I believe it will prove prudent to be prepared for volatility in global and domestic equities to rise over the next few months. That means have some cash aside to buy high quality growth and yield stocks at lower prices in August.

There is clearly now going to be debate about when the Fed next raises the Fed Funds Rate (FFR) by 25bp. Current expectations see a 30% chance of a June rate hike, but I tend to think they will rise to 50% over the weeks ahead and the June meeting is “live”.

To my way of thinking, the prospects of the FFR rising from 0% a few weeks ago to my forecast of 50% by next week will lead to basic profit taking that isn’t US dollars.

I expect to see the US dollar Index (DXY) rally, commodities fall, commodity currencies fall, short-dated bond prices fall and equity indices fall, remembering the rally from February lows was all driven by the perception the Fed had moved to the sidelines, which saw the US dollar fall (and everything else rally). That view was too dovish and a more hawkish Fed will drive profit taking, where profits are to be taken.

This is a good thing for those of us holding cash, but particularly in Australia, where any globally driven pullback in equities will provide excellent opportunities in a country where the cash rate is heading the other way, down. There could be a great buying opportunity in the right Australian stocks AHEAD of the full year dividend season in August and ahead of the next RBA rate cut.

Let’s be clear, the RBA has fired a shot and will fire another as Australia joins the global currency devaluation war.

The recent commentary over the last few months had suggested that the RBA was comfortable with a rebalancing of economic growth, driven by a strong housing sector and a falling Australian dollar. As such, the majority of economists interpreted monetary policy settings as appropriate.

The incumbent view changed abruptly, however, when the RBA unexpectedly cut the cash rate to 1.75% earlier this month.

Clearly, the lower-than-expected CPI data forced a dramatic change in the RBA’s monetary policy outlook. As the chart below shows, ABS data revealed Q1 16 underlying inflation slowed to just 1.55% pa, compared to expectations of 1.95% pa. This was the weakest core inflation growth on record and well below the 2-3% pa medium term inflation range targeted by the RBA.

Following the CPI data, the RBA slashed its medium term inflation forecasts, with the release of the quarterly Statement of Monetary Policy (SoMP).

As the chart below shows, the RBA previously forecast underlying inflation at 2% to June 2016, before rising to 2.5% (middle of the range) by Dec 2016 and remaining at that level out till June 2018.

The next chart shows the dramatic SoMP downgrades, with the June 2016 forecast revised down from 2% to 1.5% and Dec 2016 from 2.5% to just 1.5%. In the following two years, inflation is forecast to rise to 2% by June 2017 and remain at that level out to June 2018, which is down from 2.5% previously.

Make no mistake. This represents a very significant change for a central bank. It’s worth noting that underlying inflation is not forecast to reach the bottom of the RBA’s target range of 2-3% pa until June 2018. More importantly, the revised forecasts reflect the latest rate cut and market pricing of a further cut this year.

The importance of the RBA downgrades should not be underestimated. The SoMP inflation revisions virtually ensure at least another rate cut and maybe even more. It now appears very likely that the deflationary tide from Japan and Europe has washed onto Australian shores.

Unsurprisingly, the subsequent fall in domestic long bond yields has reflected the dramatic change in the RBA’s inflation projections. The benchmark 10-year Australian government bond recently fell to an all-time low of 2.20%. This compares to 2.55% prior to the RBA’s rate cut just over 3 weeks ago.

With the US 10 year bond yield at 1.82%, the Australian 10 year bond is now trading at just a 50bp premium. In contrast, the Australian cash rate remains at a 150bp premium to the Fed Funds Rate. This provides further confirmation that the RBA will have to cut rates again. Indeed, bank bill futures are pricing an 80% chance of a 25bp rate in August and a 92% chance in September. Given the dramatic revision of inflation forecasts, I wouldn’t be surprised to see the cash rate at 1% or even lower.” Don’t ask: why? ask: why not?

This prospect OBVIOUSLY has important implications for investors, especially those who rely on investment income to live.

First, it appears that Australia is facing the prospect of a deflationary threat similar to Japan and Europe. Second, investors should prepare for an extended lower return environment. Third, with a rapidly declining interest rate differential, the Australian dollar could break below recent lows of $US 0.69c. Fourth, it re-affirms equities as the asset class of choice. Finally, the search for yield has returned with a vengeance.

It’s worth noting that the Chairman of the Future Fund (FF) stated recently that achieving a real return of 5% is “very” difficult with the current level of interest rates. As a result, the FF is rumoured to be in negotiations to either lower its return target from 5% above the CPI level, or gain approval to invest in more risky asset classes.

Meanwhile, the major Australian banks are yielding around 6%, or over 8% grossed up for franking credits. Let’s be conservative. Even lowering payout ratios and assuming an aggressive 1% fall in the dividend yields, the grossed up major bank dividend yield still attracts a 525bp risk premium over the cash rate. I reckon that is a risk worth taking. Especially when dividend yield has contributed nearly 60% to Australian total equity returns over the long term.

What else does this mean? It means stocks I have recently written on in the Switzer Super Report such as Telstra, Sydney Airport, Transurban, Star Group, and Southern Cross Austereo will continue to outperform as their dividends are sought, as will US dollar earners, such as Aristocrat, CSL and Treasury Wines Estates in terms of earnings upgrade translation.

What could easily happen is the RBA cuts rates in August, after the Fed has lifted them in June or July, the world’s equity markets are a touch lower, the AUD is lower, but the ASX200 is cum all the big fully franked annual dividends. That is a combination I am saving some cash for and I tend to believe it’s worth waiting for that moment, as it will prove an excellent way of generating total returns well above anything available more broadly.

Patience is a virtue in investing, but we also need to have our magazine loaded and targets identified for when they start moving into the “buy zone”. This can all happen quickly and the key is to be prepared and ready and willing to pull the “trigger” when the prices are right.

So don’t think I am outright bearish, I’m just waiting for volatility to increase and share prices to pull back a notch. Then I will deploy more cash into the right Australian equities, as their potential return over cash increases via their prospective dividend yields alone.

Dividend yield is going to play an ever-increasing role in total returns from equities.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.