What impact will a rate cut have on the Australian economy?

RBA rate cut?

A big week ahead with the market fully priced for a rate cut. If the rate cut does not occur it will because:

The RBA is actually an independent central bank and so does not care if the Albanese government is re-elected.
The RBA uses its trimmed mean measure of inflation when measuring inflation and this is still above 3%.
Employment remains strong with the unemployment rate still at 4% when the participation rate is near an all-time high at 67%.
There have been many spending announcements made by the Albanese government over the past few weeks and none of them have been costed or scrutinised ahead of the March Budget (that won’t be handed down if an election is called before March 25).
The RBA has said on numerous occasions that it will look through the impact on the CPI of the political electricity subsidies at state and federal levels when it judges the inflation outcome.
A rate cut will push the AUD lower and this is inflationary.
A strong argument could be made that the Australian economy is already in fiscal dominance – an economic condition that occurs when a country’s debt and deficit levels are sufficiently high that monetary policy can no longer effectively control inflation. Governor Bullock has on several occasions over the past year has tried to explain how Aggregate Demand > Aggregate Supply due to government spending is inflationary.

There were a few good articles then in the AFR that are worth reading. It is unfortunate that the AFR continuously seek out the opinions from banks and long duration debt fund managers when writing these stories as they are inherently biased. Only an absolute return debt fund manager is unconflicted when talking about the interest rate curve because only an absolute return fund manager can adjust duration:

The media and biased bank economists are not asking the right question.

The question should be, ‘what impact will a rate cut have on the economy’? It won’t increase employment because labour supply is already limited given the fact that the economy is operating well beyond full employment (unemployment below 4.75%, RBA measure). It will only increase government spending as it will improve the ability of state governments to go further into debt. It will only enable households to increase spending on credit cards and possibly bid up the price of residential real estate even further. It can only result in an increase – not a decrease with all other things held constant – of inflation. An independent RBA will not be cutting rates until:

There is an exogenous economic shock (like the pandemic).
The financial system becomes unstable (like a bank collapse, e.g. SVB in the US in 2023).
Unemployment rises above 4.75% while inflation is still above 2.5%.
Inflation is below 2.5% for successive quarterly readings (RBA trimmed mean measure). It needs to be understood that inflation is a rolling stone that actually gathers moss. We are only just beginning to see the impact of private sector wages growth being above 4% over the last 12 months on household confidence (spending) and we are yet to see the catch-up public-sector wage increases that are currently being negotiated impact on final prices. Even the current average wages growth of 3.5% is inconsistent with an inflation outcome of 2.5% given Australia has negligible labour productivity growth.

Right here, right now, we are far more concerned that the next period of financial instability will be triggered by a sharp and significant move in government bond yields. There are at least 2 flags here:

US Treasury Secretary, Scott Bessant, has inherited an unbalanced Treasury debt profile. In late October 2023, when the US 10-year yield was threatening to break above 5% and the German-Italian 10-year spread breach the 2% ECB cap, Yellen, the Federal Reserve and the ECB took extraordinary actions to manipulate the 10-year (and in the US 5-year) bond yields. The Federal Reserve and the ECB made deeply dovish statements that convinced the financial markets that the US would see 7 rate cuts in 2024 (proportionally the same in the EU) and Yellen switched from the normal pattern of financing the US debt requirement with bonds and 15-20% short-term treasury bills to something like 20% bonds and 80% treasury bills. This reduced the expected supply of bonds, and the 10-year yield fell to 3.8% in early 2024. When Bessant moves back to the normal pattern of bond issuance yields will rise to reflect the increased supply. Remember that the long end of the Australian benchmark curve yields is set relative to the US curve.
When the ALP government was first elected in 2022 the Australian 10-year yield moved to a 75bp premium to the US 10-year. Normally we have seen the Australian 10-year trade in a range of +20bp to -20bps against the US 10-year. If the ALP can form a majority after the next election (now expected on the 29^th of March) then there will be no change to the difference between Australian and US bond yields, however, if the ALP form a coalition with the Teal-Greens parties in order to have a majority, then this increased instability and irresponsible spending, on ideologically driven outcomes, is likely to see the spread between Australian and US 10 year bond yields blow out to something wider than 75bps.

US inflation data

Last week both the CPI and PPI data releases were stronger than expected. This does not come as much of a surprise for non-bank economists that are not blinded by their employer related bias to rate cuts. The stronger than expected price outcomes are a reflection of the pump priming at a fiscal and monetary level in the December quarter made with the hope that they would support the Democrats holding onto the Presidency. Inflation readings may well pull back in the very short term until the full impact of the actual Trump tariffs can be assessed.

