MB is big fan of Westpac’s Bill Evans but he’s wrong today:
Westpac is maintaining its call that the RBA will be raising rates from the September quarter next year.
In that regard an important issue is how far rates might rise in the next tightening cycle.
The best approach in making that assessment is to forecast the new “neutral” rate. The “neutral” rate is defined as that real rate which keeps GDP growth at its potential with inflation around the RBA’s target. Rates above “neutral” will be constraining growth while those below “neutral” will be stimulatory for growth.
The second aspect of the process is to assess how far above “neutral” rates need to move as the tightening cycle intensifies.
Potential growth will be determined by productivity growth and growth in the labour force (essentially population growth in the long run) while preferences for saving will also impact calculations, (sensitivity of investment, including property, to a particular rate of interest is captured by these preferences).
A good example of this thinking is the long run forecasts of the Federal Open Market Committee which sees long run federal funds rate at 3.75 per cent; long run GDP growth at 2.25 per cent and long run inflation at 2 per cent. Therefore the real long run Federal funds rate is estimated at 1.75 per cent, slightly below estimated real potential GDP growth. Arguably this shortfall might be seen as capturing the effect of “savings” preferences.
For Australia it might be helpful to think of the neutral floating mortgage rate. With around 60 per cent of outstanding credit being mortgage related and only around 15 per cent being fixed the floating mortgage rate seems a reasonable proxy for an interest rate which can be seen to impact activity.
In the 10 years preceding the GFC period the floating mortgage rate averaged around 6.6 per cent. However, this period was associated with the household debt to disposable income ratio lifting from around 70 per cent to 150 per cent. Reasonably, sensitivity to debt and therefore housing investment should have been rising during that period but this was not evident in borrowing and activity levels until the advent of the GFC and households, fearful of house prices and job prospects, sharply lifted savings rates from around zero to 10 per cent of disposable income.
Although gross household debt to disposable income ratios have remained steady at around 150 per cent households have been using these higher savings to strengthen their balance sheets and lower their vulnerability to higher rates. We estimate that household debt net of deposits has fallen from 90 per cent of disposable income to 65 per cent. In addition, households are paying down debt more rapidly. In its latest results Westpac reported that nearly 75 per cent of borrowers were ahead on their scheduled loan repayments.
Since the GFC, and during this period of strengthening household balance sheets, the variable mortgage rate has averaged around 6.1 per cent. Reasonably, this ongoing strengthening of balance sheets should raise households’ investment preferences. Of course, at this stage of the cycle risk aversion still dominates but this evidence points to a lower sensitivity to rates at whatever time the economy moves back near equilibrium (economy growing at potential and inflation around target).
Choosing a future “neutral” rate will always be subject to considerable uncertainty but a 6.5 per cent target for the floating mortgage rate seems reasonable for the next cycle given strengthening household balance sheets over the last 7 years.
What does this mean for the RBA cash rate?
The current spread between the cash rate and the variable mortgage rate is 260bps. That is up from a 130bps average pre- GFC. Based on the previous discussion the “neutral” cash rate would be 4 per cent, assuming that the mortgage /cash rate spread holds.
In assessing that likely spread two arguments are relevant. Firstly, spreads are even narrower in other OECD countries. Secondly, the increase in spreads post GFC was associated with banks’ moving to rebalance funding ratios towards a higher proportion of retail funding. The resulting pressure on deposit rates contributed to widening mortgage spreads. With funding ratios now rebalanced, competition for assets amongst banks might see those asset spreads narrowing through the next tightening cycle. That would put upward pressure on the neutral cash rate for a given neutral floating mortgage rate.
For now, our forecast of the neutral cash rate during the next tightening cycle is retained as 4 per cent with potential for that rate to increase under the pressure of banks’ competition for assets.
Finally, we need to assess the likely overshoot of the cash rate above the neutral level. Our forecasts include a 75 basis points overshoot. With balance sheet repair in the household sector raising preferences for debt in the next cycle that estimate might prove to be conservative.
Westpac is expecting the next tightening cycle to begin in the second half of 2015. Markets are likely to begin to anticipate that cycle around 6 months in advance. While markets are currently in denial that a business cycle exists, current market estimates of the peak rate in the cycle look to be conservative.
With the neutral cash rate around 4 per cent we expect the next market peak in the cash rate to be 4.75 per cent – fixed rates are likely to eventually embrace that outlook.
Let’s play this out. History suggests that this business cycle has roughly two years left to run. If we’re a year from rate rises then the RBA is going to have to raise rates very fast in 2016 – five or six times – to meet Bill Evans target. It’s possible if we’re entering a major house price and economic blowoff but very unlikely.
Here’s why. Studying the composition of growth delivers a much lower neutral cash rate estimate. By the end of 2016, the capex cliff will be drawing to a close but still in force. Consumers won’t be spending much more than they are today even if house prices are higher (they no longer believe realty is stable savings, quite sensibly) and APRA will have already been tightening prudentially for eighteen months stalling price gains anyway. The government’s infrastructure agenda will be rolling out and net exports will still be providing an unusually large support to headline growth as LNG projects come on stream. But the terms of trade will also be falling as LNG prices accelerate downwards and iron ore writhes in agony as Chinese demand growth ends. The budget will continue to struggle.
In short, even if headline growth returns to trend, the composition will be weaker for domestic activity, unemployment will be remain persistently higher than expected and income growth elusive. In that environment the neutral cash rate is more likely to be 3%, before plunging to 1% as the global business cycle ends.
