Are we nearing the peak of the interest rate cycle?

We know that the Reserve Bank Board decided to increase the cash rate by 50bps to 2.35% at its September meeting.

But the RBA recently signaled that the ‘normalisation’ phase of their rate rises is over.

Note: RBA hikes 50bps again but drops reference to ‘normalisation’

Bill Evans, Chief Economist of Westpac recently made the following commentary in Westpac's Market Outlook report:

He said:

The most important change in the Governor’s decision statement is the description of the tightening cycle.

In previous Statements, he referred to the rate increases being "a further step in the normalisation of monetary conditions”.

In the latest decision statement, this ‘normalisation’ note has been removed.

Normalisation can be interpreted as the process of moving policy settings towards neutral.

In previous speeches, the Governor has estimated ‘neutral’ as being at least 2.5%.

In not referring to this move as a step towards ‘normalisation’ we can, arguably, conclude that consistent with the 2.5% estimate, the Governor believes the policy is now neutral.

It is Westpac's view that policy should quickly move to neutral and then move more slowly as it traverses through to the ‘contractionary zone’.

That slower pace would imply a step back to 25bp moves going forward.

Some support for the concept of being a little more cautious with rate moves is provided in the comment:

"The full effects of higher interest rates yet to be felt in mortgage payments.”

Note: Further tightening is required but a slower 25bp pace makes sense from here given uncertainty and ‘treacherous lags’ in a system that operates through multiple channels

The Governor gave further support to a slowdown in the pace of increases in a speech two days after the Board meeting where he noted:

"We are conscious that there are lags in the operation of monetary policy and that interest rates have increased very quickly… the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises.”

Note that the decision statement also notes:

"The Board expects to increase interest rates further over the months ahead”.

Maintaining a 50bp pace when there are lags involved, particularly with respect to the impact of a heavily indebted household sector, would seem to be unnecessarily risky.

The best approach, now that neutrality has been reached, is to maintain the emphasis on inflation being the central commitment while backing that up by continuing to tighten policy.

During the Q&A session following the Governor’s speech on September 8, I proposed that if a handbook existed for central bankers, it would recommend rapid moves to normalise rates be followed by a slower approach as the central bank considers the impact of moves given ‘treacherous lags’ in the system that can see the pressure build-up and release quickly when rates move so quickly.

Consideration of lags is particularly important for Australia given the high level of household debt on floating or short-term fixed rate terms – the rate rise effect on household cash flows can be much more potent than in the US for example, where mortgages are typically on fixed rates that run for 20–30 years.

And remember that even though only one-third of households have a mortgage, rising rates impact through a variety of other channels including:

  • cash flows for non-mortgage borrowers;
  • the indirect effects on rental payments for tenants as investors respond to higher funding costs;
  • negative wealth effects of falling house prices, which affect outright property owners as well as owners with a mortgage;
  • higher borrowing costs for business; and deeply pessimistic confidence.

Note: Downgraded near-term path for AUD as a clear signal on inflation and rate risks takes longer to emerge

We have lowered our profile for the Australian dollar against the USD.

We now cannot see that lift to USD0.73 over the course of the remainder of 2022.

Our end-year target has been lowered to USD 0.69.

We anticipate significant volatility over the remainder of 2022.

Markets will remain risk averse until they can see the prospect of a clear downward trend in inflation and the peak in interest rates for central banks.

That is unlikely to emerge over the course of the remainder of 2022.

In contrast, we continue to expect the AUD to be strongly supported against the USD in 2023 with a USD 0.75 target.

That is because we do expect a steady emergence of that confidence around inflation and rates in 2023.

Note: We still see a strong rally to USD0.75 in 2023 but volatility will persist until several big issues are clarified

As central banks go on hold; inflation eases and markets look to rate cuts in 2024, risk assets, including the AUD, will be better supported.

But, for now, the ‘safe-haven/risk off’ attraction of the USD appears set to be sustained for longer than we had expected, while some of the supportive factors for the AUD we had anticipated in 2022 appear to be much more uncertain.

For example:

  • markets are pricing in a wider interest rate differential between AUD and USD than we currently expect;
  • China’s progress in stabilising its property market has been slow with more setbacks to reopening from the latest COVID lockdowns;
  • and uncertainty around energy security in Europe is weighing heavily on the outlook for the Continent.

In 2023 we expect these issues to be clarified but the outlook for 2022, when markets will not be able to take comfort from central bank certainty, is going to be volatile and not supportive of any sustained upswing in the AUD/USD.

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Jason Gwerder
Thursday, 15 September 2022

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