The weekend press had some new material on the question of what’s coming for the economy and interest rates. Tim Colebatch held a panel of economic forecasters:
The optimists share the view of Treasury and the Reserve Bank that economic growth will be close to trend this year, and accelerate into 2014-15, as mining exports gather pace, the lower dollar lifts trade-exposed industries, and lower interest rates stimulate a housing recovery and higher consumer spending.
Three market economists – BT’s Chris Caton, Citi’s Paul Brennan and TD Securities’ Alvin Pontoh – predict that there will be no more rate cuts and the Reserve’s next move will be to lift interest rates early next year. They expect growth to average 3 per cent over the next two years and unemployment to stay in the fives.
Note to self, ignore all of the above in future. Back:
The middle ground of panellists expect one more rate cut this year, with the Reserve then likely to stay on hold. They, too, see the economy picking up speed in 2014, with a bit of help from the dollar.
The pessimists are not too pessimistic: they expect the Reserve to move fast to nip trouble in the bud, with two or three rate cuts by Christmas. Most believe that will see the economy return to trend growth by 2014-15.
Tim Toohey, of Goldman Sachs, Bill Evans, of Westpac, Su-Lin Ong, of RBC, and Greg Evans, of ACCI, tip two interest rate cuts by Christmas, while Macquarie’s Richard Gibbs predicts three.
We are in this position of slowing growth because the mining boom is going bust and historically low rate cuts have so far failed to generate enough activity to offset the mining decline. More rate cuts will eventually succeed but not until they are low enough to push the dollar down to 70 cents. And even then they will need to stay low. Back:
The market economist most worried about 2014-15 is Merrill Lynch’s Saul Eslake. He warns that by then mining investment will start falling off the cliff – dragging growth down to 2 per cent and blowing out the federal budget.
In a category of their own are our resident pessimists, Jakob Madsen, of Monash University, and Steve Keen, recently retired from the University of Western Sydney. Keen is the only panel member to forecast a recession. He predicts output will slump 0.5 per cent this financial year, as China’s growth slows to 6 per cent, causing commodity prices to crash and take the dollar with them. The dollar’s fall would at least mean a rapid rebound in 2014-15.
Madsen picks growth to slow, to 1.5 per cent this financial year and just 1 per cent in 2014-15. He, too, sees China’s growth slowing abruptly, but he also sees the Reserve Bank reversing course to raise rates in response to higher expectations of inflation and federal budget deficits.
Now we’re finding some sense on potential growth but not on the RBA. It will look through tradable inflation.
Melbourne University’s Neville Norman, our top forecaster in 2009-10 and 2010-11, sketches an unusual scenario: lowish growth this year (2.22 per cent), which then accelerates dramatically to 3.8 per cent in 2014-15, as China defies the sceptics, households replace ageing durables, and a new federal government lifts business confidence by tackling the deficit – among other things, by lifting the GST to 18 per cent.
Yes, and Elvis will perform at the after budget party!
And, the MB house view? If you were a member you would already know. Trend growth will continue to slow all of this financial year to somewhere between 1% and 2%. We will then be close to stall speed. If another terms of trade shock arrives we’ll be in trouble. Regardless, it will all feel recessionary as rising unemployment, stalled national income growth and ongoing consumer caution limit growth.
That brings us to David Bassanese and an article he wrote on the weekend suggesting that the rate cycle is turning:
Deep in the bowels of global capital markets, long-term interest rates demanded by professional investors are on the rise and are already being felt in asset prices.
If sustained – which seems increasingly likely – this shift in funding pressures will also start to filter through into the retail deposit and lending rates faced by most Australian households.
In short, the days of super-low interest rates are coming to an end, which will affect not only borrowing and lending rates but asset prices more broadly. As a result, it’s an opportune time for investors to take a reality check on their financial strategies.
Where’s the evidence that rates are rising? …Probably the single most important market-determined interest rate in the world is that on 10-year US Federal Government bonds. Since early May, the yield demanded by investors to hold these bonds has lifted from an exceptionally low 1.6 per cent to a recent high of 2.5 per cent…Closer to home, falling commodity prices – and the prospect of tighter US financial conditions – mean the Australian dollar has taken a tumble from around $US1.05¢ to just above US90¢. As a weaker $A will help improve the price competitiveness of trade-exposed companies, it has reduced the need for the RBA to cut interest rates a lot further to support the economy in the face of the looming mining investment downturn.
Bassanese is certainly one of the better AFR observers but this is premature. The global interest rate cycle has certainly turned courtesy of the Fed. No argument there. But after the initial spike in interest rates as massive bearish bets on bond markets unwind, I expect slowing growth to prevent any immediate taper. Irrespective, in Australia we are still a long way from a turn in the cycle. The Australian dollar will only keep falling if economic weakness and commodity price falls prompt it to do so. That same context demands more rate cuts and a long period with them at the bottom.
However, rising global yields (and falling commodity prices) are pushing up another set of interest rates that Australian investors will need to factor in. Australian bank CDS prices were at 124 bps on Friday. That’s a big spread historically (and has risen 70% in six weeks) implying reasonably high 5 year unsecured bond rates. That will mean that although the RBA will be forced to keep lowering rates, the banks will still widen their margins further, potentially forcing the cash rate lower still. Gail Kelly set this up on the weekend:
The cost of wholesale borrowing for banks has recently fallen sharply to levels not recorded since before the 2008 global financial crisis. However bank debt spreads for five year bonds has climbed from below 80 basis points over the bank bill swap rate in May to about 100 basis points over swap.
“People aren’t out there raising money through offshore wholesale funding opportunities because of the volatility and the expensive nature of that funding,” Mrs Kelly told Financial Review Sunday.
Bassanese argues that for investors:
…if you’re a borrower you might consider locking in low funding costs while you still can. As it is, some fixed mortgage rates offered by banks have already started to creep higher, but on average fixed rates are still below variable rates – and the latter will rise when the RBA does start raising rates again.
…Australian home prices are also enjoying a lift due to low interest rates – but overall affordability levels relative to household income are still stretched, and prices could easily soften again when and if rates rise.
As for the sharemarket, currently popular high-yielding defensive stocks will be less attractive when the interest rates on offer elsewhere start to rise.
In historical terms you really can’t go wrong locking in rates now. But that’s not the same thing as thinking that they won’t go lower. On the share market, anyone still chasing yield plays needs to freshen up their view. Not because Australian financial repression is over – it’s just begun – but because the reversal out of yield internationally will raise risk premia on Australian yield plays as well. Non mining dollar exposed stocks remain the go.
If you’re still chasing the dream in housing then rising interest rates is the least of the risks you face.
