Andrew Baume
Head of Fixed Income
Macro & Markets
28 Jul, 2022

Australian economists were pleasantly surprised when the June quarter CPI was released, and it was “only” 6.1%. The violent adjustment in bond yields, equity prices and sentiment that came along with that dragon jumping out of its cage earlier this year was nowhere to be seen.

Markets were shaken in March with an expectation of an inflation spiral but now are not stirred.

ABS reports that annual goods inflation was the highest since 1987, as the impacts of supply disruptions, rising shipping costs and other global and domestic inflationary factors flowed through the economy.

In terms of price action, this impact was already well understood. The release came in slightly below expectations (of 6.3%) and containing no shocks in the detailed components meant bonds were lower in yield and the All Ords traded higher.

The core to the strong price action is the view that the inflation impulse is waning, that central bank action will be enough to avoid price spirals and that the economy will walk the fine line between needing to keep rates rising and a near-term reversal because demand has choked. As one more than one commentator has said, markets are pricing to perfection.

The most aggressive price movement was in new dwelling purchases by owner-occupiers, with that component reflecting the cost of materials and the shortage of labour. As unemployment in Australia is now a multi-decade low of 3.5% the scarcity of tradies is not going to disappear.

This brings back to focus what the RBA (and its senior leaders) have released in speeches and minutes of rate-setting board meetings. The Deputy Governor, Michelle Bullock, has released research suggesting that with rates up to 3% higher than now Australian mortgage borrowers will not be in enough stress to cause a systemic issue.

Their modelling seems to suggest that a significant move lower in property values would also not be an unacceptable outcome. Coupled with the CPI pressure on new home costs in many ways a house price tumble could in fact suit the central bank.

The RBA Board meets on August 2 and will deliver another rate hike that is now expected to be 50bps, bringing the target rate to 1.85%.

This inflation spike means no central bank is operating in a vacuum, effect on currency is another key consideration. The AUD has been very weak on risk sentiment while the fundamentals remain quite constructive. The RBA will keep this weakness in mind as they consider when to formally declare the crisis over by pausing its rate hike cycle.

Market Economists now expect the pause to happen at higher levels. Previously few had considered that rates would break above 3%, but following the comments from the RBA most are now expecting them to at least reach that level. The economists’ calls and the pricing in the rates markets look more aligned after 4 months of disparity.

The Federal Reserve’s Open Market Committee sets their base rates (Fed Funds Rate) and are also on an aggressive tightening path – in fact more aggressive than most other jurisdictions. Early morning 28 July Australian time they opted to raise Fed Funds by 75 basis points for the second meeting in a row. Their target is now between 2.25 and 2.50%, leaving the RBA potentially needing to catch up even further.

Despite this historically aggressive rate hike, markets also rallied following the announcement as they took the aggressive action to mean that the heat from the inflation dragon’s breath is well and truly containable. The risk of not hiking enough to achieve that or tightening too much and causing a recession is perceived now to be less of a knife’s edge with the Fed being afforded some kudos for their sharp and definitive monetary policy response thus far.

Notwithstanding the Fed had just moved rates up by 1.5% in just over a month, US bond rates were lower, the Equity market rallied as did the AUD as the risk barometers moved back to mild.

Dragons being a mythical beast are not easy to understand, there is no definition and every writer can interpret them in a way that suits them. Inflation is as hard to predict, hard to contain and every writer can view its path their own way.

Markets in 2022 have been shaken to core by its emergence, many commentators deriding the central banks for causing it to stir. Nonetheless, both the Fed and the RBA have chosen paths that have stabilised price action and been widely seen as effectively managing the scenario which may have been of their own doing.

Data is still going to be the key, in Australia we wait another three months for CPI but the Fed has a relentless release of indications and measures to consider. They have August off so by the time we are back in September the effect of the recent decisions will be clear. The market is priced for perfection, both the Fed and the RBA will be hoping they are right.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.