The Reserve Bank conceded yesterday that the direction of the next move in interest rates was outside its control. It acknowledged a wall of worries - Europe's sovereign debt crisis, America's economic slowdown, the consumer spending strike, "subdued" lending growth, soft house prices, the high Australian dollar, lacklustre jobs growth and the final fading of the government's crisis spending. Taken together they had all helped lower the near-term growth outlook.
It repeated its growth and inflation meme: the resources boom is still going, growth appears set to accelerate in the medium term, and the risk of inflation breaking out above its 2-3 per cent target range remains.
But comments about a growth rebound and the inflation threat it contained were both modified by the same caveat: growth will return to trend or higher "unless the world outlook continues to deteriorate".
And the inflation outlook depends on "the extent to which softer global and domestic growth will work, in due course, to contain inflation".
The big answers will come from over there, in other words. If the world shrugs off its troubles and surges forward, rates are headed higher here, because the commodity price boom and the price pressures it is creating will intensify. If the global economy succumbs, we could get interest rate cuts, and get them quite quickly.
That in turn will depend on the result of an ideological battle that has been one-sided , but may not be from now on.
Bond market vigilantes are in the ascendant right now. They have hunted in packs before, to push bond prices down and yields up as inflation rose around the world in the '70s for example, to the point where policymakers cracked down on growth in the '80s to contain inflation, and set up a 30 year bull-market for bonds that also pulled shares higher.
This time the bond market vigilantes want Europe's cot case economies to cut spending, raise taxes and get their debt under control. They also want similar austerity elsewhere, including the UK and the US (even as, paradoxically, they rush to the safety of US and UK gilts). And this time, sharemarkets want the opposite.
Citigroup equity strategist Robert Buckland says there are nuances - bond investors with exposure to the EU problem nations also favour intervention and bailouts, while those exposed to the stronger north including Germany oppose them.
But the basic demand is primal: give me my bond coupon and don't compromise your ability to do so by issuing too much debt and let my real rate of return be undermined by inflation.
Europe's bond vigilantes are in command as usual this week, attacking Italian bonds as Italy tries to push through a ?45.5 billion ($60.8 billion) budget austerity package and roll more than ?60 billion ($80 billion) of debt.
They have also pushed the yield on Greek debt past 50 per cent for the first time as Greece fights yet another of its quarterly battles to qualify for more financial adrenalin. Europe's banks are caught in the vortex, their share prices spiralling down.
While bond market vigilantes helped sharemarkets in the '80s and '90s by forcing a low inflationary regime that also resulted in price-earnings multiples expanding, the new vigilante attack is bad news for stocks because if it succeeds it will bear down on economic growth, corporate profits and dividends.
The emergence of sharemarket vigilantism to counter bond market vigilantism and lobby for policies that stimulate economic growth is both desirable and overdue, Buckland believes. If pressure for policies that chase economic growth raises "inflationary risks and threatens the credit rating of the northern European nations, then so be it - that's the bond market's problem," he said.
But sharemarket vigilantes are going to struggle to grasp the tactics of extortion. It is high-risk game that in this case would involve pushing the prices of the assets progressively lower in the face of signs the bond market vigilantes were going to get what they wanted. The idea is to get policymakers to blink, but there could be unintended consequences.
A relief package that involved a recapitalisation of Europe's banks would, for example, dilute existing shareholders. Goldman Sachs recently told its clients that up to $US1 trillion ($945 billion) of new capital may have to be found.
The near to medium fate of this economy and the commodity markets it feeds off hangs on whether policymakers listen to the bond markets or the sharemarkets. If the bond vigilantes continue to have the squirrel grip, the next interest rate move here is down.
Frequently Asked Questions about this Article…
What did the Reserve Bank say about the next move in interest rates in Australia?
The Reserve Bank said the direction of the next interest-rate move is largely outside its control and depends on the global outlook. It repeated that the resources boom is still under way and growth may accelerate in the medium term, while the risk of inflation breaking above the 2–3% target remains. If the world recovers strongly, rates here are likely higher; if global growth weakens, rate cuts could follow.
Which global risks are weighing on Australia’s near-term growth and interest-rate outlook?
The article cites a ‘wall of worries’ including Europe’s sovereign debt crisis, America’s economic slowdown, a consumer spending strike, subdued lending growth, soft house prices, a high Australian dollar, lacklustre jobs growth and the winding down of government crisis spending — all of which have lowered the near-term growth outlook.
How could the commodity or resources boom affect inflation and Australian interest rates?
According to the article, the resources or commodity boom is ongoing and could intensify price pressures. If commodity-driven price pressures strengthen and the world outlook improves, that would push inflation risk up and push Australian interest rates higher.
Who are 'bond market vigilantes' and what impact are they having now?
Bond market vigilantes are investors who push bond prices down and yields up when they fear inflation or excessive government debt. The piece explains they are pressing Europe’s problem economies to cut spending and raise taxes, have attacked Italian bonds amid a large austerity package, and have driven Greek yields above 50%, putting pressure on European banks and share prices.
What does the article mean by 'sharemarket vigilantes' and what risks do they pose to investors?
Sharemarket vigilantes are investors who pressure policymakers to adopt growth-stimulating policies by pushing asset prices lower to force a policy response. The article warns this is a high-risk strategy: while it aims to counter bond vigilantes, it could lead to unintended consequences like further market volatility or dilution of shareholders if bank recapitalisations are imposed.
How are European banks and government bond markets affecting global investor sentiment?
European banks are caught in a downward spiral as bond-market pressure pushes yields on sovereign debt higher. The article notes severe strain in Italy and Greece — Italy attempting to pass a €45.5 billion austerity package and roll more than €60 billion of debt, and Greek yields rising past 50% — and says banks’ share prices have been falling as a result.
Could bank recapitalisation dilute existing shareholders and how big could the need be?
Yes. The article says a relief package that recapitalised Europe’s banks would dilute existing shareholders. It cites Goldman Sachs warning clients that up to US$1 trillion (about $945 billion) of new capital may need to be found, which would be a large-scale dilution if implemented.
What should everyday investors watch to understand where interest rates and markets are headed?
Everyday investors should watch the global economic outlook (especially developments in Europe and the US), commodity market trends, bond yields, and policymakers’ responses (austerity versus stimulus). Also monitor Reserve Bank commentary on growth and inflation and indicators like lending, jobs, house prices and the Australian dollar — because the next interest-rate move hinges on whether the world outlook improves or deteriorates.
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