Mututal Limited’s CIO Scott Rundell has provided the following overview of what the rate rise may mean for markets, cost of living and inflationary pressures.
Cash Rate Announcement
- At its July meeting the Board of the RBA elected to increase the official cash rate by +50 bps to 1.35%. The move was in-line with consensus estimates and represents the third-rate hike in the current cycle as the RBA normalises monetary policy setting. The cycle commenced with a +25 bp hike in April (to 0.35%) and another in July with a further +50 bps hike (to 0.85%). At the July meeting the board also increased the interest rate on Exchange Settlement balances by +50 bps to +125 bps.
- The RBA’s statement was hawkish, but no more so than the previous meeting. The board signalled they “intend to take further steps in the process of normalising monetary conditions in Australia over the months ahead.” The board acknowledged households were holding up well, but they also represent a source of uncertainty…“household budgets are under pressure from higher prices and higher interest rates.” Global uncertainties remain, specifically the war in Ukraine and its effect on energy prices and agricultural commodities.
What are the reasons for the RBA rate increase?
- The RBA has determined prevailing accommodative monetary policy conditions – which were put in place in 2020 to soften the blow of the COVID pandemic – were no longer necessary given the macroeconomic backdrop. Specifically, concern around inflation remaining uncomfortably outside the RBA’s target range if accommodative conditions were left in place. Resilient domestic demand, low unemployment, accumulated household savings, and wages pressure were also contributing factors.
- The RBA’s long-standing target for inflation (CPI YoY) remains 2.0% – 3.0% on a sustainable basis. Prior to the COVID pandemic, and post the financial crisis, Australian CPI has averaged 2.1% and ranged between 1.0% YoY and 3.5% YoY. The last CPI print was 5.1% YoY (March) with the RBA advising previously that CPI could peak at 7.0% YoY by the end of 2022. At this stage, inflation is forecast (consensus) to be back within the RBA’s target range “next year,” which may prove challenging.
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How high are rates expected to go this cycle?
- That depends on whether you accept market pricing as a given, or favour the views put forward by professional market pundits, i.e. interest rate strategist from within the banks. Current market pricing suggests the terminal rate for this cycle will be 3.55% with the cycle to peak around the middle of 2023. We think this level is too high. Note, market pricing peaked as high as 4.40% in mid-June. Strategist expectations on the other hand are less aggressive, ranging from 2.60% to 3.35%, with a median or average around 2.75%, by mid-2023. We favour 2.75% – 2.85% as the likely peak for the current cycle.
Which type of investors are likely to benefit from the rate rise?
- Emergency monetary policy settings put in place through the pandemic crushed interest rates, which in turn saw term deposit rates fall to near zero, an environment detrimental to retirees and savers. As interest rates rise, savers begin to benefit. We’ve witnessed this with term deposit rates rising over recent months.
- In the bond market, floating rate note investors benefit from a rising interest rate environment, whereas fixed rate investors face risk of capital losses. Floating rate note investors suffer less capital volatility and rising income profile vs fixed rate bonds.
- A simple example illustrates this. If we look at a couple of bonds issued by ANZ, both senior unsecured, both with the same rating, issued at par ($100.00), and the same maturity (January 2025). One fixed rate, one floating rate.
- The fixed rate bond (1.65% coupon) is currently pricing at $94.18, representing a yield to maturity of 4.07%. An investor who purchased this bond at issuance (in January 2020), has seen their capital price fall over 5.0%. Reflecting the bond’s exposure to rising interest rates, since issuance, these bonds have traded in a wide $92.28 – $105.00 range.
- The floating rate note is not exposed to the same interest rate risk with the coupon reset at a margin (BBSW 3M + 76 bps) every 90 days. Currently the note is pricing at $99.93. The prevailing coupon is 1.12%, last set in April, when the BBSW 3M rate was 0.36%. The coupon resets in just under two weeks, with BBSW likely to be around 1.90% – 2.00%. The next coupon will likely be around 2.66% – 2.76%. equal. The traded price range of these notes has been $97.09 – $102.20, much narrower than for the fixed rate bonds.
- Historically, floating rate notes provide greater capital stability than fixed rate notes, especially in a rising interest rate environment.
