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23 May 2024 - The Rate Debate - Navigating Australia's Economic Crossroads

By: JCB Jamieson Coote Bonds

The Rate Debate -

Navigating Australia's Economic Crossroads

JCB Jamieson Coote Bonds

May 2024

Without the significant influx of people migrating to Australia over the last 18 months, the country has been in recession since the first quarter of 2023. In fact, when adjusted for population growth, this marks the longest running recession Australia has experienced since the early 1990s.

There's mounting evidence that the Australian economy is losing momentum. Not only in economic indicators such as declining retail sales, dwindling consumer confidence, collapsing savings rates, and unemployment ticking higher, amongst other signs. Many readers will likely agree that the hardships facing many people in the community are becoming increasingly evident through personal stories and experiences.

The Reserve Bank of Australia (RBA) has acknowledged this trend, stating that "household consumption growth has been particularly weak as high inflation and the earlier rises in interest rates have affected real disposable income. In response, households have been curbing discretionary spending." This raises the question: what would be the cost to the Australian economy if interest rates were to go up from here?

There's no doubt that inflation remains high and has exceeded the RBA's target range. However, it's also true that inflation is easing in response to one of the fastest monetary policy tightenings in history. Given these factors, the RBA must carefully consider the potential economic fallout before deciding on additional rate increases.

It's both sobering and indeed encouraging to see just how far we have come in the fight against inflation in a relatively short period of time. After reaching a peak of 7.8% in the December quarter of 2022, we've observed a consistent downward trend in the quarterly year-on-year Consumer Price Index (CPI) numbers: 7.0%, 6.0%, 5.4%, 4.1% and most recently, 3.6% in the January quarter. It's easy to forget, but the inflation figure for the final quarter of 2023 surprised on the downside, with a quarter-on-quarter increase of just 0.6% versus the expected 0.8%.

It's as if some inflations hawks are pushing for a deep recession just to bring inflation down rapidly. They seem to think that rescuing an economy from a potential deep recession is easy and that slashing interest rates will solve all the problems. However, economic momentum is everything, and a steady return to target inflation, rather than forcing a deep and painful recession, is a much smarter approach to pursue price goals. Thankfully, Michelle Bullock acknowledged as much in her recent press conference.

Amazingly, global markets currently predict that only two central banks - the Bank of Japan and the RBA - are expected to hike interest rates over the next two years. Meanwhile, other central banks in the developed world are projected to cut interest rates from here, with some like the European Central Bank, Bank of Canada and the Bank of England, planning fairly aggressive cuts over the coming 12 months. Even the US Federal Reserve (US Fed) is likely to cut rates by the end of the year.

In my over 20 years in the bond and money markets, I've never seen such a wide dispersion of views and opinions on interest rates as we currently have in Australia. We are at a pivotal moment in monetary policy.

Inflation hawks point out that the RBA cash rate is significantly lower than the US Fed's (4.35% versus 5.375%), but there's a clear reason for this discrepancy. Since the first round of rate hikes, Australian mortgage rates have increased by over 3%, compared to just 0.5% in the United States. This difference illustrates how much more potent the transmission of interest rate hikes is in Australia compared to other jurisdictions.

The dominance of 30 year fixed rate mortgages in the US, contrasted with the predominantly floating rate mortgages in Australia, means it's much harder for monetary policy to slow the economy down in the US than it is in Australia - that is, monetary policy has a more immediate impact on the Australian economy. It's evident that the 425 basis points of rate hikes since 2022 are working, and the lags of monetary policy are hitting the economy just enough to slow it down. Given this, raising rates to 5.0% would be seriously detrimental to the Australian economy. It's essential to consider this context when debating the appropriate level for interest rates in the current environment.

Whilst first quarter inflation numbers came in above market expectations due to factors that rate hikes can't easily control, the wild predictions of several more rate hikes from here are unfounded. I believe the RBA's next move will be a rate cut later this year as the economy continues to slow down and react to the squeeze of higher rates. The RBA has indicated that the current level of interest rates is sufficient to bring inflation back within target by the end of next year.

Meanwhile, in the US, the mortgage market is unlikely to be a source of any turbulence from higher rates. The real risks lie in the corporate credit markets, where tenors of borrowings are much shorter and significant expiries are set to occur from 2025 and onwards. Consider this: $2.5 trillion dollars of corporate bonds expire in 2025, and another $2.8 trillion in 2026, all rolling off very low interest rates. With the US Fed likely projected to cut rates only one or two times this year from six that were priced in at the end of 2023, many chief financial officers will be anxious about whether investors will lend to lower-rated corporates when a 10-year US Treasury bond offers 4.50%. Different countries face different challenges, and it's crucial to understand these nuances when considering monetary policy and its broader effects.

Given these complexities, Australians face a unique economic landscape. The current context requires careful consideration of monetary policy's role in stabilising the economy without triggering a deeper downturn. Understanding these dynamics is key to navigating the uncertainty ahead.

Funds operated by this manager:

CC Jamieson Coote Bonds Active Bond Fund (Class A)CC Jamieson Coote Bonds Dynamic Alpha FundCC Jamieson Coote Bonds Global Bond Fund (Class A - Hedged)

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