RBA Review: Cuts Underpriced

Summary

• The Reserve Bank of Australia (RBA) paused, against our and 11 of 30 analysts’ expectations. Forward guidance has introduced uncertainty.
• While this may well be the peak in rates, inflation seasonality, current financial conditions, and our unemployment index leave room to tighten further.
• We turn our attention to cuts. Household balance sheets suggest caution, with a significant number of mortgages set to roll from fixed to floating. Those doing so have riskier balance sheets, too.
• We think the RBA is at risk of cutting more than currently priced.

Market Implications

• RBA cuts are underpriced.
• Value in paying AUD OIS 3M vs 1Y.

The RBA Peak?

Against our and 11 of the 30 analysts’ expectations, the RBA left the cash rate at 3.6% to assess the impact of 3.5 percentage points of hikes delivered so far.

Yet to Signal the All-Clear

Inflation Seasonality Could Encourage Another Hike

Headline inflation is moderating, but the central bank remains concerned about services inflation, of which rent and utilities price inflation are important. As a result, we think it is too early to celebrate; services are typically strong through March and April (Table 1). Meanwhile, (smoothed and adjusted) rent indices give little indication of a slowdown in rent inflation (Chart 1).

Questionable Horizon on ‘Tighter Financial Conditions’

The RBA expect recent banking system problems in the US and Switzerland to lead to tighter financial conditions, which could be another headwind for the global economy and therefore Australia. However, this feels purposely vague. They fail to specify what this means for RBA monetary policy – they seem unsure.

As it stands, and concentrating on Australia, financial conditions are short of GFC highs while hikes have historically continued with equally as tight financial conditions (Chart 2). This is on the back of a ‘strong, well capitalised and highly liquid’ Australian banking system.

Labour Market Remains Very Tight

The RBA have acknowledged that the labour market remains very tight. They find many firms still struggle to hire workers, although some report easing labour shortages, and the number of vacancies has declined a little. Our indicator for Australian unemployment is yet to suggest a forthcoming uptick (Chart 3).

Cuts Are Underpriced

Household Balance Sheets Point to Cuts

On the economy, the RBA said ‘there is further evidence that the combination of higher interest rates, cost-of-living pressures and a decline in housing prices is leading to a substantial slowing in household spending. While some households have substantial savings buffers, others are experiencing a painful squeeze on their finances.’

We take a different angle. House prices were always going to fall (and likely will continue to do so). They are one of the most interest-rate-sensitive sectors of the economy, with less of the population desiring a new mortgage (Chart 4). However, the passthrough of RBA hikes to households is far more interesting. To understand why, we first address the spike of Chart 3 – when nearly half of new mortgages were taken on a fixed rate (usually on a three-year fix; Chart 5).

A vast majority of mortgages are set to roll from fixed to floating over the next two years, with roughly 90% of these seeing their scheduled payments increase by 30% or more (Chart 6)! A recent piece by the RBA found these borrowers are ‘more risky’. Unsurprisingly, then, those on fixed-rate mortgages are more likely to have higher loan servicing ratios than those on variable rates (Chart 7).

The impact of the rollover may not be instant. Fixed-rate mortgagees will only see their mortgage rate 25bp shy of the cash rate by the end of 2023 before closing the gap to 0bps by the end of 2024. And as they rollover, buffers (fixed-rate mortgage holders are more likely to hold savings outside of prepayment buffers due to restrictions) will be eaten into (Charts 8 and 9). Therefore, we see a sharper slowdown in demand occurring later in the year.

What We Expect Going Forward

The RBA has revised its forward guidance, signalling greater uncertainty in the process. It now says, ‘The Board expects that some further tightening of monetary policy may well be needed’ (changed from ‘The Board expects that further tightening of monetary policy will be needed to ensure that inflation returns to target and that this period of high inflation is only temporary’).

Additionally, they will be watching developments in the global economy, trends in household spending, and the outlook for inflation and the labour market. We believe there remains a risk of one more hike while we think cuts will come in Q4 2023.

As it stands, markets are pricing 47bps of cuts within 17 months (Chart 10). This is initially more aggressive than cuts that followed the final 1994 hike (though a rapid group of cuts ensued), in line with 2010 (this was a relatively mild hiking cycle), but way off 2000 and 2008 cutting cycles. This increases our conviction that markets are underpricing RBA cuts.

One way to trade this is by paying AUD 3M versus AUD 1Y. The spread sits at 11.5bps and traded at least 70bps higher in the 2008 and 2010 cutting cycles (Chart 11).

Ben Ford is a Researcher at Macro Hive. Benjamin studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)