The next move in rates could come sooner than expected - here's what it means

For much of 2026, Yarra has found itself at odds with the consensus view on the Australian economy. While policymakers and many commentators focused on inflation risks and a supposedly overheated economy, we have argued that growth momentum was already fading, financial conditions were becoming increasingly restrictive, and labour market weakness would emerge sooner than expected.

In this quarterly outlook, we revisit those calls and assess what the latest economic data is telling us. We explore whether the Reserve Bank has tightened policy too aggressively, the growing evidence of AI's deflationary impact, and the far-reaching implications of the Federal Budget for investors, housing and economic growth. We also outline why interest rate cuts may be back on the table sooner than markets expect and what that could mean for portfolios in the months ahead.

Watch the video above for the full experience, or read a transcript below.

VIDEO TRANSCRIPT

Welcome to our September quarter outlook. We are recording this on Tuesday afternoon, just after the RBA meeting and in between the announcement of a peace deal with Iran, but prior to the formal signing of that agreement, which is scheduled on Friday. Whether that deal holds, and whether it is actually an improvement over what was in place prior to the War, is still anyone’s guess given the limited and conflicting information shared on the details of the deal.

To recap, our last video in March made five key points;

1. Firstly, despite the fluid nature of the conflict and repeated claims of victory by the US and unrealised peace deals, our base case was that a de-escalation deal would occur and that, well prior to that event, financial markets would likely stage a solid recovery even if this left the Iranian regime still entrenched and the future of transit of oil in the Strait of Hormuz and enriched uranium unclear. This rally is certainly now well advanced. The S&P500 is 10% higher since the start of the conflict, and the WTI is now 29% off its highs and only 20% higher than when the War commenced.
2. Secondly, the main topic was that the spike in oil prices, in concert with three rapid fire interest rate rises by the RBA and the escalating threat of AI, were central to the collapse in consumer and business confidence. The RBA Governor was dismissive of the collapse in confidence, initially claiming that confidence was low for some time and people still seemed to be spending. Our view was that confidence had fallen precipitously and the fallout in the economic data would follow in time. That’s now started to occur; household spending data declined 1.1% in April – the second largest monthly fall in the ex-COVID period since the data commenced in 2012. Consumption volumes likely declined by more, given the 0.4% rise in consumer prices in that month.
3. The third topic was the RBA’s insistence in March and through April that financial conditions hadn’t tightened very much and were around ‘neutral’. We pointed out the RBA had cut the data off in January when making that assessment, and our more real-time measures of financial conditions had tightened aggressively. We noted that financial conditions were consistent with economic growth slipping below 1%yoy over the next 12-18 months. In other words, financial conditions were clearly in the restrictive zone. It took until the May Statement of Monetary Policy for the RBA to acknowledge tighter financial conditions, but they still added the caveat that the “extent to which Australian financial conditions are restrictive overall remains uncertain”. Again, the RBA are using lagging credit indicators to guide future interest rate decisions, which, in my opinion, is suboptimal.
4. Fourthly, we maintained that the implications of AI are now firmly within the policy window. We noted that, despite a wide range of potential outcomes our base case was that the unemployment rate would be closer to 6% than the 4.3% in March, productivity would likely grow at double its long-run average and wage and inflation outcomes would be printing well below the RBA’s targets over the next two years if AI is developed and deployed at scale in the developed world. That is, it would prove to be a deflationary shock. It’s early days in the search for evidence, but we do note that wage outcomes in the West are continuing to lose momentum. Redundancies are increasingly citing AI as the causal factor, particularly in the IT and Finance professions, and the AI capex boom is now an order of magnitude greater at the end of the June quarter compared to the end of the March quarter. That is, we are just getting started on this journey.
5. Finally, we simply just didn’t agree with the RBA’s starting proposition from which all else followed. The RBA raised interest rates primarily because the RBA has assessed that the Australian economy cannot grow more than 2%pa without generating inflation. They have determined that Australia has a large positive output gap and that, by virtue of Australia’s economic growth expanding at a 2.6%yoy pace into the end of 2025, inflation is increasingly an excess demand story. The March and May rate rises were attributed to wanting to get ahead of rising inflation expectations. It is this starting proposition that we want to spend a few more moments digging into the evidence.

