Did we just see the peak of the rate cycle?

Posted by Gavin Chau

It was a relief to see a sensible response from the RBA this afternoon, with the interest rates remaining on hold at 4.1%. If you were to annualise the CPI from January to May, it’s now below 2.8%, and we still have 12 past rate hikes that haven’t fully flowed into the economy.

The rate of inflation has fallen sharply, moving from 6.8% to 5.6% in the 12 months to May 2023 from a peak of 8.4% in December 2022. This is mostly due to something called the base effect, with the current prices being divided by the higher prices of the previous 12 months. While an unpopular opinion, we maintain the view that inflation will come down faster than most people think. One thing to note about these extreme spikes in inflation historically is that virtually all of them tend to have a reflexive effect. That is to say that when they go up by the elevator, they also tend to come down by the elevator. By the time the June CPI figures are released this month, we are likely to see inflation continue to move down sharply, provided there are no unexpected shocks.

While it is unclear what the RBA is thinking anymore, what we do know is that pressure for further interest rate increases is fading fast especially considering that the full effect of the interest rate rises is not factored into the data.

Many industry pundits like to compare the interest rate levels for a given level of inflation in Australia to other parts of the world, noting that our interest rate is not high enough given the level of inflation. However, they seem to ignore the fact that Australia is amongst the most sensitive economies to interest rate changes in the world.

This is due to our outsized levels of household debt to disposable income levels combined with the bulk of our mortgages being on variable rates. If you compare it to the US, where 90% of mortgages are on 30-year fixed rates with a substantially lower overall household debt level, the burden of higher interest rates tends to fall on regional banks, commercial real estate, small businesses that rely on bank loans and unprofitable tech companies rather than households.

The risk of recession remains significant, and you must wonder whether the RBA is taking a leaf out of the US Federal Reserve’s playbook. While the official mandate is to promote maximum employment and stable prices, literally every single rate hiking cycle in the US has ended with something in the economy breaking. If you were to look at their actions rather than listen to their words, you could be mistaken for thinking this is a deliberate tactic. Some kind of economic failure is one way to ensure that they can resume rate cuts in an environment where inflation doesn’t (initially) flow into general goods and services as measured by the CPI. Instead, the first place inflation would appear is in asset prices – something that nobody setting the policies seems to mind. But whether it’s some kind of diabolical plan or simply incompetence doesn’t really change anything. The first rate cut has always signaled the start of a bull run in the property market.

Posted by Gavin Chau, on 4th Jul 2023