Damien Hennessy
Despite markets pricing in up to two further US rate hikes this year, Damien Hennessy, investment director at Zenith Investment Partners, expects the Federal Reserve to delay any move to raise rates, and the Reserve Bank of Australia (RBA) to likely remain on hold ahead of a possible cutting cycle.
The US is battling core inflation that is still rising, while Australia appears close to the end of its tightening cycle. US core inflation is running at 3.4 per cent and moving away from the Federal Reserve’s target, prompting markets to anticipate further tightening.
Despite this shift, Hennessy believes the central bank, under new chair Kevin Warsh, is more likely to sit tight.
“The US market has almost two rate hikes priced in – payrolls have ticked up, the AI cap-ex story has been strong, so the US economy has seemed fairly resilient,” Hennessy says.
“Core inflation is 3.4 per cent, which is going in the wrong direction of the target. The Fed has to show that it has a bias toward tightening and it has done that at the recent FOMC.
“Our modelling, based on current core inflation, unemployment close to NAIRU and a real neutral rate of 1 per cent, suggests the Fed should be at between 4 and 4.25 per cent now, but I suspect we could well see the Fed on hold for an extended period.
“What the Fed should do and what it actually will do could be two different things though. I suspect Kevin Warsh is likely to delay any move to tighten rates, which could be based on three different factors.”
The first factor is energy. Although risks in relation to the Middle East crisis remain, oil prices have retreated to the levels seen before the conflict, and market measures of expected inflation have fallen alongside them.
“Oil prices have basically returned to pre-Iran war levels. If you look at implied inflation expectations in the US, it currently sits at 2 per cent which is well down on the 3 per cent we saw in the early days of the conflict. Markets have priced it down and eventually this will flow through to core inflation,” Hennessy says.
The second factor is the Fed Chair’s own conviction that technology-driven productivity gains can do some of the heavy lifting on inflation.
“I think Warsh is a strong believer in the productivity narrative and would like to give that scenario more time to play out.”
The third factor is the underlying condition of the US economy, which Hennessy considers weaker than headline data suggests, pointing to strain in the housing sector and among small businesses.
He believes the US economy isn’t as strong as some people have suggested, adding that the outlook for US company earnings is being driven by forces largely separate from interest rate policy.
“The earnings story is quite separate from the interest rate story,” Hennessy says.
“The earnings story in the US is very much driven by an AI cap-ex boom that’s flowing through to markets, and although we are seeing increases in earnings outside of the Magnificent 7, it’s in the order of 12–13 per cent, not 25 per cent.
“I don’t think the Fed lifting rates by 25 or even 50 basis points is going to have too much impact on the earnings outlook for US companies.”
Australia is at a different stage of the cycle, having moved earlier than the US, and Hennessy believes the RBA is likely to keep rates where they are before potentially turning to cuts in 2027.
“In Australia, the economy reached a point of about 2.5 per cent growth, and we were unable to sustain that without contributing to inflation, so the RBA could be poised to tighten if it gets another bad inflation number,” Hennessy says.
“However, the case for doing nothing is greater than it has been in the past three to four months. This is due to a combination of softer employment data, weaker business and consumer confidence, and the impact of the budget on the housing sector following recent rate rises. Borrowing capacity could have dropped by as much as 10 per cent, which has to have an impact on lending and an impact on growth.
“My view for the RBA is that it is probably going to hold, and that we could well get to the end of 2026 and be discussing the next cutting cycle.”
By Damien Hennessy, investment director