Just how low can Oz interest rates go?

From the weekend AFR:

The Reserve Bank of Australia cut rates to a historic low of 2.25 per cent earlier this month,and analysts are tipping another cut to 2 per cent in coming months.

Queensland Investment Corporation chief economist Matthew Peter warned this weekthat should the United States central bank defer raising interest rates, the RBA could be forced to cut local rates to 1.25 per cent, which he predicted “would give a 15 per cent lift to housing prices”.

I expect rates to go lower than 1.5% before the easing cycle is done, though not this year. A Fed slow to raise rates is one reason but the major one is the commodity super-cycle going comprehensively bust, which is also why I doubt the house price forecast.

But it raises a fascinating question. For years now, virtually alone in the Australian interest rate discourse, MB has argued that this path to lower rates is probable. That’s not to brag but to make the point that even the outlying doves have been outgunned to the downside. Several years ago I didn’t think Australian interest rates could sink below 1.5% because of the need to fund the current account deficit but now I can see them going sub-1%.

The reason is that China has fallen faster, commodities corrected more steeply, the US dollar recovered more fully, and the Europeans and Japanese gone more bananas, than all but the most hardened bears could imagine. As a result the global price deck for yields is lower than even the very dovish expected, with perhaps the exception of uber-bear Albert Edwards!

So, how low can Australian interest rates go? The first point to make is that, as the above suggests, context will be crucial. So let’s break this discussion into halves.

The first scenario is a continuation of a global economy on its current trends. In that event, Canada is a good place too look for some clues. Canada has as similar banking system, though less externally funded, a similar mix of over-valued property markets (though less extreme), some commodity dependence in oil (though less extreme and with a much larger manufacturing sector and greater exposure to the US market), and runs a small current account deficit (with a better history of surpluses). It currently has a cash rate at 0.75% and many analysts are calling for it to fall to 0.5% at the next BOC meeting.

Compared with Canada, Australia is more at risk on each of the cited metrics meaning investors are going to demand a greater premium to put their capital here. Let’s say 25-50bps. That means that so long as the global yield price deck continues along its deflationary course, Australia could drop rates to 0.75-1% without risking capital flight and a disorderly crash in the dollar.

That brings us to scenario two, in which the above morphs into a cycle-ending global event such as an implosion in the US stock market, blowback from emerging market debt as commodities deflate, a Grexit etc.

In that context, global capital will retract to its home markets, especially the US and Japan. Both of these currencies will rocket, while all others will fall and some tumble. Commodity prices will crash to their shakeout lows and emerging markets with shaky external balances will be forced to raise interest rates to prevent a complete rout of their currencies, as well as to prevent severe domestic credit crunches.

In this context where does Australia sit? It is a unique mix of sophisticated capital markets with an atavistic commodity export reliance. Which would markets judge to be most important?

If it had any interest rate cuts left in its kit bag, the RBA would use them but what is the bottom of its range? In considering the answer ask yourself this: what would draw global capital to Australia in such an environment? There are several possibilities:

  • a AAA rating
  • yield differential
  • a safe harbour from capital losses as bonds rally
  • growth

The first would not immediately be stripped. It would take a year or so after the event for the budget deficit to blow through its 30% ceiling, so that’s a support.

The second is not going to be very appealing in a crisis which would privilege return of capital over return on capital.

The third is real so long as interest rates can keep falling.

The fourth will be no help given Australia’s stimulus capability is now much more limited.

What we can discern, then, is that Australian interest rates can keep falling in a crisis up to a certain tipping point where there is no reason left for foreign capital to be here. Once the prospect of making money on rallying bonds is surpassed by the currency risk and the approach of zero interest rates then why stay and risk losses? Furthermore, bonds managers will anticipate this point so it’s actually a little early than it appears.

The obvious tipping point is the stripping of the AAA rating but markets will anticipate that and move earlier. Is Australian zero interest rate policy (ZIRP) at 75bps?

Houses and Holes

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