Monetary Policy & Interest Rates
Contrary to market expectations late last year, which had leaned toward an ongoing easing cycle, the Reserve Bank of Australia increased the cash rate by 25 basis points on Tuesday, 3rd February. The decision followed the release of the December quarter CPI data on 25 January 2025, which showed a renewed acceleration in inflation, with headline annual CPI of 3.8%, rising well above expectations.
Key contributors to the spike included higher electricity and gas prices, increases in insurance premiums, rents, and continued strength in services inflation, particularly in health and education. In the RBA’s official Monetary Policy Decision statement, the RBA noted that while inflation has moderated from its peak, it remains above the midpoint of the 2 – 3% target range, with underlying inflation remaining elevated.
The Board indicated that demand continues to exceed the economy’s supply capacity and, as such, tightening was required to ensure inflation returns sustainably to target within a reasonable timeframe.
Fiscal Influences on the Inflation Outlook
Ongoing elevated Federal and State Government spending has not helped the inflation outlook. Key areas of rapid expenditure growth include the National Disability Insurance Scheme (NDIS), which continues to expand at a pace well above nominal GDP; aged care funding following the Royal Commission reforms; defence spending under the AUKUS program and broader capability upgrades; health outlays including Medicare and hospital funding agreements; and interest payments on government debt as higher bond yields lift servicing costs.
Excessive Government spending sits at odds with the RBA’s objective of returning inflation to its 2 – 3% target band and risks sustaining demand-side inflationary pressures, effectively working against the disinflationary intent of monetary policy. This has led markets to price in the possibility of another rate increase later in the year. This is a long way removed from prior market expectations as recently as October last year of multiple interest-rate cuts throughout 2026.
Federally, as confirmed in Commonwealth Government Securities data published by the Australian Office of Financial Management (AOFM), gross Federal Government debt now exceeds $1 trillion. The increase has been driven more by higher government spending than weaker revenue, with Government expenditure now accounting for 26.9% of GDP, the highest level outside pandemic years, and representing a materially larger contributor to the medium-term budget deterioration than previously reported.
Asset Market Reactions
The repricing of macro risks has been evident across major asset classes, with markets adjusting to a higher-for-longer interest rate environment and a reassessment of fiscal and inflation dynamics:
• Currency:
The Australian dollar has strengthened sharply, to around USD 0.71, supported by relatively high yield differentials and the repricing of global risk assets. As Australian interest rates have moved higher relative to other developed markets, capital flows have favoured UD denominated assets. From an inflation perspective, the stronger currency may help moderate imported inflation pressures; however, it also presents headwinds for exporters and companies with significant offshore earnings, as foreign revenues translate into fewer Australian dollars.
Fixed Income:
The Australian 10-year government bond yield is now approaching 5%, reflecting not only higher expected policy paths but also an increase in the term premium as investors demand additional compensation for duration risk. The move higher in long-end yields has been driven by upward revisions to the expected trajectory of the cash rate, firmer real yields, and concerns around the scale of government bond issuance required to fund elevated fiscal deficits. As a result, the risk-free rate embedded in asset pricing models has reset materially, influencing valuations across both equity and property markets. This is reflected in the 30-year government bond yield now trading above 5.2%
With Federal Government spending continuing unabated, and with the Liberal opposition party presently in disarray and unable to hold the Government to account, it would not be a surprise to see Bond yields continue to appreciate.
• Equities:
Growth shares, such as those listed in the table below, have experienced significant share price falls, as rising real yields elevate discount rates applied to long-duration cash flows. In discounted cash flow terms, even modest increases in the risk-free rate can materially reduce the present value of earnings that are expected further into the future. This has led to significant contraction in high-valuation sectors, particularly where earnings visibility is more dependent on sustained growth assumptions rather than near-term cash generation.
We consider that within the above list of shares, there will be instances of substantial opportunity once current selling starts to abate.
Resource shares are inherently more volatile than many other sectors, largely because their earnings are directly linked to fluctuating commodity prices, currency movements and global economic cycles. However, over the longer term they have often fared well during periods of rising inflation. Commodities such as energy, metals and bulk materials are tangible assets with intrinsic value, and their prices tend to increase when inflation lifts input costs across the economy. As a result, resource companies can benefit from higher selling prices, which may support revenues and margins, helping to preserve real value.
Recently, resource shares have generally performed well, reflecting improving commodity prices and continued demand for raw materials. For investors, this linkage means resource shares can act as a partial hedge against inflation, while also providing portfolio diversification and exposure to assets tied to real, globally traded goods.
The big four ASX-listed banks. Commonwealth Bank, Westpac, ANZ and NAB — together with Macquarie Group, have performed very strongly of late and, given their substantial weighting in the Australian share market, have been a key driver of gains in the major indices. Banks often benefit in rising interest rate environments because higher rates can expand net interest margins, the difference between what banks earn on loans and what they pay on deposits, thereby supporting profitability, provided credit quality remains sound. More recently, their strength has also reflected solid profit results and resilient balance sheets.
In addition, the sector has attracted capital as it has been considered a safe haven amid broader market volatility, with Australia’s well-regulated banking system appealing to offshore investors. Ongoing international fund flows, potentially encouraged by a weakening US dollar, have also contributed to demand for large, liquid Australian financial stocks, further underpinning both bank share prices and overall market index performance.
Property & Yield Sectors. A-REITs and other yield-sensitive strategies have been sold down, reflecting both higher discount rates and higher funding costs. Rising bond yields reduce the relative attractiveness of property income streams, while increased borrowing costs place pressure on balance sheets and future development activity. In addition, higher capitalisation rates are being factored into asset valuations, which can weigh on net tangible asset values and investor sentiment in the sector. However, in the long-term, inflation increases the replacement cost of buildings and eventually this will be recognised by investors. This could be magnified in Australia, with essentially no new construction of office buildings occurring at the current time, and as such there will be no new additional lettable space coming to market.
Implications for Portfolio Positioning
The current environment is proving to be more volatile than normal and highlights the need to clearly separate short-term, cyclical market swings from what represents long-term fundamental value of underlying investments – something that is easier said than done! Elevated bond yields are enhancing the income potential of fixed interest investments, while simultaneously lifting the cost of capital for growth-oriented and highly leveraged sectors. Assets that provide a hedge against inflation are in favour.
Excessive ongoing State and Federal Government spending, and the associated pressures on debt servicing, indicate that monetary policy may need to stay tighter for longer than markets had earlier expected.
As always, our portfolio strategies remain grounded in long-term objectives, robust risk frameworks, and diversification, rather than reactions to near-term headline movements.
We would welcome the opportunity to discuss how these broad dynamics influence your specific investment exposures.
