Why the RBA cut interest rates

Why the RBA decided to cut interest rates


Lower rates have tended to support the equity market in the past, but we think this time around the reaction is going to be far more muted.

Boh Burima

Boh Burima

Last quarter's inflation print fell well short of the RBA's target range of 2-3 per cent underlying inflation. And despite a healthy labour market, the unemployment rate (5.2pc in April) sits above where the RBA believes it has the potential to create inflation concerns. A 25bps cut to the official cash rate was seen as appropriate under these circumstances.

Lower rates have tended to support the equity market in the past, but following the afterglow of the election, we think this time around the reaction is going to be far more muted. Moreover, elevated valuations and the proliferation of downgrades caps the upside. We think global influences (the three Ts: Trade, Trump and Tariffs) rather than domestic factors will play a bigger role over the next two months on the direction of the market.

What are the markets saying on rates?

The Bloomberg Survey of Economists shows another 25bps cut in August. Futures are pointing to a greater than 50pc chance of a 25bps cut in August followed by another 25bps move by December.

What does this mean for the economy?

A lower level of interest rates can 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.

Availability to credit remains a key impediment for the transmission of the rate cuts, so 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.

How does this affect sector positioning?

In terms of broader investment trends, a rate cut will prolong the chase for yield 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 REITs that offer high and sustainable dividend yields will find further support.

Elevated asset valuations continue to be a hallmark of the Post-GFC 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.

What does this mean for the major banks?

The fall in funding costs, removal of the 7pc serviceability hurdle and the out-of-cycle increases to lending rates in the back half of 2018 have eased pressure on margins for now. We think any subsequent cuts will be passed on in the vicinity of 50-60pc.

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.

We think the impact of lower risk free rates will be the key driver for major bank valuations moving forward. With significantly dovish shifts in the monetary policy stances of the US Fed Reserve and the ECB, and with the RBA also adopting a more dovish tone, bond yields have generally declined across the developed world including Australia. Our view is that this will translate to Cost of Equity Capital (COEC) compression for the major banks over the next 12 months and we expect this to be one of the key drivers of share price upside over this period.

  • Boh Burima, Financial Adviser (Authorised Representative: 000341081) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410

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