Options & Warrants

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Yesterday, the Reserve Bank of Australia (RBA) board met and reduced the Australian cash rate by 25 basis points to 4.1%. At the same time, they released the Quarterly Statement of Monetary Policy, which provides a broad range of outlooks for various variables affecting the Australian economy. The release of this report, on a quarterly basis alongside the RBA meeting, serves a similar function to the Summary of Economic Projections released by the Federal Reserve.

The RBA’s initial message was that even with the reduction in monetary policy, the outlook remains restrictive. However, according to our own model, A Cash Rate of 4.1% is not restrictive, but modestly expansive. Our model is based on 35 years of data.

The Quarterly Statement indicated that the outlook for the Australian economy is for considerable expansion. After last year’s GDP growth of only 1.1%, which economists consider a soft landing, growth is projected to pick up, with a forecast of 2% for the year to June 2025. This is followed by 2.4% for the year to December 2025 Growth continues between 2.3% and 2.5% over the following years. Even in 2027, growth is expected to remain above 2%. This represents a promising future for the Australian economy. Interestingly, business investment is not expected to be the main driver of this growth. Business investment growth for the year to December was zero and is expected to remain at zero for the year to June, only growing by 1.4% by the end of 2025. It seems that growth will accelerate only after the economy picks up speed. Household consumption is also forecast to increase slightly from 0.7% last year to 2.6% this year.

The primary factor driving the anticipated growth is Public Demand, largely funded by "other people’s money". Public Demand (Government Spending) grew by 4.9% in the year to December 2024 and is expected to grow by 5.3% or more for the year to June 2025, with projections of 4.3% for December 2025 and 4% for 2026. This growth in public demand, largely financed through public borrowing, includes Federal and State Government spending, particularly on infrastructure projects. While this expansion will stimulate demand, it will be paid for later by taxpayers.

The unemployment rate, currently at 4%, is expected to rise slightly to 4.2% mid-year, where it is anticipated to remain. The RBA has indicated that this increase in unemployment will help reduce inflation, although not to the target of 2.5%. Inflation is projected to fall from a trimmed mean of 3.2% for the year to December 2024, to 2.7% by June 2025. However, inflation is expected to stabilise at this level, not reaching the 2.5% target.

This raises an interesting question: why does the RBA believe that inflation can fall to the lower end of the 2-3% range without unemployment reaching 4.6-4.7%, as suggested by historical data? We believe that the significant import boom in Australia, with imports rising by 6.2% for the year to December 2024, has played a role. Import growth is expected to slow in the coming years. We think that but year's surge in imported manufactured goods at low prices has created an illusion of sustainable low inflation at the same time as relatively low unemployment.

Our analysis suggests that such low inflation is unsustainable unless unemployment rises to 4.6% or higher. This issue may resurface in the coming quarters as the true challenges of reducing inflation are revealed. However, for now, we can say that the Australian economy appears to have bottomed out. We’ve had our soft landing with 1.1% growth in December 2024, and growth is now accelerating, even if it is being driven by public spending. By the end of 2025, growth is expected to reach 2.4%, and the economy is set to maintain above 2% growth for the next several years. This represents a strong recovery, and the Australian economy appears poised for a period of better performance in the coming years.

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The start of an easing cycle is upon us, but the path forward remains unclear, much like the post-pandemic economy. The debate now shifts from when the cycle commences to where the terminal rate for this cycle might land. Nonetheless, the first interest rate cut since November 2020 marks a definitive turning point for market sentiment and its impact on risk assets.

Rationale for the Cut

The RBA's decision for a 25bps cut reflects a view that inflation is sustainably moving back towards the Bank's 2-3% range. Three consecutive declines in quarterly core CPI from 4.0% to 3.2% in the December quarter afford some space for monetary easing.

In the February statement, the Board also highlighted some weakness in the demand side of the economy, with consumer and business sentiment subdued. Noting that "there has also been continued subdued growth in private demand and wage pressures have eased".

The Board was careful to point out that upside risk remains, suggesting that the labour market may be tighter than previously thought. So, while today’s policy decision recognises the progress on inflation, the Board remains cautious on prospects for further policy easing.

While Australia's economic stability presents minimal recession risk, the RBA must balance stimulus against potential overheating concerns from ongoing fiscal spending, as our economist Michael Knox points out in his recent piece.

What is priced in

Before today's announcement, futures implied a further 50bps interest rate cut, taking this cycle's terminal rate to 3.6% by December 2025. The RBA's forecast assumes three further cuts by June 2026 and a terminal rate of 3.4%. Given the uncertainties around the path of inflation, we think the RBA’s comments will unlikely alter the market outlook for interest rates.

Updated Economic Forecasts (Feb 2025)

Michael Knox is more cautious and believes there is limited scope for further rate cuts until unemployment rises from 4% to around 4.6%. The situation is complicated by fiscal policy. The Labor government has been expanding employment in sectors like the NDIS and other areas of the public service. This fiscal stimulus is preventing unemployment from rising to the level needed for inflation to fall. As a result, unemployment remains stuck at around 4%, and inflation remains too high for the RBA to cut rates further.

ASX performance following the first RBA rate cut (1996 – 2021)

The impact on investor sentiment is clear - historically, the ASX 200 has risen by an average of 4% in prior cycles since 1996 when the RBA proactively cut interest rates, excluding the periods of the Global Financial Crisis and the COVID-19 pandemic. As per prior cycles, we think this marks a definitive turning point for sentiment and is likely to support the positive underlying momentum in the equity market.

