Rate cuts and beyond

Whilst the Reserve Bank of Australia’s (RBA) decision to cut the interest rate to a historical low of 0.1% was expected by the market at its November meeting, the RBA also announced a significant expansion to its quantitative easing program, as well as striking a more aggressive approach to meeting its inflation target.

What has the RBA announced?

Interest rates have been cut again, to a record low of 0.1%, applied to the cash rate; the three-year bond yield target; and the Term Funding Facility rate (the rate at which the RBA provides cheap three-year funding to the banks). It’s new territory in Australia, but actually just keeps pace with comparable countries around the world.

The RBA has also ramped up its quantitative easing program, announcing $100 billion of five to ten-year government bond purchases over the next six months, which was in excess of market expectations.

But perhaps the most significant part of the announcement was a formal revision to forward guidance for monetary policy which effectively places higher interest rates on ice until inflation is sustainably within the 2-3% target range. The new guidance provides a higher bar for inflation and gives confidence that the RBA will keep rates at its current levels for long enough to generate significant gains in employment and a return to a tight labour market. According to the RBA, this is at least three years away, though rates could easily stay on hold until 2024 and beyond. It also marks a temporary but historic shift in the RBA’s priorities from controlling inflation to dealing with the rate of unemployment generated by the COVID-19 pandemic.

Is this a step towards negative interest rates?

While we shouldn’t rule out the possibility of negative interest rates – “never say never” as Sean Connery once said - (particularly if the US Federal Reserve heads down this path) the prospect in Australia at the moment is unlikely – in fact “extraordinarily unlikely”, according to the RBA. The evidence for the effectiveness of negative rates in Europe and Japan, where they have been introduced, is mixed at best, and the confusion they produce could prove to be problematic for consumer confidence.

RBA ready to provide more monetary policy stimulus

Given the RBA’s stated aversion to negative interest rates, it’s reasonable to expect that we’ve reached the bottom of the barrel in that regard. However, there are more levers available in terms of quantitative easing, and the RBA will be “prepared to do more if necessary” to ensure that Australia recovers at a steady pace.

What does this announcement mean for investors?

First and foremost, interest rates that are lower for longer and longer, potentially through to 2024. This will keep bank deposit rates at unattractive levels and drive a continuing search for yield amongst the major asset classes. In this context, the dividend yield on fully-franked Australian shares will continue to look attractive even in the face this year’s fall in dividends, driving valuations in this asset class.

Falling mortgage rates, along with the recently announced relaxation of lending standards should support house prices, but the twin spectres of unemployment and lower immigration will loom over the property market for some time.

Finally, a lower than otherwise would have been the case Australian dollar thanks to quantitative easing boosting the supply of Australian dollars will help boost the economy, particularly if iron ore prices remain high. As we’ve seen in the past, however, the dollar usually rises on the back of strong commodity prices, and if a global economic rebound boosts commodity markets than the Australian dollar is still likely to head higher – just more slowly than would otherwise have been the case.