The real point we are trying to make here is that US (and Australian) inflation may well keep rising as the economy moves from the transitory nature of the pandemic supply shock, to cost push inflation. This is the pattern we have seen in the 1980’s when after the Oil shock abated inflation in the US began to rise again. The flowing chart shows the pattern – in blue – of inflation form the oil shock in 1972 through to 1983. This is then compared to the current path of inflation since January 2020.The rolling stone of inflation is very difficult to stop once it has gained momentum.

Interest Rates

US bond rallied (yields fell) last week despite the worse than expected CPI and PPI data releases. The bond market remains highly volatile but the focus, remarkably, is not on the inflationary implications of the Trump tariffs but the longer-term growth implications. Yields fell on Friday night after a sharp drop in the US retail sales number in January.

The Australian 10-year yield fell slightly last week closing at 4.40%. The 2-year yield rose a little, perhaps, with some participants (and the AFR) looking for the RBA to remain on hold now. There has been too much emphasis placed on the market pricing of near dated swaps implying a rate cut probability of 90%, because this market is dominated by the major banks that are all hopeful of a rate cut even if it is for political reasons.

Our view remains that an independent RBA would not have a rate cut under consideration when the RBA trimmed mean is still above 3% and the unemployment rate is below 4.75% (RBA measure of full employment).

Major Credit Markets

US investment grade (IG) markets were strong with spreads moving towards lows. The US IG iTraxx is at 46 pts, basically a low since the GFC. This level has been reached four times since the GFC, although for two of those periods (late 2021 and in the past 12 months) this level has persisted for some time. Low periods however do end.

The 90-day BBSW rate has now fallen to 4.19% in anticipation of a rate cut from the RBA this week. The lower benchmark rate does not appear to be impacting demand for floating rate credit yet, but we expect that participants will step back and allow credit spreads to widen if the BBSW rate does not push back to the 4.4% area in the weeks ahead. It was a surprise to see Rabo Bank back with a 2.5 and 5-year senior offer again so quickly. Both priced very tight at 65bp and 85bps respectively. This A+ issuer would normally price 10bps wider than an Aust major bank, but ANZ a few weeks ago sold a 5 year at 82bps. Aust Major bank 5-year senior is currently trading at 77bps and 3-year at 64bps.

High Yield Markets

US high yield markets are steady however this is at margin lows. Junk-rated borrowers continue to churn out primary deals, offering investors a menu of eclectic trades in what remains a hot market for issuers (Reuters).

The hybrid market is showing signs of lift with volumes up and margins slowly contracting. This was in contrast to the previous week where selling was across the curve, possibly as naïve investors raised funds to buy two recently invented ‘credit like products’. Last week buying was concentrated in the longer end of the maturity curve, with CBAPM (June 2030) topping the volume with over $8m traded. Funding appeared to come from the short end with AN3PH and WBCPH volumes almost matching that of CBAPM.

Listed Hybrid Markets

Hybrid margin curve
Most major bank hybrids pay dividends in March. ANZ, CBA and NAB tend to be quoted ex-dividend in the first week of the month, with Westpac the 2^nd-3^rd week. For the upcoming March dividends that means the last two weeks of February are when dividend hunters seek. One way to spot best value for cash flow is to compare the running yield (or RY, which is simply the dividend yield, like a share dividend yield) to the total yield, which unlike the Running yield, takes into account any difference from the purchase price to the $100 maturity value. For example, if we buy a 12-month hybrid at $102.00 and it pays a $6 dividend for the next year, then the Running yield is 5.88% ($6/$102). However, we must take into account that we are losing $2 capital when repaid ($102-$100). Hence our total return is only $4.00. On a yield basis, the total yield is then 3.92% (-104+6+100)/102. So, buying higher RY stocks may be false economy, as we may be receiving a lower maturity value. Nevertheless, getting more return in the short term may suit an investor’s needs. The chart shows the best RY per total yield for major bank hybrids. Right now, as in the chart MBLPC, MQGPD, NABPF and WBCPJ are the standouts. These hybrids maybe trading at a significant premium to face value. Investors should consult their tax advisor as preference shares (hybrids) are traded on capital account not income account line bonds, hence the loss from the premium above face to the $100 redemption value maybe a tax loss.

Forward Interest Indicators

Australian rates
Swap-rates fall in line with bond rates.
Swap rates:

10-year swap 4.37%
7-year swap 4.20%
5-year swap 4.05%
1-month BBSW 4.22%

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