This week we saw the RBA introduce the first rate rise since November 2010, bringing the cash rate to 0.35% in response to the current inflation-driven economic environment. 

RBA Monetary Policy Decision¹

The RBA board increased the cash rate target by 25 basis points to 35 basis points this week. We are now entering a new era, after experiencing close to 12 years of interest rates ratcheting down to 0.10% and held there from November 2020 until April 2022.

Having said that, the rate rise has come as no shock, with inflation proving to be consistently above the RBA’s 2-3% target range and with the labour market continuing to tighten and place pressure on wage prices. Despite the wage data being a leading indicator to the RBA’s monetary policy decision and still yet to be released later this month, the Board acknowledged that rising job ads and stronger upward pressure on labour costs is likely to continue.

Inflation over the year up to the March quarter was 5.1%, and while it still sits lower than most other advanced economies, the level is higher than we have experienced for many years and higher than what the RBA was forecasting.

Ongoing unprecedented global shocks such as the Russian invasion of Ukraine, lockdowns in China and simply living with COVID-19 has caused supply chain disruptions and sharp increases in the prices of oil and gas. The end consumer is feeling the pain at the hip pocket, with producers and manufacturers passing on these pricing pressures to the final product and therefore straight through to the end consumer. The unemployment rate now stands at 4% and is expected to further drop to around 3.5% over the course of this year, which would be the lowest in 50 years. Labour force participation has also risen to a record level. 

The combination of fiscal and monetary support provided throughout the course of the pandemic resulted in a resilient economy that was able to weather the uncertainty and difficulties presented over the past few years. Given the current strength of the economy, the RBA now believes that the record low interest rate is no longer required and that it is the appropriate time to begin withdrawing some of the extraordinary monetary policy support that was put in place to help Australian’s during the pandemic. The RBA expects to see a further increase in the inflation rate as the effects of global developments feed through until such time that supply chain disruptions are resolved, and prices settle. Their central forecast which is based on further interest rate increases, is that underlying inflation will decline to the top of the target band in 2024. If interest rates were to remain unchanged, inflation would be much higher than this. 

All major banks took the opportunity to pass the rate rise straight onto their lending rates.  

The RBA also made the decision not to reinvest the proceeds of maturing government bonds, meaning that their bond holdings and balance sheet will decline as bonds mature. This contraction will contribute to the tightening of money supply in Australia and assist with the return to the inflation target.

The decisions the RBA board make in the coming months will continue to be driven by the evidence on both inflation and the labour market.

Portfolio Management Commentary

The RBA pressed go on lifting interest rates this week, with the intention of continuing to do so over the coming months. The move comes off the back of months of economic data proving inflation is persistent and around to stay for some time.

One of the main advantages we have in our book in relation to interest rate risk is our investment in floating rate securities, where the yield will increase in line with the cash rate, or short-dated fixed rate loans where we can reprice on maturity. We do not run long dated interest rate risk, which is a major issue with bond portfolios in the market.

We are entering a new economic environment whereby supply and demand imbalances are at play causing ongoing inflationary pressure which will continue for months to come, as a result of the ongoing conflict in Ukraine and COVID-19 lockdowns in China. Additionally, the low interest rates and heavy fiscal support that was provided during the pandemic is no longer warranted as we return to normal and shift to the endemic phase of the pandemic. It is expected that interest rates will continue to rise in Australia and overseas, with the Federal Reserve further announcing another rate rise yesterday. Yesterday’s hike was the biggest interest rate hike since 2000, with a 0.5% rise to a new target range of 0.75%-1%. We expect to see the RBA follow suit and continue with raising the interest rate over the next few months. At this point in the market, one needs to steer clear of the overleveraged borrower. With cash rate increases, we will see continued downward pricing pressure on assets valued on a discounted cashflow methodology such as equities and bonds.

We see this market shift as a great opportunity for the alternative asset space and in private debt as we seek additional lending prospects.

¹ RBA Monetary Policy Decision – May 2022

The Aura High Yield SME Fund aims to provide investors with stable and consistent returns which are uncorrelated with public markets through the purchasing of notes in Australian SME lender warehouse funding facilities. Due to the fund’s underlying exposure to Australian SMEs and the adverse impacts the COVID-19 pandemic has had on the sector, this weekly letter aims to provide investors with regular updates on relative news and portfolio commentary.

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