Is the Reserve Bank of Australia going to raise interest rates against the trend? Australia's 10-year government bond yield is approaching 5%.

As the Federal Reserve and most central banks around the world shift towards an interest rate cut path, Australia may be brewing a radical policy "U-turn."

According to the latest report from Bloomberg, driven by persistently high inflation and a strong labor market, economists generally expect the Reserve Bank of Australia (RBA) to raise the cash rate by 25 basis points to 3.85% this Tuesday. Overnight index swaps show the market has priced in a roughly 73% probability that the Australian central bank will raise rates by 25 basis points.

Yet less than six months ago, the bank was trying to boost the economy by cutting rates. This shift means Australia may become one of the few major economies tightening policy at this stage.

10-Year Government Bond Yield Nears 5% Mark

The re-evaluation of the policy path quickly spread to the bond market. Australia's 10-year government bond yield closed last week at 4.81%, surging to 4.90% after stronger-than-expected inflation data was released, and is expected by many institutions to briefly break above 5% in the coming months.

National Australia Bank (NAB) predicts that if the Australian central bank raises rates in February and May, coupled with upward pressure on global sovereign yields, the 10-year yield will face further room for increase.

However, some institutions believe that it will be hard to stay above 5% for long. Chris Manuell, portfolio manager at Jamieson Coote Bonds, said: “At these levels, demand from overseas investors and asset allocators will emerge.”

Inflation and Employment Data Changes Policy Pricing

The turning point in policy expectations stems from a series of recent "unexpectedly strong" data.

In the fourth quarter of last year, the core inflation indicator closely watched by the Australian central bank remained high, clearly above the 2%-3% target range. Meanwhile, the unemployment rate, which had been expected to gradually rise, unexpectedly fell to 4.1%, 0.3 percentage points lower than the central bank's forecast.

Stephen Miller, investment strategist at GSFM, said bluntly: “Inflation is a real and pressing threat, and responding by raising rates now is the most appropriate choice. If we don't act, we may have to resort to more aggressive policy tools in the future.”

Bank of America strategist Nick Stenner also pointed out that with inflation continuing above target and upside risk present, “keeping rates unchanged will prompt market doubts about the central bank's inflation commitment.”

Global Monetary Policy Divergence Intensifies

The potential rate hike by Australia’s central bank comes against the backdrop of clear global monetary policy divergence.

The Federal Reserve and some Asian economies are seen as approaching an easing window, the eurozone is expected to remain on hold, while Japan is still leaning toward further tightening.

This divergence has already been reflected in exchange rates. The Australian dollar has risen about 5% so far this year, ranking among the top major currencies, and is viewed by the market as a “passive tightening” of financial conditions.

National Australia Bank noted that if a rate hike occurs this week, it's more likely to be a “preventative hike” rather than the start of a new round of tightening.

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