RBA Hikes Interest Rates 25bp, More Hikes to Come

For the second month in a row, the Reserve Bank of Australia has raised overnight interest rates. In the classic buy the rumor, sell the news type of reaction, the Australian dollar has given back some of its earlier gains.

Part of the reason why the Aussie sold off after the release is because the RBA said the recent appreciation of the exchange rate "is likely to constrain output in the tradeables sector and dampen price pressures." In other words, the want to add some two way action in the Aussie by letting the market know that they are keeping a close eye on their currency. However the RBA still believes that growth will be close to trend and inflation will rise in the coming year. In terms of growth, the RBA is happy with the initial improvements in the labor market and with the risk of a serious economic contraction off the table, policy makers are focused on taking interest rates back to neutral levels.

Despite the dip in the Aussie, it is important to remember that the quarter point move takes the official Australian yield up to 3.5 percent, securing the Australian dollar's spot as one of the highest yielding G20 currencies. Last month, the RBA became the first central bank in the G20 to start raising interest rates and to this day, they remain the most hawkish G20 central bank. Having just raised growth forecasts, the positive tone of the RBA statement is the central bank's way of expressing their vote of confidence towards the Australian economy. Despite criticism from Australians, the RBA does not believe that their rate hikes will undermine the recovery. Once again, the central bank cites growth in China as one of the primary reasons for the strength of the Australian economy which suggests that where China goes, Australia goes as well. The labor market continues to improve as evidenced by the latest job growth which should help to spur consumer spending. With Australian house prices continuing to rise strongly and the economy running on all cylinders, the RBA has no choice but to continue to raise interest rates.

More specifically,the monetary policy statement indicates that the central bank intends to continue to "gradually lessen the stimulus provided by monetary policy." We expect back to back quarter point rate hikes over the next few months. Interest rates are still at emergency levels and it will take another 75 to 100bp of tightening before rates return to neutral levels. This provides a great deal of opportunity in the Australian dollar, particularly against the currencies of countries whose central banks are not nearly as hawkish as the RBA. The Federal Reserve for example has been very passive at a time when the RBA is very hawkish which should help to fuel further gains in the AUD/USD over the medium term. Last month, the Reserve Bank of New Zealand made it crystal clear that they have no plans to raise interest rates until the middle of next year. This divergence with the RBA should also cause the New Zealand dollar to continue to underperform the Aussie.