Bond traders wrong-footed by RBA rate rise

Bond yields shot up after the Reserve Bank of Australia wrong-footed investors with a surprise interest rate increase and warned of more tightening ahead as it vowed to return inflation to target.

The Australian dollar jumped more than 1 per cent to just above US67.06¢ and the S&P/ASX 200 dropped 0.9 per cent. Markets and most economists had expected the cash rate to stay on hold at 3.6 per cent for the second consecutive month to assess the impact from the sharpest series of interest rate increases in a generation.

The central bank has lifted rates by 3.75 percentage points in just a year with borrowers yet to feel their effect, particularly mortgage holders.

The three-year bond yield surged 17 basis points to 3.3 per cent, the biggest daily move in a year, and the 10-year added 7 basis points to 3.5 per cent. Three-year futures slumped 22 ticks to 96.780, the sharpest daily drop since September last year.

The sharp repricing of the yield curve left investors nursing heavy losses and trading desks reported “a lot of swearing on the floor”.

Bond traders had implied a 90 per cent chance the RBA would stand pat given core inflation, the central bank’s preferred measure of price growth, slowed a touch more than expected at 6.6 per cent in the first quarter of the year, from a year ago.

“They’ve put the inflation focus at the forefront of the decision, and it was a judgment call around inflation not coming back down to the target based on the forecast,” said Christian Baylis, founder of Fortlake Asset Management.

The decision confounded the market.

“The surprising thing is that the last inflation report was in line with the forecast, if not slightly below it,” said Mr Baylis. “Despite that, they still increased interest rates.”

‘An insurance hike’

Andrew Canobi, director of Australian fixed income at Franklin Templeton, said today’s move was “an insurance hike”. He, too, was taken aback given that CPI came in a tad softer – “for the RBA to raise is quite a surprise”.

There was also some sharp criticism about the RBA’s messaging as bond markets had only given a 10 per cent probability of a move.

“If you use the market pricing as a barometer of how effective the RBA’s communication is, clearly they’ve made a misstep with the market,” Mr Baylis said.

Economists speculated that one area for the RBA’s decision to lift interest rates was the immediate pop in house prices caused by the talk that the central bank was done raising rates. National house prices rebounded over March and April, with a solid 3 per cent gain in Sydney property prices last month.

David Bassanese, chief economist at Betashares, said the RBA’s firm policy tightening bias suggested another rate rise possibly as soon as next month or at least by August after the release of the June quarter CPI report on July 26.

Pain relief

Interbank futures ramped up expectations of further rate rises, implying a 56 per cent chance of an increase to 4.1 per cent by August. Fortlake Asset Management believed the cash rate would need to reach 4 per cent to be sufficiently restrictive.

“When you look at our core inflation in Australia, it is ultimately higher than in Europe and the US, yet those central banks are still increasing interest rates,” said Mr Baylis.

Commonwealth Bank, which had correctly called an interest rate rise, believes it was the final increase for the central bank this cycle.

“The budgets of many home borrowers will be under considerable strain over the coming year,” said Gareth Aird, head of Australian economics at CBA. He predicted the central bank would reverse and cut the cash rate by half a point by Christmas and again early 2024.

Franklin Templeton expects rate cuts to kick off next year. “In our view, they’re done and with growth forecast to dwindle to 1.25 per cent over 2023, we should expect the market to start to entertain easings by early 2024,” said Mr Canobi.

Other key central bank decisions this week include the US Federal Reserve, which is expected to raise interest rates by a quarter of a percentage point at the end of its two-day policy meeting on Wednesday (Thursday AEST) to get on top of inflation.

Also on Thursday, the European Central Bank is widely expected to raise the deposit rate for the seventh straight meeting. It could surprise with an outsized increase, with markets implying a one-in-four chance of a half-a-point lift to 3.5 per cent to contain price pressures.

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