Market Musings: The RBA has more work to do
Since kicking its tightening cycle off in May 2022, the RBA has raised the cash rate by a cumulative 375bps. This has been the most abrupt rate hiking cycle since at least the 1980s, but there looks to be more work to do. Recent information is likely to force the RBA’s hand, and we expect another 50bps worth of rate hikes over coming months. This would take the cash rate from 3.85% to 4.35%, a high since late-2011, however higher household indebtedness means this level of rates should pack a far bigger punch than it used to. The upcoming 6 June RBA meeting is ‘live’ for another change, and we feel that the balance of risks are tilted to the RBA having to do even more on the policy front in order to slay the inflation dragon.
Domestic inflation pressures remain high, and importantly, the baton is being passed from ‘goods’ to sticky ‘services’ prices. The experience offshore shows that services inflation is a hard nut to crack, and in Australia the upswing appears to be gather momentum. The demand/supply imbalance is pushing rents up, and on the back of the tightening in the labour market, wages (a driver of services inflation) are also rising. Indeed, we believe the larger than anticipated 5.75% lift in the minimum award wage, which covers ~1/4 of the workforce, is an added positive impulse for inflation, particularly due to Australia’s lacklustre productivity growth. Importantly, stronger wage growth can push out the time it takes core inflation to return to the RBA’s 2-3% target band. And although the RBA is trying to keep things “on an even keel” and navigate the narrow path to a “soft landing”, we doubt policymakers are open to tolerating a further delay given the risks this creates for inflation expectations and a possible wage-price spiral. The RBA is already only forecasting inflation to be back at the top of the target band in mid-2025.
For the Australian economy, we judge that additional policy tightening from here could be quite impactful with rates moving further into ‘restrictive’ territory. It is a hard pill to swallow, but to break the back of services driven inflation an extended period of sluggish growth and higher unemployment is the price that needs to be paid. As the chart above shows, based on how high household debt now is in Australia, on our figuring, a further 50bp lift in interest rates would push repayments (principal and interest) across the household sector to a historically high share of income. Given many households don’t have a mortgage, the indebted ones will feel it disproportionately. And from our perspective this is where the rubber could hit the road for broader activity and the labour market as these typically younger households are also the ‘workhorses’ that tend to drive household spending, the largest part of the Australian economy (~52% of GDP). Our analysis of some more detailed national accounts data also finds that this group of households holds a larger share of debt, but don't hold much of the ‘excess savings’ that have been accumulated over the past few years. As illustrated, we estimate that the bulk of the 'excess savings' is being held by older/wealthier households, and this cohort isn't normally a strong source of 'discretionary' consumption.
We have long thought that Australia's economic growth would slow materially over the next few quarters as the substantial cashflow hit on the heavily indebted household sector intensifies. There is still a decent amount of policy tightening that has yet to flow through to households and businesses due to the normal policy ‘lags’ and because of the fixed rate refinancing that has yet to take place. Additional rate hikes on top of this could make the evolving slowdown even deeper and/or longer, in our opinion. In time, we expect this step down in growth and added economic uncertainty to spillover into business investment, and the labour market, with unemployment projected to rise over the next year.
For the AUD, we think that further rate rises by the RBA can provide some support as it should help, even if temporarily, close the yield gap that has been opening recently against many of its peers. However, FX is a relative price, and global forces have proven to be far more influential on the AUD’s performance. And on this score, we believe that some AUD headwinds remain in place, and we don’t expect the AUD to snap back overly sharply for a while yet. We continue to forecast a sustained AUD revival to come through later this year and early 2024 with the AUD projected to move back into the low 0.70s over that time. Over the near-term, the unfolding slowdown in global growth, particularly across the commodity intensive industrial side, coupled with China’s faltering post-COVID recovery, and further rate hikes and/or ‘hawkish’ rhetoric by other central banks such as the Bank of England, ECB, and the US Fed, could counteract further RBA action, in our opinion. We think the AUD’s 200-day moving average (~$0.6695) could provide some stiff resistance over the period ahead.
That said, we also remain of the view that barring an exogenous shock, the AUD is unlikely to move much below recent lows. As we have pointed out before, since 2015, the AUD has only traded at ~$0.65 of lower ~3% of the time, with Australia’s positive capital flow dynamics a strong support that hasn’t been there historically. Australia's current account surplus is now ~1.2% of GDP, this compares to a long run average ~3% of GDP deficit.
Currency Strategist - APAC