However, at a sector level, performance is mixed - Industrials, Healthcare, and Utilities generally outperform the ASX 200 in the three months following the first cut, while Financials, REITs, and Energy tend to lag.

Market implications

The multiples being paid by the market, particularly for interest rate-sensitive sectors, are high (ASX Industrials c22x vs the 10-year average of 19x), suggesting that some level of interest rate easing is already factored into prices. The prospect of two further rate cuts will help sentiment but is unlikely to create a step change in earnings forecasts. Every cycle is unique, so positioning is key for us, especially around industries and stocks that are best placed to benefit from this easing cycle.

Banks

A lift in front book volumes and more-buoyant mortgage demand needs stronger anticipation of lower product rates than a modest start to easing would bring at this stage. We still struggle to find value across the major banks (CBA – no major upside surprise supporting the price).

Consumption

Assuming a terminal rate of 3.60%, this equates to a savings of ~$300 a month for the average $666k loan size  (ABS housing finance). This is expected to provide a modest boost to household consumption but the full impact is unlikely to be felt until 2H FY26. We prefer consumer linked stocks tied to lower-valued products (UNI, LOV) over housing-linked exposures at this point in the cycle.

Best ideas

Universal Store, Lovisa, Webjet Group

Property/Housing

As borrowing capacity improves, the housing market could see increased activity in lower-priced segments, alleviating some affordability issues that persist and offset inflation that is still evident in the cost of building. Banks are likely to actively promote fixed-rate mortgages ahead of potential further cuts.

Best ideas

James Hardie, Qualitas, Maas group

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I was particularly interested last week by the comments from one of two U.S. economists I really like. These two economists are Jason Furman, who has emerged as a top figure on the Democratic side, and Kevin Hassett, a leading figure on the Republican side. When I have seen them both debate in person, Kevin Hassett usually seems to be enjoying the event more than Jason Furman. Maybe Hassett just has a sunnier temperament.

Kevin Hassett, served as Chair of the Council of Economic Advisers to the President Trump in his first Administration. In Trump's current administration, Hassett holds the position of Director of the National Economic Council. The National Economic Council is responsible for coordinating all major economic policy actions across the top departments. This is a significant role, far beyond just offering advice.

Hassett was discussing the strange movement in the U.S. payroll numbers published by the U.S. Department of Labor. Last week, the numbers came in one million lower than expected. In fact, it wasn't just one million lower for that month; it was one million lower for the previous four years. It appears that during the Biden administration, the U.S. Department of Labor had overestimated payroll numbers by a million workers per month for the entire period, and immediately after the Biden administration left office, those numbers were reduced by a million. I thought this was a particularly insightful observation, as it led me to update all my numbers for U.S. employment.

I decided to examine U.S. employment growth and its median and then compare it with Australia's figures. The data revealed that the median growth rate of employment in the U.S. is significantly lower than in Australia. The median growth rate of employment in the U.S. is specifically 1.65% per year. Including the most recent updates, the current year-on-year growth rate is now only 1.3%. In this case the Fed might cut monetary policy. Employment growth is an easy way to look at monetary policy, though it’s not my preferred model, which is based on unemployment, excess resources in the economy, and current inflation, as well as inflation expectations.

What these models show, both in the case of the Federal Reserve and the Reserve Bank of Australia (RBA)—is that the decision-making of central banks is not so much about where inflation is currently, but where they expect inflation to be in the future. This expectation is heavily influenced by the level of unemployment and, to some extent, expectations around that. However, in Australia, as I mentioned a couple of weeks ago, the problem is that unemployment isn't high enough to bring inflation to a low enough level to allow the RBA to reduce rates.

When we look at the U.S. case, employment growth is lower than the long-term median. In this case the Federal Reserve could consider cutting rates. My model, which explains 89.3% of the monthly variation in the federal funds rate since 1982, suggests that the equilibrium Fed Funds rate is 3.9%. This is lower than the current Federal Funds rate of 4.35%. This indicates that the Fed could cut rates anytime it wants to. However, what Jay Powell, the Chair of the Federal Reserve, said at the last meeting was that he thought monetary policy was in a satisfactory position for now. Still, our model suggests that a rate cut could happen soon, as future inflation is expected to be lower than current inflation.

The situation in Australia is different. The median employment growth rate in Australia is higher than in the U.S. The median in Australia stands at 2.1%. This is higher than the U.S. rate of 1.65%. Right now, Australia's rate of employment growth at 2.8% is higher than its long-term median. This is not the usual circumstance in which the RBA could be expected to cut rates. The reason for this is that employment is growing fast is due to the Government adding more workers to the public sector, particularly in the National Disability Scheme.

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When we run our model for Australia, it explains 89.4% of the monthly variation of the cash rate since 1992. This is when the Australian cash rate first came into existence. The model suggests that the equilibrium rate is 4.41%, which is slightly above the current Australian cash rate of 4.35%. Based on where future inflation is expected to go, and considering the current level of unemployment, it is highly unlikely that the RBA will cut rates in the near future.

I know that this view doesn't align with the consensus, but I'm comfortable with that, as I often do better when I’m not in line with the majority opinion. The problem is that, as I shared a couple of weeks ago, historical data on the relationship between unemployment and inflation in Australia shows that over the past decade, unemployment needs to reach 4.6% or higher for inflation to be sustained at a level of 2.5%. Australian headline Inflation is falling, and Treasurer Jim Chalmers has been influencing that, as we know from the subsidies on electricity.

However, the RBA's decision will be based on where it expects future inflation to be, and my expectation is that we won't reach the 2.5% target for some time. Consequently, the RBA is unlikely to cut rates at its next meeting.

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