JUST how low will official interest rates go in 2013? If you can answer this question you may unlock the answer to how high the sharemarket will travel in this current rally.
Official interest rates are currently sitting at 3 per cent, equal to the low posted following the global financial crisis, and the debt markets are betting the Reserve Bank of Australia will cut rates by about another 25 to 30 basis points over the next 12 months.
Unless commodity prices improve, however, this is looking increasingly conservative. It may seem unfathomable to some but there is a robust case to argue that we could be heading towards cash rates of just 2 per cent.
The RBA has slashed official interest rates by 175 basis points over 13 months, driven by a slowing mining sector, sluggish domestic demand and a stubbornly high Australian dollar. Twelve months down the road, with official interest rates sitting at historic lows, all of these concerns persist.
The efforts of the RBA to rebalance the economy away from mining towards domestic demand has been undermined by the all-powerful banking sector that has seen fit to line its own pockets by refusing to pass on all of the cuts.
In 2009, when official interest rates were 3 per cent, consumers could lock into a fixed home loan at 5 per cent. Today they are paying about 50 basis points more.
What would be the main driver of a further 100 basis point cut to official interest rates in 2013? At the top of the list would be a rapid conclusion to mining activity.
When the RBA started to cut official rates back in late 2011 it believed capital expenditure in the mining sector would not peak until the end of 2014, giving it ample time to reboot the domestic economy. More recently the central bank has been forced to bring forward its prediction on peak mining spending by 12 months.
To make matters more acute, some market strategists are now forecasting the peak may already be upon us. This places inordinate pressure on the RBA to rapidly stimulate domestic demand to avoid an economic funk.
The second nagging factor for the RBA is the indestructible Australian dollar. RBA governor Glenn Stevens and his board would have been crestfallen when they cut official interest rates in December by 25 basis points only to see the Australian dollar strengthen.
The high Aussie is devastating to a range of exporting industries, including mining, and unless it starts to head south it will be mightily hard for the RBA to crank up economic growth.
Rounding out the trio of factors driving interest rates is the federal government's determination to achieve a budget surplus this year.
The desire to balance the books is providing a handbrake of up to 1 per cent of GDP.
That said, there appear to be cracks in the government's determination to achieve its stated goal. Meanwhile, the Australian consumer, choking on a 30-year debt binge, has merrily taken the recent interest rate cuts, or the trifling amount the banks have passed on, and applied it to their debts.
In most economic cycles loose monetary policy currently being experienced would have started to find its way back into the economy through a spike in housing loans and/or retail spending.
All this adds up to the RBA having to cut more than it would like.
RBA deputy governor Philip Lowe recently stated Australia does not want to get into the dangerous territory experienced by other Western countries of cutting rates to zero. Unless mining spending does last out to 2014, as initially thought, this view may have to be compromised somewhat.
This all sounds fairly dramatic but lower interest rates are traditionally a boon for the sharemarket. Of all factors, monetary policy and company earnings are the most powerful drivers of stock prices.
In reaction to the global financial crisis, the US Federal Reserve slashed interest rates to zero and then starting pumping money into the economy. The outcome has been a 115 per cent rally in the benchmark S&P 500 Index.
In comparison the Reserve Bank of Australia initially slashed interest rates to cope with the crisis, only to start jacking them up all the way to 4.75 per cent. This acted to stymie the local sharemarket that has only managed a 48 per cent rebound, less than half the US performance. More recently, though, the RBA cuts have forced people out of cash and into the stockmarket.
Not only has the local sharemarket rallied about 13 per cent since early June, there are some powerful signs emerging.
Cyclical stocks are running hard and a handful of capital raisings undertaken in the industrial side of the market in the form of Cash Converters and Webjet have been heavily over-subscribed. Early indications are the $300 million plus initial public offering of internet group iSelect, set for early 2013, is garnering enormous interest already.
These green shoots have given stockbrokers a smidgen of hope that the volumes will return to the market in 2013 after a five-year drought. If interest rates continue to decline and term deposits drop under 4 per cent then a wall of money may be chasing more productive assets.