JACKSON HEWETT: US interest rate cut could mean no Australian interest rate cuts for all of 2025

The Reserve Bank’s job just got harder.

As Governor Michele Bullock tries to walk the fine line between full employment and inflation, the US Federal Reserve just tipped the balance in the wrong direction.

The Fed cut by a quarter of a per cent as expected but a change in forward guidance sent markets into meltdown, prompting a massive selloff in US equities.

The Australian dollar also nosedived, tumbling to its lowest point in over a year, hitting 62 US cents.

What happens next will be critical for Australian interest rates.

A lower dollar increases the cost of imported goods, hurting shoppers and driving up inflation — something the RBA is striving to contain before considering its first rate cut in over a year.

There were glimmers that the RBA might be changing its position on inflation and more open to cut rates. Even if mortgage holders and the Government desperately want relief, strength in employment, backed by public spending and immigration have kept growth ticking along at a level just high enough to be inflationary and not low enough to warrant support.

Now a new inflationary spanner has been thrown in the works.

“When the RBA put their inflation forecasts out they were working off a currency level much higher than 62ish cents. If the dollar stays there, that just means imported inflation is going to have a real pulse in the next few CPIs going forward,” said Christian Baylis, co-founder and chief investment officer of Fortlake Asset Management.

“This really has made the life difficult for the RBA. We come back to this situation, which no one really wants to talk about that we might actually be stuck at the current cash rate for all of 2025.”

Markets had been expecting the US Federal Reserve to cut interest rates four more times next year to 3.4 per cent. But Fed Chairman Jerome Powell warned that last nights rate cut might be the last for a while, as US inflation picked up slightly and the labour market showed further signs of strength.

“Today was a closer call, but we decided it was the right call,” Powell said at a news conference after the meeting. “From here, it’s a new phase, and we’re going to be cautious about further cuts.”

That sent markets tumbling with the major US indexes falling over three per cent.

Australian markets followed suit, tumbling two per cent, with interest rate sensitive financial stocks hit hardest.

US markets have been priced to perfection with the S&P 500 having its best year since 1998, up by 27 per cent before today’s fall. American investors haven’t been as bullish about future prices in decades meaning markets are vulnerable to any kind of bad news.

Rate pressure may get worse

The Fed’s decision to adopt a more conservative policy on rate cuts comes before President-elect Donald Trump comes to power. If President Trump goes ahead with his high-tariff agenda, as well as loosening corporate regulations and cutting taxes, it has the potential to drive inflation up further.

The independent Peterson Institute for Economic analysis calculated the impact of Trump’s campaign promises and found that, if enacted, inflation would jump from a forecast 1.9 per cent in 2026, to between 6 and 9.3 per cent.

Analysts think the Fed may have eased their cutting bias in anticipation of more inflationary policies next year but any meaningful lift in inflation might stop or even reverse the current rate cycle.

“If they had to hike rates our currency will be below 60 cents and imported inflation becomes a real issue. You’ve also got this huge tailwind for inflation coming through from the US as well,” Baylis said.

“That creates huge issues for the RBA facing into an unemployment rate of 3.9 per cent and probably one of the most resilient jobs markets that we’ve seen. We’ve got hours worked going up. We’ve got unemployment falling. Everywhere I look ... the RBA potentially just has no room to cut rates at all.”

Share markets challenged

How the rates cycle plays out matters for both the US and Australia. Stripping out the hype stocks in the so-called Magnificent Seven (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla), and the US markets still look overvalued on a price to earnings basis. To reach the potential that share prices indicate, US firms would have to deliver outsized growth in earnings and revenue. That is reliant on not just Trump’s expansionary policies but an accommodating Federal Reserve cutting rates.

Interest rates affect the discount rate used to value a stock by adjusting future cash flows to their present value, accounting for time, risk, and opportunity cost. The lower the interest rate, the higher the valuation and vice versa. Any upwards move in interest rate expectations will widen the gap between share price sentiment and true value.

Australia will not be immune to the cycle either.

Macquarie finds the price to earnings ratio paid for the Australian market is near an all time high. Prices are at 22 times earnings, just under the post-COVID stocks boom when cheap money was flooding the economy and higher than the tech boom of the turn of the millennium.

Last week Macquarie told clients it has already gone mostly defensive and advised them to pivot to health stocks like CSL and Resmed, real estate investment trusts and gold in advance of a US market meltdown. That is starting to look like a good call.

Higher or stable interest rates in Australia will pressure ASX valuations by elevating discount rates, while inflation will impact consumer spending and companies reliant on imported goods priced in US dollars.

That will hurt consumer stocks in the discretionary sector as customer claw bank spending, while banks will likely see lower demand for loans if interest rates do not fall.

Stocks likely to benefit include those more resilient to inflation, such as toll road operator Transurban, supermarkets, and infrastructure providers like Telstra.