Calm after a rates storm

Property Observer

Following the RBA's 'surprise' decision to hold rates steady in February, financial market pricing has changed quite strikingly. My first chart below compares the financial market's best estimate of the RBA's cash rate in June this year with the RBA's actual cash rate over the last 12 months.

The implied or predicted cash rate, which is represented by the blue line, is derived from the Sydney Futures Exchange's 30-day interbank futures contract for the month of June 2012 (which settles on the average cash rate in June). It is, therefore, the best proxy of investors' future beliefs, apropos the actual cash rate in June, that we have available to us.



The chart vividly illustrates how fickle financial market beliefs can be: they swung from pricing in more than two rate hikes back in February 2011 – and that was from a far higher base cash rate of 4.75 per cent (it's 4.25 per cent today) – to an incredible six-plus rate cuts in late November last year when the doomsayers really had their way.

The convergence of the blue line towards the red one, which denotes the RBA's prevailing cash rate, shows us how investors have drastically pared back their expectations for monetary policy accommodation.

Today the ‘market' is forecasting that we will only get one more RBA rate cut by June, notwithstanding the major banks' efforts to protect their oligopoly profits via out-of-cycle hikes. Another rate reduction following the two in November and December last year would push the RBA's target down to a rather stimulatory 4 per cent.

One take-away from this analysis is that investors are not especially good at predicting rates. Having said that, they would appear to be better than economists. In a recent study, RBS's Kieran Davies and Felicity Emmett empirically assessed the predictive powers of economists compared with a range of financial market benchmarks. In their own words:

"We tested the accuracy of futures market pricing of the outright level of the [RBA's] cash rate in a year's time versus economist forecasts. Our analysis shows that the futures market comes out best on various measures of forecast accuracy, for both the long-term and recent history, although neither approach is particularly good. The futures market beats the economists' forecast 60 per cent of the time, although both approaches persistently overestimate the cash rate and both have large average absolute forecast errors (1.1 percentage points for the futures market versus 1.2 percentage points for the economists). Worryingly, both approaches often point in the wrong direction to where the cash rate ends up – this happens 36 per cent of the time for futures pricing versus 41 per cent of the time for the economists.”

Davies and Emmett's finding that financial market expectations can end up wildly divorced from reality is reinforced by the chart above. In the first six months of 2011, the market's estimate of the June 2012 cash rate was directionally way wrong. At one stage in February last year investors' best guess at the June 2012 cash rate was 5.4 per cent, which is nearly five standard RBA hikes above its present-day level.

Yet investors are not stupid. They were being guided by the RBA's communications, which at that time were pointing to higher rates given the vigorous core inflation pulse that was expected by the bank in the years ahead.

Then, of course, the world changed. We had a rolling series of natural, political and economic disasters in Japan, the Middle East, Europe and the US. And so by July interest rate expectations started to swing from hikes to pricing in cuts by June 2012. Importantly, the market managed to manoeuvre its 'base case' well in advance of the stickier views of economists, who, with a few notable exceptions, took longer to buy into the emerging offshore downside.

Based on the best available information today, it would appear that the financial markets – and, frankly, some very dovish economists – overreacted. In late November 2011 the market was pricing in an incredibly low 2.9 per cent cash rate by June, which is about the same level it reached during the worst days of the GFC. While no credible economist got quite this negative, there were certainly some forecasting cash rates as low as 3.5 per cent, which would mean another three cuts from the current threshold.

Of course, what actually transpires in the future cannot be known with confidence, and there is a state of nature in which these worst-case possibilities could still be fulfilled.

The RBA's striking policy shift in late 2011 has had a profound impact on consumer expectations. According to the latest Westpac-Melbourne Institute Consumer Sentiment survey, the average Australian has gone from budgeting on two to three rate hikes in mid-2011 to thinking that rates will remain unchanged over the next year (having already pocketed two cuts).

The RBA's decision to leave rates unchanged in February had a similar effect on consumers to that which has been observed in financial markets. Prior to the last RBA board meeting, 41 per cent of Australians expected even lower interest rates over the next year, with only 31 per cent banking on rises. After the RBA's 'shock' February call, the share of doves slumped to 30 per cent while those expecting higher rates (i.e. hawks) soared to 48 per cent (see chart below).



Today's final chart shows Westpac's analysis of variations in consumer rate expectations over time, expressed in the form of forward variable mortgage rates. And it emphasises a point I have belaboured here, which has significant consequences for housing market dynamics: specifically, the change in consumer interest rate beliefs has been far larger than the actual adjustments to the RBA's cash rate.



In June 2011, the average Australian thought the RBA would lift mortgage rates to a very restrictive 8.6 per cent. Today they believe that home loan rates will be basically unaltered at around 7.4 per cent.

I've argued here that with unemployment sitting close to its full employment level, underlying inflation bubbling along inside the RBA's target band of two to three per cent, and the economy more broadly expanding at an unequivocally 'trend' pace, a period of interest rate stability would probably be a good thing.

The RBA knows it is fallible and does not want to over-engineer the price of money. So, unless we get some new data that decisively shifts the RBA's base case, there is a persuasive argument in favour of it not interfering further with the economy.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.

This article first appeared Property Observer on Thursday 21. Republished with permission.