Balancing a seesaw rates debate

Property Observer

Anyone predicting a much lower 3.5 per cent Reserve Bank cash rate by June this year is being frustrated by the notoriously fickle financial markets (and a purportedly error-prone RBA), which, as I anticipated here, have concluded that their late-2011 assumption of up to six further rate cuts was absurd.

The markets have scaled this back strikingly to merely one cut by June. And all the economists who thought we'd get more cuts in the first quarter (following the Reserve Bank's sudden turnaround) have been compelled to shift back the next RBA move to May at the earliest, with some abandoning their calls for cuts altogether.

As I've said for a while now, it is not inconceivable that the next move in rates is actually up, not down, although the probabilities associated with a cut in May remain very meaningful given the weak economic growth and labour market data combined with middling signals out of China.

Reserve Bank governor Glenn Stevens recently offered up some unsolicited advice to economists: "There are two rules of forecasting: the first rule is, Don't! Second rule is if you do forecast, never forecast exchange rates because that is easily, without question, the most poorly forecast variable in economics.”

Economists feel compelled to supply us with long-term forecasts, and almost never explain the true uncertainty around these numbers (an issue I've complained about for years). History would suggest that any forecast longer than six months is likely to be worthless (see Steve Keen's track-record here). This low conviction is evident in the schizophrenic prognostications of local analysts over the last year or two, who have oscillated from hikes galore to no hikes to lots of cuts and now possibly no more cuts.

The vacillation is understandable: it has been awfully hard to 'hold the line' with your view of the Australian and global economies amid the highly turbulent and frequently conflicting daily information flows coming out of Asia, Europe and North America.

Right now I would personally put a low probability on a cut in April (because of the dramatic drop in bank funding costs over recent weeks and an upward surge in global sentiment), and I think it is probably a coin toss in May.

The RBA's May decision will be heavily influenced by: (1) the first quarter inflation results, which we get in late April; (2) what banks independently do with their lending rates in the meantime; and (3) the currency movements, and whether our trade-weighted exchange rate looks to have shifted materially downwards (at the time of writing the Australian dollar is at 103.97 US cents).

A big move down in the currency will afford its own unique form of economic accommodation, while jangling the nerves of the inflation hawks inside the RBA.

On the banks, it is getting increasingly hard to justify further margin expansion given funding costs are falling quite sharply: Commonwealth Bank's excellent AAA-rated covered bond (disclosure: I was an investor) was issued in January at an enormously high margin of 1.75 per cent over the bank bill swap rate, and is now trading at around 1.15 per cent over (ie, a 60 basis point decline, or a rise in the actual price of this bond).

This has given the buyers of covered bonds terrific capital gains, which show little sign of faltering. ANZ's latest covered bond issue priced at a margin of just 0.95 per cent over the bank bill swap rate.

One way or another, the local rate debate should furnish us with entertainment, especially in the context of my bet with ALP-aligned economist Stephen Koukoulas, about what will happen by June. Late last year I was confident (as one can be) that the cash rate would remain above 3.5 per cent while the gloomier Koukoulas was certain it would crash down to this level or lower. While I proposed that the loser do a 'nudie run' around Martin Place, Koukoulas wisely rejected this condition.

One of my long-held expectations – that US bond yields would eventually rise in response to better-than-expected growth and inflation pressures stoked by money-manufacturing central banks – does seem to be slowly coming to fruition. In this respect, UBS argues:

"The jump in US Treasury yields this week marks a secular turning point for bond markets. We believe a long-term bear market has commenced. The source of the sell-off is clear – an improved and more durable global economic recovery, particularly in the US… There are three main reasons for a bear market: (1) a sustainable recovery in the US has taken root, (2) Chinese and overall emerging economy growth will be just fine, and (3) the eurozone recession poses fewer risks to the rest of the world economy."

Traditional fixed-income managers who invest in fixed-rate bonds (and are 'long duration') will likely suffer in this environment (rising yields mean falling prices). Last year, they knocked the ball out of the park. An investor in long-term Aussie government bonds captured a total return of around 30 per cent (including capital gains) while UBS's Australian Composite Bond Index was up over 11 per cent. In contrast, Aussie shares slumped another 15 per cent.

This year more conservative fund managers that are long interest rates, or short 'duration' via investments in floating-rate bonds, may outperform. It should also be a reasonable year for Aussie shares. I turned bullish on domestic equities for the first time since 2007 when the Reserve Bank commenced cutting rates. I would be even more bullish on equities (and house prices) if the flock of doves on the RBA board prevail in 'rolling' the staff – as Graham Kraehe sensationally revealed they've done in the past – and forcing rates lower again.

This article first appeared on Property Observer on March 23. Republished with permission.