Tuesday 03 February 2015 by William Arnold Opinion

RBA cuts - bonds rally hard

On Tuesday, interest rates were cut for the first time since August 2013. This cut reduced the official rate by 25 basis points to 2.25%, a record low since the RBA gained independence and started targeting inflation in the 1990s

Following the rate cut, the AUD plummeted to 76.50 US cents, the lowest level since July 2009.

Last week, government bond yields were down 10 basis points for both five and 10 year bonds. Yesterday, the bond market reacted aggressively to the RBA decision. Following the rate cut, yields fell 15-20 basis points across the curve. Five and 10 year bonds were at all-time lows of 1.85% and 2.25% respectively. The bond market gets it right more often than not. It is clearly expecting more rate cuts and a period of low interest rates for many years.

RBA Governor Glenn Stevens said domestic demand growth was overall quite weak:

“In Australia the available information suggests that growth is continuing at a below-trend pace, with domestic demand growth overall quite weak. As a result, the unemployment rate has gradually moved higher over the past year. The fall in energy prices can be expected to offer significant support to consumer spending, but at the same time the decline in the terms of trade is reducing income growth. Overall, the Bank's assessment is that output growth will probably remain a little below trend for somewhat longer, and the rate of unemployment peak a little higher, than earlier expected.”

Governor Stephens noted that for the past year and a half the Board has taken time to assess the effects of the substantial easing in policy that had already been put in place and monitored developments in Australia and abroad. In conclusion Stephens summarised that:

“Taking into account the flow of recent information and updated forecasts, the Board judged that, on balance, a further reduction in the cash rate was appropriate. This action is expected to add some further support to demand, so as to foster sustainable growth and inflation outcomes consistent with the target."

Calls for an interest rate cut have been growing since early December, when official data indicated Australia’s economy entered last year into a so called “income recession” (where in per capita terms, real net disposable income contracts for two consecutive quarters). In Australia, this measure shrank 0.8% per cent in the September and June quarters driven by plunging commodity prices.

Mr Stevens said further declines in the Australian dollar were needed to balance the economy. He also said the unemployment rate would peak higher than previously expected.

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