We have been at odds with the RBA and most of the economic commentariat over the past six months. Our contention has been that Australia’s economic growth momentum peaked in November 2025 and entered 2026 with falling momentum. We obviously acknowledged the impact upon headline inflation from the oil price shock, the last vestiges of the lapsing of the electricity subsidy and the contribution to inflation from taxes such as the tobacco excise and property charges. However, we maintained there was scant evidence of a broad-based pick-up in inflation and that the starting proposition of policy makers that the Australian economy was operating with a large positive output gap was more open for debate. We argued that financial conditions were already tight by February and that further tightening would risk an unnecessarily excessive slowdown in activity. And we maintained that the labour market would likely demonstrate greater weakness through 2026 than the RBA forecasts suggested.

It’s still too early to feel vindicated, but we think the data has clearly fallen our way. And today the RBA took a large step in that direction. The latest round up of economic and survey data reveals the unemployment rate rising sharply, some of which may be due to the survey period over Easter, a monthly CPI print for April that continues to demonstrate remarkable stability with the monthly trimmed mean rising from 3.3% to 3.4%yoy, and clear indications that the economy had lost momentum in 1Q, long before the full effects of the Iran conflict and the collapse in confidence have been captured in the data.

Economic growth expanded at just 0.3%mom in the March quarter of 2026, and declined in per capita terms. Booming Datacentre capex (machinery and equipment investment contributed 0.7% to economic growth in the quarter) was a dominant theme in the GDP report, however the associated imports (which subtracted 0.5%qoq from economic growth) were also large. The net impact of just 0.2% confirms our thesis that the net economic benefit from the surge in AI investment is modest, at least during the initial capex phase.

It is hard to escape the conclusion that the economy’s 2.5%yoy growth over the year to March is currently running a little below the RBA forecast tracking into mid-year; however, the combination of persistent shocks to the business and consumer sectors, tighter financial conditions and a new shock via the Budget suggests a more material slowing in economic growth is now in prospect.

The NAB survey is widely watched by the RAB and others, and business forward orders were consistent with the slowing in the economy that we have already witnessed; however, it is worth noting that forward orders tend to follow business confidence with a lag and that’s fallen sharply. And new orders of inventory suggest the economy will cool further over the coming months.

Given the reception the Budget has been given by business leaders, it is likely that business confidence will remain at a low ebb in the coming months, providing a likely stepping stone to weaker realised economic growth.

The RBA’s favourite chart over the past six months has been its estimate of the ‘output gap’, which has shown on their estimate a large positive output gap indicating that the economy is growing too fast for its productive capacity. The ‘proof’ or crosscheck that the RBA pointed to was NAB’s capacity utilisation series, which also looked relatively elevated.

Our contention was that there was little evidence that underlying inflation was responding to demand-led pressures in the Australian economy, consistent with an economy that had long run out of spare capacity. Importantly, alternative measures of capacity utilisation were telling a very different message. We pointed out that the AIG measure of capacity utilisation has been falling since November 2025, is well below its historical average, and a large gap has opened up between the two surveys. Interestingly, the NAB survey’s utilisation measure is now also falling in recent months, narrowing the gap to the AIG measure, and it is at a level where the RBA was happy enough to commence the 2025 easing cycle.

The reason why all of this is important is that capacity utilisation tends to lead the unemployment rate by around three months, strongly implying that the recent jump higher in the unemployment rate was not just noise. On the NAB measure of capacity utilisation, the inference is that the unemployment rate will be close to 5% by the time we do the next quarterly video update. On the AIG measure, the inference is more extreme, suggesting that the unemployment rate could be closer to 5.5%.

