of next year. This came after underlying inflation jumped 0.7% in September, lifting the annual rate to 2.1%.

The latest announcement occurs against the backdrop of an ASX that has continued to push higher, nearing all-time highs just 18 months since markets around the world dived in the single biggest (and sharpest) one day fall since the 1930s.

As you scratch your head wondering what it all means - while also counting your winnings (or tallying your losses) from today's Melbourne Cup - we've done some of the hard work for you by seeking some expert opinions below. 

"The economy is slowing itself"

Ken Liow, head of portfolio strategy and risk management, Realm Investment House 

1. We don’t expect to see rate rises in 2022 at this time, although there will certainly be ongoing tension between printed inflation and an ongoing transitory narrative that remains intact, from the RBA’s perspective. The criteria the RBA has stated for raising rates, particularly sustainable wage inflation, are very unlikely to be met in 2022.

The RBA ended the yield curve target for the April 2024 bond but continued to indicate that conditions for a rate rise would probably not be met by 2023. But it appears that the conviction in this position has weakened a little since the last meeting, albeit by much less than the market had imagined following a surprise September CPI announcement recently. This will leave more room for the market to continue to trade in a detached fashion from the RBA guidance and, from the looks of things, even hawkish market economists.

The RBA re-affirmed the centrality of wage inflation in its considerations for monetary policy. The circumstances under which the wage inflation requirements will be met are highly unlikely to occur in 2022 and the RBA re-affirmed it may not be achieved for some time after that.

The immediate market reaction has been very muted. If this persists, fixed-rate mortgages will continue to rise in the near term and may filter more meaningfully into prices next year.

2. The September CPI print, very strong vaccination outcomes and the decision to open borders for immigration much earlier than had been expected have affected our outlook. Whilst the economic recovery towards our pre-covid baseline may be faster than previously hoped, the supply of labour will also increase materially and offset wage pressures as well. Overall, we think a rate rise may occur in mid-late 2023.

The details of the inflation outcomes so far continue to indicate they are of a transitory nature. While there may be problems with urgent supply, longer-term supply appears adequate for the most part, although there will be pockets of exceptions. With a higher premium now required for the timeliness, there is increasing evidence of delaying of purchases, which reduces the need for rate rises to dampen demand. 

The economy is slowing itself to some degree. Shipping and freight costs are declining, for example. As the frictions preventing a complete re-engagement and enlargement of the workforce ease, areas of major labour shortage like retail, hospitality, logistics and farming should be alleviated without creating a lasting wage-price spiral that is worthy of monetary intervention.

We expect any hints of rising wage-price rigidity emerging will be somewhat dampened by the return of foreign students, tourists and other skilled immigrants which should converge towards the prior baseline over a period of perhaps three years. Towards the end of 2022, the market may well become focused on how hard it is to generate inflation all over again.

3. Banks will be affected by the pricing of debt beyond the cash rate. Given the yields of 3-year bonds, for example, mortgage rate rises for fixed-rate loans will almost surely occur even if the RBA takes no further action in the immediate term. Given the proportion of borrowers favouring fixed-rate loans is material, this will affect affordability and sentiment.

4. On the question of when we would introduce higher rates, and what would influence such a decision, we're informed by a tendency undershoot our inflation outcomes for some time. We would be watching for the development of rigidity in the wage-setting process. Some increase would actually be welcome. Market and survey inflation expectations will also be closely watched.

Concern for overly strong property prices has been tempered by the inevitable rise in fixed-rate loans which will be coming if market pricing for imminent rate rises next year remains in place. If anything, our immediate reaction for property has become one of stressing our portfolios for an increased likelihood of downside scenarios.

"It has left risk-takers wondering if they can trust the RBA"

Tim Toohey, head of macro and strategy, Yarra Capital Management

1. We had been of the view, prior to the CPI print, that the RBA would commence hiking rates in mid-2023. Upon the release of the CPI, we brought forward our first expected hike to May 2023 with a second expected in August 2023.

It was clear the RBA was going to have to upgrade its view on underlying inflation materially and that clearly happened today. Nevertheless, the RBA’s stressing that it wants to remain patient suggests rate hikes are a 2023 event and that 2022 will be a year for tapering and waiting for inflation to exceed the mid-point of the target range for several quarters.

Obviously, financial markets are pricing for a more aggressive response, but we see 1H2023 as the most likely kick out date.

The hardest-hit sector will be new residential construction and real estate turnover. Although consumer discretionary spending is typically impacted relatively sharply by higher interest rates, we believe the prospect of solid household income growth, large prior wealth gains and over $180 billion of excess savings since the pandemic commenced will see the consumer remain resilient.

