The Reserve Bank of Australia (RBA) faces a dilemma at its next meeting. Go up 25bp or 50bp? We think the odds are stacking up firmly for 50 basis points. Even in the event of a hawkish surprise, expect very limited profits for the AUD in the near term.
What is the real question here?
Most central bank meetings come down to a fairly binary choice: to increase or not to increase; to cut or not to cut. For the July RBA meeting, the choice is to raise 25bps or 50bps. Why? Well, RBA Governor Philip Lowe told us just over a week ago. On July 21, in the Q&A after a speech to the American Chambers of Commerce in Australia (AMCHAM), Governor Lowe said: “We will be looking at the data we have each month and the level of interest rates and l inflation. But I think next month we’ll have the same discussion at our board meeting: 25 or 50.”
Inflation and inflation expectations
Source: ING, Melbourne Institute
Not enough to continue
The RBA told us that its decisions would depend on the data, but very little data has been released since the RBA’s last meeting on June 7. We’ve had a couple of slightly soft business and consumer sentiment surveys, a decent jobs report (no wage data though), and especially no inflation data, because that’s not good course published only quarterly.
What we do have, however, is inflation expectations data from the Melbourne Institute. Central banks are very agitated by the evidence that inflation expectations are no longer anchored. Thus, the impression of 6.7% in the latest version of this institution should have banished any idea of a lesser increase or even no increase at all.
The other factor to consider is that with the latest inflation rate at 5.2%, and likely higher when we get the Q2 figure on July 27, at 0.85%, the rate target for RBA cash is a long way off where it needs to be to even suppress the stimulus in the economy, let alone start to actually start restraining growth and lowering inflation. It must therefore be at least 50 basis points.
Why not 75bp?
There is an argument for a bigger hike, but it seems the decision has already been made not to consider a hike of 75 basis points or more, despite the considerable ground the RBA needs to make up.
One of the factors putting pressure on the RBA to rise even more aggressively at this meeting is that it meets to discuss monetary policy every month, not every six to eight weeks like the US Federal Reserve.
That means it can cover a similar amount of ground over a quarter with smaller incremental rate increases than the Fed. Also, it gives the central bank a bit more flexibility next month when it has new hard inflation data to consider. There may well be arguments for a bigger hike at the August meeting, or in September after the August 17 wage-price data. So keeping some crunch flexibility in reserve at this next meeting leaves more dry powder to potentially meet later this quarter.
Medium-term outlook for rates
With the cash rate target now at 0.85%, and likely to hit 1.35% at this next meeting, where do we think rates will end the year? We assume that the inflation data for Q2 is rising, but does not necessarily require a 75 basis point larger upside response. This would bring rates to 1.85%. Wage price data will most likely also provide an excuse for another 50 basis point hike in September, taking rates to 2.35% by the end of 3Q22. At this point, rates are likely to be roughly neutral to inflation and the economy, so the RBA should be able to slow the pace of further hikes. We expect an additional 75 basis points by the end of the year, bringing rates to 3.1%. By contrast, our insider view on the US pegs the upper bound on the federal funds rate at 3.75% by year end.
It’s not clear that this will mark the end of the RBA’s tightening, but we think the US could well be nearing the end of its tightening cycle by then. And with the RBA traditionally hating to sound more hawkish than the Fed, this could indeed be the high, or near high, for this rate cycle. For now, we have rates peaking at 3.6% in 1Q23 and falling by the end of the year, although the forecast for 2023 is subject to considerable uncertainty and does not represent a high conviction view. .
Cash Rate and Fed Funds Forecast (Upper Bound)
FX: Major headwinds for AUD to persist
The Australian dollar fell around 9% in the second quarter, in line with widespread losses in most pro-cyclical currencies. At the end of this week, we saw an intensification of the pressure on the AUD, which largely comes down to the defensive return of the markets in the exchange markets after some end-of-quarter rebalancing flows went against, as well as the unfavorable environment for raw materials. Australia’s main export, iron ore, is facing heightened vulnerability amid resurgent fears the Chinese government will impose restrictions on steel, at a time when stock data is already beginning to suggest somewhat lower demand.
All of this means the Aussie is approaching July’s RBA meeting with mostly headwinds, and a significantly weakened link between domestic monetary policy momentum and AUD/USD suggests a rebound to the lows. 0.7000 is unlikely to materialize soon, even in a hawkish crisis. surprised by the RBA (the markets do not fully anticipate a 50 basis point hike).
The extent of the RBA’s tightening is likely to only have currency implications beyond the near term, and in an environment where markets feel more comfortable with their pricing of a global slowdown and see the peak in rates, which could fuel a stabilization of global risk sentiment and a reconnection between the dynamics of short-term rates and the exchange rate. From this perspective, a more aggressive RBA tightening may suggest a wider margin for AUD/USD recovery towards the end of this year and early next year (assuming it is at market sentiment is beginning to recover), but a number of other factors – particularly related to Chinese demand and the outlook for the US dollar – will also continue to play an important role. All of this makes any consideration of the AUD’s outlook purely based on rate dynamics still reductive.
Our base case for now is a gradual return to levels above 0.7000 in AUD/USD for the rest of the year, with most of the gains likely concentrated in Q4 when the USD may start to drop some earnings.
Read the original analysis: Reserve Bank of Australia’s Big Decision: Raise 25 bps or 50 bps?