The Reserve Bank of Australia sets the cash rate which form the basis of all variable interest rate products in Australia. Australian commercial banks sets the cost of home and business loans as a spread above the cash rate. As cash rate increases, the ultimate cost for the borrower increases as well. Vice versa when RBA cut the cash rate.
Reserve Bank board meets on first Tuesday of the month, 11 month a year except for January. The news on interest rate changes whether it is a rate rise, a rate cut or even holding interest rates steady is released to the market at 2:30 pm after every Reserve Bank Board meeting.
RBA’s most recent interest rate decision was in August 2016 and it reduced overnight cash rate to record low of 1.5%. The reduction in rates was primarily driven by the weak CPI rate. Even after the most recent change in interest rates. Australian interest rates is still higher relative to interest rates on the US dollars and Euros.
RBA Interest Rate Decisions
Exhibit above shows the trend in the RBA cash rate since 2000. After peaking in 2008, the interest rates has been steadily declining.
Interest Rate News Impact on Investment Portfolio
The news from the interest rate market is that current rate is expected to be steady going forward.
News on interest rates is important for investor due to the implication on the investment return of various asset class. The value of an asset is not only dependent on interest rates today but also the future interest rates. As expectations change, the value of investments will also change accordingly.
Reserve Bank Interest rate decisions play a large role in the value of Australian real estate. This is because debt form a large portion of the purchase price.
Our Sydney property forecast is the debt binge in the last decade is unsustainable. The market is especially susceptible for rises in interest rates.
In the FX market, the idea that there will be no more rate cuts is positive for the value of the Aust dollar. On other hand in the bond markets where bond prices moves inverse to interest rates.
The rally in bonds is over for this cycle. Fixed Income ETF performance going forward will be capped as the tailwind of interest rate cut is removed and the next change in rates will likely be going up.
Key Indicators in Interest Rate Decisions
There is no single indicator that the RBA looks at in its future interest rate decisions The bank takes into consideration of a number of factors before a move in rates. The level of emphasis on each segment is dependent on the broader economic context. During periods of strong economic growth, the bank would focus more on inflation while periods of weak economic growth. The bank would factor in GDP and Employment more than inflation and AUD rate.
The reserve bank target the inflation rate between 2% – 3%. The key interest rate risk is if the inflation breaches 3% annualized rate, then it is a matter question of when rather if when the rate will rise.
Latest inflation numbers shows there is very little pressure on RBA to raise rates. Actual rate of inflation and future inflation expectation plays an important role in the RBA decision process. Quarterly Australian inflation number is a key economic indicator investors should keep an eye on.
The RBA does not have a specific GDP target. GDP plays an over arching background in the rates decisions as it represent the health of the economy. Interest rate is a key monetary policy tool in guiding the economic growth given inflation and employment numbers.
Unemployment is another key factor. High interest rate put pressure on employment while low interest rate would encourage growth and employment growth. This is balanced against inflation risk.
Foreign Exchange Rates
A high interest rate would raise the Australian dollar verses US, Japanese Yen (AUD to Yen) and Euro (EUR to AUD). While a low interest rate would put pressure on the value of the dollar. There are positives and negatives in each instance.
Currently the emphasis has been on maintain a low exchange rate is to encourages exports and make domestic business more competitive against imports. The governor has been making semi verbal interventions noting the Australian exchange rate is higher than it should be. Right now it is a key tool in encouraging growth.