2. The RBA abandoning the 3-year yield curve control policy has been poorly handled. The policy was introduced to provide certainty for risk-takers. Instead, the RBA refusal to defend its own policy over the past week has introduced enormous volatility in the broader bond market. Not only has it caused one of the largest liquidity squeezes in decades, but it has left risk-takers wondering whether they can trust the remainder of the RBA’s forward guidance going forward. The increased volatility and the higher level of yields will invariably see mortgage rates rise in the coming months.

3. The banks are currently awash with liquidity and deposits. There is not an immediate pressure to reprice mortgage rates, but if short-dated bond yields remain near current levels for more than two months, I think we will start to see banks testing the water with front book adjustments for mortgages.

Elsewhere in the local market, further commentary on the RBA's rates announcement was provided by Fidelity International's Anthony Doyle  and Stephen Miller from Grant Samuel Funds Management. We've summarised some of their key discussion points below.

The RBA is "caught behind the curve"

Anthony Doyle, director and cross-asset investment specialist, Fidelity International

In what had been telegraphed by last week’s chaotic sell-off at the short-end of the Australian Commonwealth Government Bond (ACGB) yield curve, the Reserve Bank of Australia (RBA) Board today announced the cessation of the April 2024 ACGB target of 0.10%, signalling the beginning of the end of emergency monetary policy settings.

The lack of any intervention to defend the 0.10% target following higher than expected inflation numbers meant that the end of yield curve control had been largely anticipated by the market. Bond yields and the Australian dollar moved marginally immediately following the RBA statement.

Calls for a review of the Reserve Bank’s performance and mandate, which has been advocated by the OECD, will likely continue to grow as it appears the decision to call an end to what was a key element of the RBA’s monetary policy support package was actually made before today’s monetary policy meeting of the Reserve Bank Board.

The RBA Board also backed away from its previous forward guidance that it didn’t expect to raise the cash rate until 2024, indicating that the bond market was correct in anticipating an earlier start to the rate hiking cycle than the RBA had previously been signalling.

Caught behind the curve by more persistent inflationary pressures, a stronger than anticipated labour market and rising bond yields, the RBA today indicated that it will likely join other central banks by beginning to lift the cash rate sooner than it had anticipated. It is also expected to end its quantitative easing program around mid-February 2022. Nonetheless, the RBA Board has emphasised that wages growth is the key to interest rate hikes and that the Board is prepared to be patient to ensure it achieves a return to full employment in Australia and inflation consistent with the target.

The RBA may be "fighting the last war"

Stephen Miller, investment specialist, GSFM

The RBA today acknowledged it had "underestimated inflation but forecast revisions are slight and today’s announced changes in policy stance are minimal." As such, the RBA risks “doubling down” on recent communication missteps by tying “outcomes-based forward guidance” (OBFG) to a calendar, implying that the policy rate won’t rise until the end of 2023.

It is a little surprising the RBA has minimally tweaked monetary settings when “emergency” settings in monetary policy have persisted well beyond their useful application date. 
At the very least, the RBA should have acknowledged some upside risk to inflation rather than a grudging “uncertainties relate to the persistence of the current disruptions to global supply chains and the behaviour of wages at the lowest unemployment rate in decade.”

More persistent inflation has been visible for some time globally and is an issue with which every developed country central bank is currently grappling. Australia is never going to be immune to those same pressures.

The previous confluence of upside inflation surprise and insufficiently nuanced communication occasioned the bond market convulsions of the last week or so. The RBA again gives a grudging nod to this noting that “bond yields have increased recently and bond market volatility has also risen significantly.” This Statement does little to assuage concerns of volatility going forward.

In fairness, perhaps even in the wake of a welter of evidence to the contrary, the RBA assumes markets possess an interpretative capability way beyond that which exists.

Conclusion: Tactics versus strategy

Today’s changes are tactical in nature. Perhaps the time has come to review that framework in a more strategic way.

Outcomes-based forward guidance can unnecessarily constrain the central bank. For one thing, it might mean the central bank only acts when the inflation genie is effectively out of the bottle. 

The pandemic induced supply shocks are coinciding with the reversal of structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation. 

Add into that mix the secular rise in female workforce participation, and the result was a massive global labour supply shock and a decline in wage growth and a structural deflationary trend. That is ending. A move to OBFG – at least the way the RBA is framing it - might be a case of “fighting the last war”.

For another, the various “outcomes” might be incompatible. For example, unemployment may remain relatively high because of geographic or skill mismatches. Monetary policy is impotent in such a circumstance. Having monetary policy target an unemployment rate under these conditions is a recipe simply for more inflation.

Macro
House prices to fall 15%-25% after the first 100bps of RBA hikes

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has around 10 years’ experience in financial services writing and editing, most recently with Morningstar Australia. Glenn’s journalistic experience also spans broader areas of business...

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