This Post Market Wrap is presented by KOSEC – Kodari Securities

• Resilient economy and low unemployment likely to push inflation higher in coming months. 

• 10-year bond yield hits 6 year high at 2.96 percent.

• Investors should brace for higher RBA interest rates this year.  

RBA on hold … for now

The Reserve Bank of Australia (RBA) at its April 5 Board meeting decided to leave the official cash rate unchanged at 0.1 percent. It has been at this level since November 2020, when the RBA reduced the official rate in anticipation of an economic slump resulting from enforced lockdowns arising from the COVID pandemic.  

The RBA indicated that it is closely monitoring emerging inflationary pressures in determining the timing around an increase to the official cash rate. The RBA noted that supply chain disruption has led to shortages of goods and materials, resulting in higher input costs. The Bank is also cognisant of the inflationary impact of soaring petrol prices. Rising house purchase costs and grocery inflation related to flood damaged crops, are other factors contributing to the rising inflationary outlook. The potential for higher inflation is exacerbated by the tight labour market that may see higher wages, adding further pressure to input costs. The latest ANZ monthly job advertisement survey pointed out that job ads are at a 13 year high. The survey supports the RBA’s forecast that unemployment will fall below 4 percent this year and remain low into next year. The Federal budget papers go further and have forecasted unemployment to remain below 4 percent for the next 3 years. Australia hasn’t experienced this level of unemployment for 48 years! 

The RBA observed in its April 5 statement that periods of low unemployment correlate with an increase in real wages, implying wage increases at a rate above the inflation rate. This prospect has elevated the inflationary concerns shared by the RBA Board.  

The inflation outlook is further complicated by the $8.6 billion cost of living relief package announced in the Federal Budget, at a time when the economy is already performing strongly. The cash injection is aimed at low to middle-income workers, who tend to spend any money received. 

The Australian economy is strong

The RBA’s announcement referred to the strength of the Australian economy following an easing of forced lockdowns introduced at the onset of the Omicron variant. The Bank also stated that household and business balance sheets are strong, and the construction work backlog is supporting employment growth. 

The RBA acknowledged that while inflation is increasing in Australia, it is less than the level in other countries. According to the RBA, underlying inflation in Australia is 2.6 percent, while the headline rate is 3.5 percent. The RBA will publish its revised inflation forecasts in May and has recently stated it expects annual headline inflation to exceed 4 percent in the months ahead. 

The impact of higher interest rates is more readily absorbed by the economy during periods of strong employment and wages growth, than in times of a weakening economy. Moderately higher interest rates at this stage of the economic cycle, should enable economic growth to be sustained at a rate consistent with near full employment, without embedded consumer price inflation, that may generate a wages spiral. This implies that an interest rate rise in the near term should have a less adverse outcome for investment markets and households, than if left until inflation is entrenched within the economy.

A strong domestic economy has given the RBA grounds to respond to an expected acceleration in the rate of inflation in the period ahead. The response will be an increase in interest rates. The question is – when, and by how much?       

Investment Implications 

RBA interest rate policy is determined by underlying inflationary expectations and not the headline inflation rate. Interestingly, the 10-year bond rate is widely considered to be a useful pointer to the direction of future interest rates. This is because bond market participants on both sides of the trade must agree a bond price that reflects the direction and quantum of the interest rate (yield) payable over the duration of the bond. Accordingly, trends in long-dated bond yields represent the real-time collective wisdom of bond market participants, making changes in long-dated bond yields a useful marker that illustrates where interest rates may be headed.    

The Australian Government 10-year bond yield has been steadily rising in recent months. The 10-year bond yield rose to 2.95 percent today, well up from 1.67 percent on 1 January 2022. The message from the Australian bond market is clear -Australian interest rates are set to move higher, on the back of higher inflation. 

The forecast continuing low level of unemployment below 4 percent, strong economic growth forecasts, and emerging signs of inflation, all indicate the need for historically low interest rates no longer exists.

The evidence suggests that the RBA is likely to announce higher interest rates soon. This may occur in June after the RBA’s revised inflation forecasts are announced in May.  

A major implication of higher interest rates for investors is the impact on equity and property valuations. The all-time low interest rate environment has supported equity and property valuations for a lengthy period. 

In response to a changing interest rate environment, now is the time for investors to evaluate their portfolio in terms of withstanding the headwinds likely to accompany a gradually increasing cost of money over the coming 12-18 months.

This Post Market Wrap is presented by Kodari Securities, written by Michael Kodari, CEO at KOSEC.