ASX surges on smaller RBA rate hike

Shares surged while the Australian dollar and bond yields dived as a smaller-than-expected RBA rate hike sparks a major downshift in interest rate expectations.

Australian shares had their best day in over two years as a smaller-than-expected interest rate hike from the Reserve Bank sparked a major reassessment of the domestic interest rate outlook.

Offshore markets also rebounded as bond yields fell after the UK scrapped part of a controversial tax cut plan and US manufacturing data showed aggressive rate hikes are working.

After approaching two-year lows at the start of the week, the local bourse added $81bn in market capitalisation as the S&P/ASX 200 index surged 242.44 points or 3.8 per cent to end at a seven-day high of 6699.3 points. All sectors finished higher, and all but one of its members closed in the green.

It was the biggest one-day rise since a 3.89 per cent jump on June 16th 2020, in the early stages of the post-pandemic bull market that followed unprecedented fiscal and monetary policy stimulus.

With the US share market leaping 2.6 per cent on Monday, as the 10-year Treasury bond yield dropped 19 basis points to 3.64 per cent, the local market had already risen as much as 2.7 per cent before the RBA released its interest rate decision on Tuesday afternoon.

Despite some suggestion that RBA might opt for a smaller rate hike in light of the recent instability in global financial markets sparked by the fiscal stimulus plan of the new UK government, the central bank’s decision to reduce the size of its latest hike came as a major surprise to markets.

The Australian dollar fell as much as 0.9 per cent to US64.51c after the RBA said it had decided to increase the cash rate by just 25bp to 2.6 per cent after its most aggressive ever hiking cycle from a record low of 0.1 per cent – including four hikes of 50bp.

Australian shares had their best day in more than two years as a smaller-than-expected interest rate hike from the Reserve Bank sparked a major reassessment of the domestic interest rate outlook. Picture: Paul Miller/AAP Image

Bond yields dropped, with the 10-year Australian commonwealth government yield closing down 17bp at 3.73 per cent and the interest rate sensitive 3-year yield down 32bp to 3.27 per cent.

It came as market expectations for the future path of the cash rate took a major hit.

Expectations for the so-called “terminal rate” of cash collapsed to 3.56 per cent from 4.14 per cent before the rate decision, with the peak now expected to occur in November 2023 rather than July.

ANZ’s head of Australian economics, David Plank, said he still expected the central bank to tighten by 25bp in November, but was less certain that the RBA will hike again in December.

“We remain of the view, however, that the cash rate will need to move into clearly restrictive territory of more than 3 per cent to ensure inflation does return to target,” said Mr Plank.

“The slower pace of rate hikes now points to the tightening cycle extending into 2023.”

While not specifically mentioning recent instability in global markets – including pressure on Credit Suisse – RBA governor Philip Lowe said in a statement that “one source of uncertainty is the outlook for the global economy, which has deteriorated recently”.

Commonwealth Bank’s head of Australian economics Gareth Aird – who had long predicted that the RBA would slow the pace of rate hikes to 25bp this month – said the central bank has delivered an “incredible amount of monetary policy tightening in a very short space of time.”

While the cash rate was now in “restrictive territory” based on the RBA’s view that the neutral rate is about 2.50 per cent, his estimate of the neutral cash rate was about 100 basis points lower so “monetary policy is now comfortably in the contractionary zone.”

BetaShares chief economist David Bassanese said the surprise decision to raise rates by only 25 basis points was “consistent with my view that the Australia economy is better placed than the US to contain inflation without needing a recession.” “Unlike the Federal Reserve, the RBA is thinking twice about pushing the economy into a recession it might not need to have,” he said.

Local annual wage inflation is less than half of US levels, despite both economies having a similarly low unemployment rate of around 3.5 per cent.

“A major reason appears to be less local post-Covid labour market scarring, with more working age Australians willing and able to re-enter the labour force,” said Mr Bassanese.

“As a result, more of our currently high rate of inflation appears to reflect global factors, such as supply side constraints and strong US demand, rather than local demand imbalances.”

Mr Bassanese also noted that with around 80 per cent of Australian home loans on variable rates compared to only 15 per cent in the US, Australia is “more sensitive to short-term interest rates – suggesting the RBA needs to be relatively more careful in deciding how quickly to raise rates.”

“Accordingly, contrary to market expectations for most of this year, I have long maintained the RBA would likely not raise interest rates in this cycle anywhere near that of the US,” he said.

But despite his surprise at the smaller size of the RBA’s latest rate hike, Westpac chief economist Bill Evans retained his forecast for a terminal cash rate of 3.6 per cent, now expected to be in reached in March versus his previous view that the cash rate would peak in February.

“There seems to a confidence building around Australia’s capacity to avoid a strong lift in wages growth,” he said. “That confidence is likely to be misplaced as we move further into 2022. Certainly, the argument about lower inflation does not align with the official forecasts.”

Mr Evans said he doesn’t share the RBA’s confidence around the containment of wage pressures and economic growth will have to slow to 1 per cent in 2023 to achieve an acceptable slowdown in inflation and wages growth.

“By engineering this positive surprise with today’s decision, the end result is likely that the tightening cycle will need to be extended into March, when another update on wages growth will be received.”