How US and Australian interest rates may impact investment markets in 2019

2019 has seen a relatively positive start for investors, particularly after the turmoil in global markets at the end of last year. However, two recent market developments in the US and Australia are particularly important to keep an eye on alongside issues including Chinese growth, resource prices and geopolitical tensions.

1. The US Federal Reserve (Fed) appears to have changed its stance on interest rates

The Fed appears to have has gone from raising interest rates and shrinking its balance sheet according to an automatic timetable, regardless of what the markets were up to, to a more flexible approach. This is being called the ‘Fed Pause’ and has important implications.

A key macro theme that we have been watching for a while now is the divergence in growth between the US and the rest of the world. The Fed’s policy stance last year was working to bring this divergence back into line (in effect to control US growth) by raising interest rates. It was also working to reduce its balance sheet, which was inflated by quantitative easing as a response to the global financial crisis, and this reduction process, which acts to remove liquidity from world markets, was on ‘autopilot’.

In our view, the Fed’s relatively hardline stance was one of the main drivers behind the market turmoil in the last quarter of 2018, as world markets tried to price in the effect of rising US interest rates and the eventual slowing of US growth.

Commentary from the Fed post the January Federal Open Market Committee meeting mostly surprised world markets. In effect, the Fed pushed the pause button, both on rising cash rates and reducing its balance sheet. Markets have seen this positively, rallying on the basis that US growth was solid, and that any policy tightening to control growth was on hold. Nirvana if you will.

Our view is that the US economy is growing well. Wages are growing, consumer confidence is decent, and corporate default rates are relatively low. While there will be undoubted knock-on effects from the Trump shut-down and the bitter winter weather, we believe the US economy is sufficiently strong that the Fed will have to resume its upward interest rate path in due course. In the meantime, the ‘pause’ is good for US markets.

2. There are also calls for interest rates to drop on the home front

An increasing number of market participants are calling for the next Reserve Bank Australia (RBA) move in cash interest rates to be down. This is in response to Australian residential property market values continuing to fall at relatively rapid rates, particularly in Sydney and Melbourne. Indeed, in early February the RBA itself moved from saying the next move in the cash rate will likely be up, to a more neutral stance.

The fall in residential property values is causing concern in a range of areas from consumer discretionary spending to bank asset values. In more normal times, current Australian economic
data would suggest that an easing bias for the RBA was appropriate. However, these are not normal times. Interest rates are historically very low. As the RBA made clear on several occasions, it is uncertain as to what possible longer-term benefits there would be from even lower rates. Lower rates would likely encourage poor risk-taking behaviour and further indebtedness in an economy already highly leveraged.

It is however, an indicator of concerns about the Australian economy that futures markets have switched from a position late last year of expecting an upward bias in cash rates to now clearly expecting lower cash rates over the medium term. In explaining these views, commentators have largely focussed on the risks associated with our very high debt levels and the flow-on effects of the slowing housing market. Interestingly, the RBA recently lowered its outlook for growth, citing rising risks in the economy, and has moved its view on interest rates to a neutral stance.

In our view, wage growth, unemployment and consumer confidence are the key statistics to watch in the current environment. Without wage growth, we believe the Australian economy may continue to muddle along without real impetus, with risks remaining skewed to the downside.

The US Fed and the RBA policy paths intersect with the Australian dollar against the US dollar

The immediate response to the Fed’s January commentary was for the Aussie dollar to strengthen against the US dollar. Subsequently, as concerns have surfaced about our own economy, this has been partially reversed. Our view is still that, on balance, the interest rate differential between the two currencies is an important determinant of future path. While we do not see the RBA reducing rates in the near term, we do believe the Fed will have to resume an upward path for US rates given the underlying strength in that economy, leading to continued strength in the US dollar against the Australian dollar.

We continue to believe that a balanced portfolio with exposure to the US economy and US dollar – alongside Australian assets and a sensible weighting to cash – is an appropriate way to position portfolios in the current environment.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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Patrick Broughton

Investment Committee Member

Patrick has 32 years of investment banking experience spanning over a broad range of financial markets, including equities, fixed income, hybrids and convertibles and foreign exchange.

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