If there is one thing that is certain, it is that when the unemployment rate is trending higher, the RBA cash rate almost certainly declines. The RBA will continue to look at a wide sweep of labour market data but ultimately it is still the unemployment rate that matters most. Given the unemployment rate is already running 18 months ahead of the RBA’s forecast, weaker economic growth will require the RBA to ratchet up their forecast for the unemployment rate in any case.

Even if the RBA chooses to dismiss the survey data, our replication of the RBA NAIRU model suggests that the unemployment rate has already moved sufficiently close to the elusive NAIRU the estimated range, even on an unchanged unemployment rate. So the RBA would likely have to concede the labour market is currently in balance and now at risk of tipping into being oversupplied.

On our estimates, the Australian economy’s supply and demand expanded in roughly equal proportion over the past 12 months. The output gap at the end of the first quarter of this year was essentially at a neutral setting. Not a large positive setting. The RBA was already forecasting weaker economic growth; however, we think that they will now be in downgrade mode during the next 12 months. On our forecasts, economic growth will slow to less than 1%yoy pace into the end of the calendar year. The consequence is that the economy will be moving further away from any inflation-threatening idea of capacity constraint.

Recent speeches and communications also make it pretty clear the RBA particularly focused on this idea of dynamic pricing and the idea that when the economy is fully employed, firms will pass on prices quickly. The RBA actually repeated that message again today.

Now that may well be true in theory. However, we would also point out the ABS did an excellent survey of almost 3,000 businesses in the last two weeks of May. So, it's quite up to date and very comprehensive data that showed that 40% of the firms didn't alter their business strategy at all in response to the oil price shock. And 80% of the remaining 60% actually absorbed the fuel and freight costs in their margins. Only a small minority of around 6% increased prices.

So contrary to the fears of dynamic pricing, it seems that the actual evidence is pointing to cost absorption. And it's also worth noting that if there was this evidence of dynamic pricing, we'd see in some of the real time measures of prices like PriceStats which is a high frequency data source of inflation. Heading through June, it looks as though PriceStats were showing some incredibly benign readings on Australian inflation.

It's also probably worth touching on long-run inflation measures of inflation expectations, which did rise somewhat in April and May, but have largely started to reverse course through June. Now, five-year breakeven inflation is currently at just 2.6%, down from 2.9% at the end of April. Meanwhile longer dated measures of breakevens are closer to 2.1%, actually near the bottom of the RBA inflation targeting range.

Recently the RBA gave a speech highlighting three-year inflation swaps as a guide to long run inflation expectations, which is to us a case of misplaced confidence. Three-year inflation swap yields peaked at the end of April, like breakevens, and have rallied about 20 basis points since. But the RBA's concern about three-year inflation swaps also ignored that 5-and10-year inflation swaps had barely moved at all, and three-year inflation swaps in Australia have just mirrored what's happened in the US.

So, it's not telling us anything really about what's going on domestically. It's also pretty clear to us that when we look at those inflation swap levels, they're not showing a concerning level. In fact, if anything, we also know that they're incredibly illiquid instruments and the RBA has previously indicated and flagged limitations to reading too much into these instruments. It's a little bit of a mystery as to why they've chosen to flag them more recently.

All of this is to say that of the available measures of long run inflation expectations, we're not overly concerned about the levels and the consistent message that we're getting from them is that inflation expectations are moving lower at the moment. Not higher.

In summary, we didn’t think the RBA’s starting proposition of an economy expanding quickly, out of spare capacity and with demand-led inflation was correct. And we think the evidence that has accumulated over the past quarter has vindicated our position. The last couple of interest rate hikes were likely not required to cool an economy that had already started to slow in late 2025 and tighter financial conditions essentially guaranteed that process was going to continue into 2026-27. The rapid fire tightening into May we viewed as a policy error, even assuming a cessation of hostilities in Iran. The question now is whether the RBA has gone too far and whether the Budget has provided a separate catalyst that now risks a more abrupt slowdown.

