Financial Markets React to US Interest Rate Delay, Implications for Australia

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Matt Comyn, from Commonwealth Bank posits that the Reserve Bank might refrain from reducing interest rates until the commencement of 2025 due to the "persistent" nature of inflation.

This circumstance exacerbates the financial strain on borrowers who rely on tax cuts and mortgage relief, contributing to heightened cost of living pressures.

The inflation rate in the United States experienced a decline from 3.4 percent to 3.1 percent during the period up to January. However, economists' projections anticipated a more pronounced decrease to 2.9 percent.

CBA had previously forecasted three interest rate reductions by the conclusion of 2024, with an additional three anticipated in the latter part of 2025. This revised projection accelerates the implementation of the second set of rate decreases to the initial half of the upcoming year.

According to this updated forecast, the RBA cash rate is expected to decline from its current level of 4.35 percent to 3.6 percent until 2025, further decreasing to 2.85 percent by mid-2025.

Since May 2022, interest rates have surged from a historic allow of 0.10 percent, resulting in an additional $1,349 per month in repayments on a $600,000 mortgage.

Weakness in labour market

Examining the labour force data for January beyond the primary unemployment rate reveals a decrease in the estimated seasonally adjusted total hours worked. Specifically, there was a decline of 49 million hours, representing a 2.5 percent decrease compared to the preceding month.

Over the preceding two consecutive years, the unemployment rate has consistently remained below 4 percent, with no observable indications of inflationary pressures emanating from the labour market.

As the Reserve Bank endeavours to achieve its specified unemployment target of 4.5 percent, it acknowledges the absence of an effective braking mechanism.

In the twelve-month period ending in December, the WagePrice Index (WPI) experienced a 4.2 percent increase, as reported by recent data released by the Australian Bureau of Statistics (ABS).

This growth slightly surpassed the corresponding Consumer Price Index (CPI), which registered a 4.1 percent increase.

Notably, this marks the initial instance since March 2021where annual wage growth has exceeded inflation, representing the most significant annual surge in wages observed in nearly 14 years.

Overnight in the United States, the S&P 500, a key benchmark, experienced a decline of 1.4 percent, accompanied by a notable increase in bond yields. This movement in the markets reflects a postponement of the anticipated initial reduction in US interest rates, now anticipated to occur in July.

In the Australian financial landscape, there is a current shift in the pricing dynamics within money markets, with expectations now indicating the likelihood of the initial rate cut by the Reserve Bank ofAustralia (RBA) occurring in early 2025.

This contrasts with previous speculations, which had anticipated the rate cut to take place in September or even earlier.

Notably, market sentiment has evolved, as evidenced by the recalibration of expectations, with indications last week suggesting the possibility of two rate reductions within the span of this year.

In both the United States and Australia, challenges persist in managing services inflation and labour costs, proving more resistant to control compared to the relatively attainable moderation observed in goods inflation after the resolution of pandemic-induced supply chain disruptions.

The specified Federal Reserve funds target range in the United States, ranging from 5.25 percent to 5.5 percent, significantly surpasses Australia's cash rate of 4.35 percent.

Furthermore, the American economy demonstrates robust growth and sustained job creation.

Australian economist Steven Hamilton, currently based in the United States, highlights the comparatively lower inflationary pressures and amore accommodative monetary policy in Australia as a less emphasised aspect in domestic discussions.

Companies looking for expansionary capital

The elevated cost of financing at higher interest rates poses a significant challenge for companies. Finding the optimal capital structure, or the optimal debt equity blend is crucial for decision makers and should be assessed regularly.  

With high exposure to debt, the escalation in borrowing expenses may lead to a reduction in a company's earnings, or worse still – lead to financial distress. This earnings squeeze is particularly evident in the performance trend reflected in the markets.

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Conversely too much equity could be more expensive. Raising capital via equity creates a dilutionary effect and a vulnerability to market fluctuations.

The reduction in earnings could have a knock-on effect for companies looking to list on a stock exchange, as reduction in earnings could erode investor confidence in a company. Investors often use earnings as a keymetric to determine a company’s valuation, financial health and growth potential.

In some circumstances these scenarios may prove advantageous for Private Equity (PE) firms seeking opportunities to acquire undervalued firms and assets.

PE firms may employ financial derivatives, such as interest rate swaps, to safeguard themselves against the volatility of interest rates.These financial instruments play a crucial role in securing advantageous interest rates and effectively mitigating risks linked to variable-rate debt.