Interest rate cut could occur

Interest rate cut could occur


The softening in underlying inflation now gives scope for the RBA to cut interest rates.

Justin Still

Justin Still

On April 24, inflation in Australia fell well short of the Reserve Bank of Australia's target range of 2-3 per cent underlying inflation. The softening in underlying inflation now gives scope for the RBA to cut interest rates which was hinted in the recent RBA board minutes (April 2) "that inflation did not move any higher and unemployment trended up, noting that a decrease in the cash rate would likely be appropriate in these circumstances".

During the first quarter of 2019 inflation was flat in quarterly terms, which meant that the annual headline inflation fell sharply from 1.8pc in quarter 4 to 1.3pc. This is the lowest rate since 2016, and below the RBA's expectation of inflation of 1.75pc.

The outlook is now similar to early-2016 when the bank cut rates on the back of weak inflation data despite steady improvements in the labour market. There is a risk that the RBA cuts rates and potentially earlier than the market expects.

What the market is pricing in

The Bloomberg Survey of Economists shows a 0.25pc cut likely in May or June. Interest rate futures are pointing to a greater than 50pc chance of a 0.25pc cut in June followed by another 0.25pc move in November. Our economist, Michael Knox, suggested a rate cut as soon as May 7. Several other notable economists have also called for a rate cut before the federal election.

What does this mean for the economy?

A lower level of interest rates could still be expected to support the economy through a depreciation of the exchange rate and by reducing required interest payments on borrowing, freeing up cash for other expenditure. With the fall in major bank funding costs the capacity for them to pass on at least one rate cut in full should help shore up the demand side of the economy. However tighter lending standards will limit the economic boost from rate cuts and tax policy and fiscal stimulus are likely to have more influence than the RBA cutting policy rates on the outlook for the Australian housing market and economy.

Will the major banks pass on a cut if it occurs?

The fall in funding costs and the out-of-cycle increases to lending rates in the back half of 2018 have eased pressure on margins for now and we see scope for banks to fully pass through one rate cut in its entirety. We think any subsequent cuts will be passed on in the vicinity of 50-60pc.

We believe it will not be wise for the RBA to wait for system home loan growth to get much softer as we are of the view that if system home loan growth drops to 3pc pa then there is a high probability of a recession on the east coast. We forecast home loan growth to pickup to about 5pc over the next two years assuming monetary policy support does come through with some fiscal support.

How does this affect sector positioning?

In terms of broader investment trends, a rate cut will prolong the chase for high yielding assets and growth as the low interest rate environment will tempt investors into the higher returning asset classes. We think assets such as banks, infrastructure and real estate investment trusts that offer high and sustainable dividend yields will find support.

Elevated asset valuations continue to be a hallmark of the post-global financial crisis period on the back of lower interest rates. Since the start of the year, the market has trended higher as central banks have shifted monetary policy to a neutral or accommodative bias. With the potential for the RBA to further cut rates, we expect the market to continue to trade at a premium particularly offshore growth opportunities and sustainable yielders.

  • Justin Still Investment Adviser (Authorised Representative: 000279726) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410

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