The Budget

Structural changes to the tax system announced in this Budget are not trivial - they alter the balance between income and capital, they reshape investor behaviour, and ultimately will influence both asset allocation and economic outcomes. What looks like a targeted reform to capital gains tax, negative gearing, superannuation, and trusts is, in reality, a broad reallocation of incentives across the entire investment landscape. Some of this is needed in an effort to address distortions – negative gearing of property and income splitting inside family trusts are examples – but when tax policy is used to punish growth capital relative to income strategies, good intentions can lead to poorer economic outcomes.

The implications of the Budget changes to CGT are quite predictable, and we think pretty significant. Growth and early-stage investing become structurally disadvantaged relative to income-producing assets. Investors are likely to respond by reallocating: growth assets migrate toward tax-advantaged structures like superannuation, primary homes, and investment bonds, while income assets become more attractive for individuals investing outside of superannuation and those in high-tax brackets. That is not just a portfolio shift—it is a major change in how capital is allocated within the economy. There may still be some scope for carve-out as the Budget notes it will consult with industry, but we may be old-fashioned, but we are running out of time.

The implications for property investing and credit growth is also profound. Our calculations on the impact of the removal of negative gearing and the change in CGT dramatically alter the economics for a residential investor in established investment property. At an average income tax rate of 32% the internal rate of return (IRR) drops 1.5% (assuming 6.5%pa house price growth, 2.5% inflation) and, for a top marginal taxpayer, the IRR drops 2.25%. Think of this Budget change as equivalent to five RBA rate hikes for established residential investment property investors on the top marginal rate.

The lower the assumption for inflation and the higher the assumption for capital growth, the worse these new changes are relative to the existing system. Importantly, the loss of deductibility of interest also interacts with the calculation of borrowing capacity, reducing it by between 8-15% in most circumstances. This is really important, given investor credit is 40% of the share of mortgage credit lending, and substitutability to new investment properties will likely be small, given investors tend to shun development time lags and builder solvency risk and prefer investments in established neighbourhoods, which are in many ways easier to rent.

However, when house prices are in decline the prospect of an investor willing to take a leveraged negative equity position is essentially zero. The implication is that housing credit, which was already slowing in response to falling housing turnover, could plummet in the coming months. Excess credit growth was one of the reasons quoted by the RBA for recent rate hikes and was quoted again today. It seems the Budget has well and truly fixed that problem for the RBA (and then some).

From a political perspective, it's also quite remarkable.

Asset-rich Baby Boomers, having benefited most from the tax incentives of the past, are now moving into the retirement phase of tax-free superannuation, tax-free family home and grandfathered CGT changes on existing assets, and they are now incentivised to load up on franked dividends, sell long-held growth assets and lift their consumption. In the generational lottery of life, it seems the Baby Boomers never lose.

The political gambit is that with Generation Z and Millennials now a bigger voting block than the Baby Boomers, the path to sustained political power is to appeal to younger voters with some redistributive income policies whilst allowing the Baby Boomers to keep the spoils of their prior wealth-generating strategies. Generation X just has to again ‘suck it up’ in the full knowledge they are too small of a voting block to matter. The problem for the Government is that the sentiment post the Budget is that the bulk of Gen Z, Millennials and Generation X are just not buying what the Budget is trying to sell.

To our knowledge, we were the only forecasters consistently looking for the RBA to pivot to an easing bias by calendar year-end and ultimately commence an easing cycle in early 2027. This Budget and the reaction by businesses and consumers might just be the force that bring rate cuts in 2026 as a realistic proposition once again.

For financial markets, this will be an important pivot. The A$ may well have already peaked as we move into the third quarter, some interest rate sensitives may capture a bid, including REITs, and after all the excitement of SpaceX, OpenAI and Anthropic IPOs, this tech-led market regime might start to finally broaden back out.

Having said that our suspicion is that the third quarter will be a pretty bumpy ride and we still have to navigate a peak in expected earnings growth in the US over the next quarter or so. We’ll also have to manage the noise from US mid-terms and lingering smoke from Middle East. Nevertheless, we still believe that Q4 will likely stage a broader risk rally and we will look to accumulate risk assets on weakness through the Q3.

All the best in the quarter ahead.