RBA rate rise: Investors brace for more interest rate pains

Investors are bracing for more interest rate hikes after the Reserve Bank shocked the market with a bigger-than-expected hike of its key monetary policy rate.

While house prices have fallen in some markets in recent months, on average they are more than 25pc higher than prior to the pandemic. Picture: NCA NewsWire / Gaye Gerard

Investors are bracing for aggressive interest rate hikes after the Reserve Bank shocked the market for a second month running with a bigger-than-expected hike of its key monetary policy rates.

Shares fell sharply, with interest rate sensitive sectors weakest, and the Australian dollar spiked as the RBA boosted its official cash rate by 50 basis points to 0.85 per cent, exceeding market expectations which were split between an increase of 25 or 40 basis points.

The biggest rate hike since 2000 came after a bigger-than-expected 25 basis point hike in May.

The benchmark S&P/ASX 200 share index fell 1.5 per cent to an almost three-week low of 7095.7 points as the Information Technology, Real Estate, Consumer Discretionary and Financials sectors dived 2-3 per cent. The Aussie dollar spiked above 72 US cents but was reined in by bets that the US dollar will continue to be pushed up by aggressive rate hikes and quantitative tightening in the US.

RBA governor Philip Lowe said the rate rise was a “further step in the withdrawal of the extraordinary monetary support put in place” during the pandemic. Picture: Getty Images

The bond yield curve “bear flattened”, with the more interest rate sensitive three-year yield up 15 basis points to 3.13 per cent and the benchmark 10-year yield up 7 basis points to 3.56 per cent.

Both rates were near their highest points since the early 2010’s. The yield curve was near its flattest point since the Covid-19 pandemic hit in early 2020, indicating building jitters about the economy.

RBA governor Philip Lowe said it was a “further step in the withdrawal of the extraordinary monetary support that was put in place to help the Australian economy during the pandemic.”

“The resilience of the economy and the higher inflation mean that this extraordinary support is no longer needed” he said. “The Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead” and is “committed to doing what is necessary to ensure that inflation in Australia returns to target over time.”

“One source of uncertainty about the economic outlook is how household spending evolves given the increasing pressure on Australian households’ budgets from higher inflation,” he said.

But while house prices have fallen in some markets in recent months, on average they were more than 25 per cent higher than prior to the pandemic, “supporting household wealth and spending.”

Dr Lowe also noted that the household saving rate was higher than it was before the pandemic and many households have built up large financial buffers. But the RBA will pay “close attention to these various influences on consumption as it assesses the appropriate setting of monetary policy.”

Matt Sherwood, head of investment strategy at Perpetual Investments said the key message from the Reserve Bank’s policy statement was that interest rate settings were no longer appropriate for the economic backdrop, with a 50-year low unemployment and multi-decade high in inflation.

“Interest rate settings are deeply inappropriate for that backdrop so the RBA does not have the option of going slowly,” he said. “Rising interest rates will continue to hit share market valuations and there’s no doubt that higher inflation and higher interest rates will both slow growth.”

Investors should “recalibrate their growth expectations for what is going to be a softer growth environment in 2023” but a recession wasn’t inevitable in his view.

“They need to mechanically lower growth because we’ve got problems on the supply side of the economy, and if you lower growth then recession risks mechanically increase.”

“But the good thing for the RBA – unlike the US Federal Reserve – is that the very-highly indebted Australian household sector is far more sensitive to policy rates than the US for example ... Inflation is very elevated and is going much higher – that’s very clear – but of course the massive amount of leverage means that the RBA has much move potency than the US Fed does.”

However, there was no indication from the RBA that it planned to slow the pace of rate hikes. “One would suspect that interest rates are going up quite significantly,” he said.

Lazard Asset Management portfolio manager Philipp Hofflin also noted that because the average Australian company wasn’t highly geared, the main impact of rate hikes would be on households.

“Some of the tightening that’s priced in – futures have 3.5 per cent priced in by the middle of next year – that seems very aggressive given the sensitivity of the household sector to interest rates in Australia,” he said. “The argument could be made that less monetary tightening is needed relative to the US.”

MLC’s Anthony Golowenko, said that with stimulus having peaked investors needed to critically examine the resilience of future earnings, cash flow, distributions and margins.

He favoured James Hardie for its strong balance sheet, robust cash flow, low gearing, pricing power and ability to manage elevated input costs and supply chain disruption.

Similarly, Citi equity strategist, Liz Dinh recommended that clients look for shares in companies with strong pricing power amid rising inflation and interest rates.

“In the current macroeconomic environment of rising inflation and interest rates, we recommend increasing portfolio exposure to quality companies that have the ability to pass the inevitable cost increases onto their customers and protect their margins,” she said.

Goldman Sachs Australia chief economist, Andrew Boak, one of the three out of 29 economists surveyed by Bloomberg who anticipated Tuesday’s 50 basis point rate hike, predicted another 50 points in July and possibly August, and a “terminal” cash rate of 2.6 per cent by the end of 2023.

‘Looking ahead, we continue to expect the RBA to hike by 50bp at its next meeting in July and ultimately reach a terminal cash rate of 2.6 per cent by December 2022,” he said.

“While this represents a rapid policy tightening over the coming year, our recent analysis suggests the Australian economy will be able to absorb materially higher interest rates in the near-term – although we see longer-term risks around the residential housing market.”

Westpac chief economist, Bill Evans, expected another 50 basis point increase in July, followed by 25 basis point hikes to a peak rate of 2.35 per cent by February.

“By front loading the moves the RBA can firmly establish its inflation fighting commitment,” he said.

Mr Evans said the key observation in the Governor’s statement was, “Inflation…is higher than earlier expected. Global factors account for much of the increase. But domestic factors are playing a role too, with capacity constraints in some sectors and the tight labour market contributing to upward pressure on prices.”

“This statement clearly signals that the Bank now recognises that it has a significant challenge to contain inflation and today’s decision points to it now being prepared to act decisively,” he said.