It's time to start talking about rate cuts

It’s time to start contemplating the next phase of the cycle as we approach the end of the monetary assault on inflation. The RBA Governor Phil Lowe yesterday, in a key speech, pointed out that the bank is close to a pause.

*RBA closer to point where appropriate to pause rate rises - Lowe, 8th March 2023.

This is a significant development as it reinforces the belief we have had that we are in the final stage of the hiking cycle. It also reinforces the key point that Australia faces different dynamics to other economies, notably the United States. We have highlighted many of these differences one of the most significant of which is the labour market. Even as participation rates in the United States remain stubbornly below pre-pandemic levels, by contrast, in Australia, supply of workers to the labour forces is growing extremely strongly. Consequently, wages growth remains moderate and consistent with the RBA’s targets.

It’s worth recapping why the RBA has moved so aggressively and how this policy has worked in practice.

The bulk of the heavy lifting has been left to central banks despite a significant source of the inflation relating to excess government spending during the pandemic which saw money showered into bank accounts almost indiscriminately. Most governments around the world deployed their own version of job-keeper and income support programs. The Federal government spent around $311 billion in stimulus during the pandemic on various support programs.

The above chart doesn’t take into account the spending of the states. In the chart below, current and forecast debt levels of the states shows how Victoria, NSW and SA borrowed heavily in the pandemic period. Victoria (red) is confronting the most strained public finances of any state (~232% total borrowing/operating receipts by 2025/26).

The RBA’s record hiking campaign has extracted significant amounts of money from the economy quickly. To visualise how the RBA is extracting money from the economy, consider the following chart from the national accounts data on household interest payments. This data doesn’t yet fully reflect the impact of rate hikes already delivered and the impact of fixed rate mortgages resetting in coming months both of which will see this surge further.

In short, it has been left almost solely to the RBA to mop up the money through the blunt indiscriminate sledgehammer of monetary policy.

We should be in no doubt that monetary policy works. Perhaps better than anyone is willing to acknowledge. In the last 2 weeks alone, we have seen a string of data that has disappointed to the downside, challenging the RBA’s February hawkish tilt and leading the bank to change its tune significantly this week. Consider the following:

The RBA forecasts unemployment at 3.6% by June 2023 and 3.8% by December 2023. We are already at 3.7%. The RBA forecast the benchmark wages price index to be 3.5% at December 2022. It is 3.3%. These are significant because the fear of a so-called wages-prices spiral is the reason behind the hawkish tilt the RBA made in February. Thus far, this fear is looking overblown, and the RBA acknowledged that this risk had abated this week. It remains our view that the RBA, having barged heavily into restrictive territory quickly, is hiking into a material slowdown, the evidence for which is growing almost by the week.

As out of mind as they have been, it’s time to consider the cutting cycle.

The average period of time between the RBA’s last hike and the first cut going back to 1990 is 10 months. The average in the last 3 cycles, over nearly 25 years, is just 7 months. This is not particularly out of sync with global trends. In the US, the average period of time between last hike and first cut is 8.5 months. At this week’s meeting, however, the RBA clearly acknowledged their hikes are starting to work and that the end could be closer. February’s hawkish tilt was materially softened. If they move again in April and then pause, a move lower in rates is highly plausible in late 23 or early 2024 (coincidentally 7-10 months later).

If the RBA is close to the end of its hiking phase, which we believe the incoming data is telling us, the only question is how long before policy needs to be eased to deal with a coming consumer slowdown as inflationary pressures ease. History tells us early 2024 is a reasonable probability and its perhaps no surprise that some of the larger forecasting banks are pencilling in cuts from late 2023 into early 2024.

How will markets typically react as this phase approaches? As always the short end of bond curves will rally the hardest as they adjust to the likely path of policy. In the last 2 easing cycles, on average, 3 year bonds rally 100bps more than their 10 year counterparts. The chart below highlights that bonds always rally before the cuts are actually delivered and also that the 3yr (green) outperforms the 10 year.

This is the part of the curve where have been incrementally adding to duration exposure lately.

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