Is the RBA or market wrong?

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In its weekly economic missive this morning, Macquarie Bank has an interesting take on the current mismatch between the RBA’s stop/start hawkish rhetoric and pricing in the interest rate futures market.

The Macquarie Weekly: The central bank that cried wolf

  • For the past year, the Reserve Bank of Australia has been forecasting great things for the Australian economy. In May 2010, the RBA predicted that Australian growth would be almost 4%YoY, but also that underlying inflation would be 2¾%. As a result, they’ve also been warning that monetary policy would have to be tightened substantially.
  • But neither the promised growth, nor the much-feared inflation, has materialised. And over the last year, the RBA has only tightened policy once. Despite that, the rhetoric of the RBA hasn’t changed a bit. According to the central bank, the Australian economy is still on the brink of a massive acceleration of growth, higher inflation is just around the corner and monetary policy will have to be tightened.
  • In its defence the RBA would point to the natural disasters in early 2011 and probably also argue that just because it takes longer for a view to materialise, that doesn’t mean that the view is wrong. But even if that is correct, this does create a problem for setting policy.
  • First, when the central bank threatens to hike rates, but doesn’t follow through on those threats, the market naturally starts to get a little blasé about how seriously it should heed the rhetoric. That appears to be the case at present. Second, the RBA argues that tightening is needed now for the forecast boom in investment. But that requires you to be confident in those forecasts of booming growth, and the evidence of the past year highlights that there can be a large gap between those rosy forecasts and the harsh reality.
  • A range of weather-related disruptions and a string of weaker data releases have seen expectations for 2011 GDP growth slashed over the past six months. At the end of last year, market expectations were for Australian GDP to grow by 3.2% in 2011. Now, halfway through the year, this forecast has come down dramatically, to just 2.0%.
  • As can be seen in the chart opposite, which shows the changes to consensus forecasts over time, the biggest drop came in the last month, following the release of much weaker March quarter GDP data. As a result, our forecast of 2.0% has gone from being bottom of the market in May, to middle of the range in June.
  • While this highlights the rapidly shifting sentiment in the Australian economy, it is unlikely that the RBA will be changing its tune quite as quickly. Indeed, it will be very interesting to see to what extent – if at all – the RBA lowers its forecasts for growth in the coming months.
  • At the May Statement on Monetary Policy (just prior to the release of Q1 GDP) the RBA expected the economy to grow 3.25% over this year. If this expectation is maintained, it would leave the central bank ½ppt above the highest forecast in the market. This is a very large gap and emphasises the very strong outlook for the economy within the RBA. It also highlights the risk of a potential over-tightening if policymakers are far more optimistic about growth than the rest of the market.
  • The final point to note is that the RBA could lower its 2011 forecasts, because of the weaker starting point, but still retain an upbeat outlook by increasing its expectations for 2012 growth. Indeed, the chart opposite shows a similar trend in the consensus numbers. That said, the RBA is already expecting growth above the market consensus.

So, what do we make of this? Look at the below chart of market pricing for interest rate futures for the past couple of years:

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The right hand scale is basis points of expected interest rate rises in the next twelve months. As you can see, since May 2010, the market for rate hikes has traded sideways in a tight range between zero and 50 basis points. Actual rates have climbed 25 basis points only, so the market has been pretty much spot on. You will notice as well that the market has recently repriced the chances of rate hikes in the next 12 months to zero.

The various bullhawks that have mounted an aggressive rate rise campaign over the past three months have lost credibility. And it’s probably fair enough that, with markets now pricing the odds of a hike at zero, Macquarie asks if the RBA’s aggressive jawboning and lack of follow through is risking the same fate.

But, to take some of the volatility out of it, let’s take a look back further at the three year bank swap rate (white) and 90 day bank swap (green) rates compared with the cash rate (red):

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What you see is that at the start of tightening cycles, 2001/2003/2009 (and ealier), the market gets ahead of itself and as RBA tightening starts to bite, along with the threat of more tightening and weakening data, market premiums over the cash rate come back.

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There are also periods when markets have underestimated the prospect of rate rises, for instance in 2003, though less frequently than overestimating them.

There is also the possibility that the RBA actually intends such a divergence at any given time, such as now, as it tries to calculates when and where to use its mallet, which Macquarie does not account for.

What we can say for sure is that there have been long periods when market pricing for the propects of the interest rates have diverged greatly from the actual outcomes engineered by RBA and, in fact, now is not an especially obvious case of such.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.