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Most of us would have heard the news of the Reserve Bank of Australia raising its cash rate target from 0.10% to the lowest target ever to 0.35%.

This is the first rate rise the RBA has put through since it raised from 4.5% to 4.75% on Melbourne Cup day in November 2010.

Cash Rate Target

The rate hike was largely anticipated by the market. However, the surprise was that it was a full 25 basis point (0.25%) increase to 0.35%. Many were expecting a 15 basis point increase to 0.25% before returning to the usual 25 basis point increments.

The market is anticipating further rate hikes throughout the year with the market pricing in a 2.765% cash rate target by December 2022. This is shown on the chart below produced by the ASX.

Northland Power
While we fully expect more rate rises, we find it hard to see a scenario where rates will increase another 240 basis points (bps) this year with only 7 more RBA Board meetings left in the year.

Impacts of Rate Rises

A 2.4% cash rate would have serious impacts on the Australian economy if implemented this quickly.

Many households would no longer be able to afford repayments on their home loan (or rental property) mortgages. Putting this aside, it would likely suggest lending standard have been too loose in the last 2 years. The media are already reporting that 300,000 people may not be able to afford their mortgage with the current rate rise.

This has many knock on effects that will impact the economy. Higher rates could cause defaults and loan losses, which will impact bank (and shareholders’) profits. It may turn many home-owners into home-sellers and in turn putting downward pressure on the housing market.

Higher rates will reduce the appetite for household and business borrowing, which will reduce economic activity – as it is designed to do. Reduced economic activity could lead to a decrease in GDP, which is otherwise known as a recession. This would be Australia’s second recession in 2 years.

Why are the RBA rising rates now?

One might question why the RBA would indeed raise rates. The reason is to combat inflationary pressures emerging in Australia, with the benchmark consumer price index moving 5.1% annualised in the March quarter. The following chart shows the quarterly inflation data: the line is the annual consumer price index (CPI) change measured quarterly, and the bars are the change in CPI over the previous quarter.
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There are many factors that have caused this inflation and it is worth briefly touching on these.

Firstly, the number of Australian dollars in circulation has increased 23% since the beginning of 2020. Economics 101 says that when the supply of something increases, it’s value goes down. Applying this to dollars, when the money in circulation increases, more money is available to spend on the same amount of goods and services, which results in prices increasing.

Further, fiscal stimulus from the government combined with major spending items such as travel not being available redirected large sums to other areas such as cars, real estate, and home improvements. Thus pushing up the cost of cars, housing, and the cost of building products.

Impact of Covid-19
Secondly, cost pressures have been seen in other areas such as commodities (oil especially has increased fuel prices for Australians). Shipping costs have skyrocketed thanks to unprecedented global demand and ecommerce, increasing costs for imported goods sold in Australia. Used car prices is a big contributor as chip shortages have led to fewer new cars available, which has filtered through to used cars. Also building products, as mentioned above is the result of rapid spending during the pandemic.

Increasing supply-side costs have featured heavily in recent conference calls and media releases from companies on the ASX, with some companies saying they have been (or expect to) be able to pass on the price rises. It is these companies that we gravitate to naturally, as pricing power typically comes as part of an enduring competitive advantage, which is core to our investment philosophy.

Summing Up

We don’t make long term interest rate forecasts. Indeed, the RBA doesn’t even do this, so if the individuals setting interest rate policy don’t have a view, what chance do the rest of us have? That said, in the short term, and Phil Lowe will agree, we do see interest rates rising over, say, 12 months.

This will continue to negatively impact the prices of assets, but we believe that investing in quality companies that have pricing power and likely to continue growing earnings over the long term is the best way to hedge against inflation and further cash rate rises.

Written by Luke Durbin
Portfolio Manager
Oracle Investment Management

Luke Durbin
Get in touch with us today for complimentary consultation to discuss your financial position and we can provide you advice tailored to your unique situation.
Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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