In May, FIIG’s Head of Research, Philip Brown, and Director, Fixed Income and Investment Strategy Jonathan Sheridan spoke with Ausbiz about the future of the RBA, using bonds and the risks apparent in the US system.
On the 8th May FIIG spoke with Ausbiz about the developments in world financial markets and how that is affecting the Australian economy, Australian investors and the RBA.
The RBA itself has been relatively measured over the past few months, but the market expectations of the RBA have been swinging quite widely. Of late, inflation market data, labour data, US trade policy and the RBA announcements themselves have all caused material moves in RBA expectations. So there was plenty to talk about!
Before Liberation Day, the market was expecting quite a shallow cycle, with the RBA only cutting rates to around 3.35%. In the aftermath of the trade war, the pricing became much more extreme, expecting a low in rates more like 2.75%. As the trade war calmed that expected bottom of the cycle rose – until the RBA meeting itself on 20 May. The comments from the RBA in the statement and the forecasts contained in the Statement of Monetary Policy in May saw the expected terminal rate for the RBA drop back down to something closer to 3.00%.
The RBA’s statement following the 20 May meeting tried to emphasise the risks to both sides of the outlook. However, the downside scenario sounded much more plausible and the market reacted to that. The upside scenario was an unexpected increase in wages driven by a strong jobs market. The downside scenario was a cautious consumer that does not increase spending much even as wages rise only tepidly in 2025. The downside scenario seemed more realistic.
The RBA has been forecasting, for a long time, that during 2025 the inflation rate would drop and there will be a simultaneous rise in the wage rate (thanks to the tightness in the labour market). When these two effects are put into the RBA’s forecasting model, they suggest there will be a material increase in consumer demand as a result and, from there, a risk of higher CPI. That’s why the RBA has been relatively cautious so far in this rate cut cycle.
That understanding of the labour market works in theory but it relies heavily on the fact that the labour market is very tight and is not able to provide any more supply of labour. If, however, the labour market is able to supply more workers, say because the participation rate rises, then the expected rise in wages doesn’t occur and neither does the rise in consumption nor the rise in inflation. What we’ve seen over the past year or so is a material drop in the vacancy rate, with a rise in the participation measures, but only a very muted wage reaction.
Those who have been reading FIIG research for a while will have seen multiple discussions around the fact that the RBA was assuming the labour market was quite tight, whereas some of the indicators were suggesting much more slack.
The RBA made small, but important, changes to their forecasts as part of the May meeting. They lowered the expected underlying CPI rate to 2.6% while also lowering the expected unemployment rate to 4.2%. In effect, they admitted there was more slack in the labour market than had previously been assumed. It was only a small change, but it mattered greatly. The RBA is starting to acknowledge that their understanding of the labour market might be overly strong – and if that view does change fully it opens the door to a much more elongated RBA cycle that lasts into 2026.
This detailed discussion of the minutiae of the labour market data does rely on the rest of the world not destabilising the whole system. While the current market backdrop seems to have the tariff war as a receding risk it could jump back to the fore at any point. Notably, the 90 day pause that President Trump gave most countries in the aftermath of Liberation Day expires on July 8 – coincidentally the same day as the next RBA meeting.
The RBA did consider a 50bp cut in May and also considered what they might need to do if there was a much more serious impact from the international trade policy. However, while the domestic data has been holding together and the offshore risks are retreating they opted for only a 25bp move.
We have been suggesting that the US trade policy is perhaps less likely to cause an imminent catastrophe and more likely to do long-term damage than generally understood. The lack of faith in the US as a negotiating partner will tell over time (and is perhaps already showing in the Ukraine War negotiations). The other US issue is one that is hiding in plain sight but not attracting much commentary. The Senate and House Republicans in the US are currently meeting (mostly behind closed doors) to thrash out an agreement on what the US budget should look like for the coming year – and presumably to raise the Debt Ceiling to meet that new requirement. There’s a suggestion that the US might choose to lower taxes further and only partially offset that reduction in revenue with cuts to health spending. If so, markets may well express further disquiet.
The recent unsettled nature of US Treasury markets was not only about tariffs in of themselves. It was the markets suggesting that the US Government was starting to try the patience of the market. The movements weren’t an earthquake, but they were a disturbing tremor for those who watch these markets closely. That was the analogy used in our discussion with Ausbiz but there’s another one that also makes sense. The increasing yield of US debt markets should be seen as a single engine failure for an aeroplane pilot. Now, modern aircraft have fail-safe after fail-safe and can fly quite happily with one engine not functioning – but that error shouldn’t be ignored. Instead, the failure of an engine is a sign to change course and correct the problem.
We’re going to find out in coming weeks or months whether the US Government does want to change course on their use of debt or whether they press on with ever larger calls on markets.
The final topic of conversation in our chat with Ausbiz was the need for diversification, both amongst asset classes and within asset classes. An investor who owns a large spread of different shares is not diversified, because they don’t own property or bonds. With so many risks to the outlook we think now is the right time consider your diversification in a holistic sense. Bonds are a good way to protect capital and still provide income – and even the more aggressive bond portfolios have a much smaller chance of capital loss than a share portfolio, a point which Jon explained very well.
So that’s a short summary of what we talked about with Ausbiz – if you’d like to see the whole thing, it’s available here.