What the U.S. interest rate cut means for Australian investors
The recent decision from the U.S. Federal Reserve (the Fed) to reduce interest rates by 50 basis points, bringing the federal funds rate to a range of 4.75% to 5%, has drawn attention from markets worldwide, including Australia. With inflation in the U.S. having moderated to approximately 2.2%, close to the Fed’s long-term target, many are questioning the rationale behind this rate cut and its broader implications for investors.
Why has the Fed cut interest rates?
Although inflation has subsided significantly, the Fed has shifted its focus to the labour market. Recent data suggests a cooling in job creation, with unemployment inching upwards and wage growth moderating. The decision to lower rates is aimed at sustaining economic momentum by reducing borrowing costs for businesses and consumers, thus providing support to employment. This is an important shift from inflation, which is seen to be under control, to the labour market, which may need some help in the US economy.
The Fed’s move indicates a cautious approach, addressing the possibility of a slowdown before it becomes more pronounced. By cutting rates, the central bank hopes to maintain stable economic growth, particularly as the risks to employment have begun to rise.
The Fed’s Chairman was very clear in expressing his view that the US economy is in a strong position presently, and they are lowering rates to maintain its strength.
Why interest rates matter for investors
For bonds and fixed income, interest rates directly impact the prices of these securities. Lower interest rates increase the price of fixed-income securities, and this increase varies by the exact bonds. For equities, the relationship is less clear. What is important is the economic backdrop of any interest rate announcement. If for example the economy is seen to be doing very well, an increase or hold in interest rates can signal positive news for equities. On the other hand, if interest rates have to be lowered to support the economy, for example like during Covid-19, then the news can be quite mixed. In other words, the changes to economic outlook are more important than the short-term changes in rates for equities.
Finally, foreign exchange can be quite responsive to interest rate movements. Generally, lower interest rates are seen as less attractive for foreign exchange holders, so when a country lowers its interest rates, it can see some movement by investors to other, higher-yielding currencies.
What this means for Australian investors
The Australian economy is in a very different position to the US economy. Labour markets are generally seen as stronger, and inflation is still higher than target. This means that the likely focus of the RBA is still inflation, which means keeping rates higher until inflation starts to lower, like it has started to do in the US.
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