Why we're in two minds about rates

Financial markets are not listening to the Reserve Bank. According to the pricing of the futures market, there is now very little prospect of a further interest rate cut in the current cycle and if anything, we should be preparing for interest rate hikes in the early part of 2014.

This is despite 16 of the 27 economists surveyed by Bloomberg forecasting at least one more interest rate cut from the bank by June and the Reserve Bank of Australia itself saying in the minutes of the March board meeting that “further reductions [in interest rates] may be required”.

The current official cash rate set by the bank is 3 per cent, down 175 basis points from the cyclical peak of 4.75 per cent that prevailed until early November 2011.

The reasons for this divergence in views are not altogether obvious. For example, the team at Macquarie Bank are holding their view that the Reserve Bank will cut interest rates to just 2 per cent by year end and there are five others expecting the cash rate to drop to 2.5 per cent within about six months.

Perhaps these views are based on an assessment that global economic conditions will falter, or that Europe is about to implode as Cyprus self destructs. Perhaps it is the ongoing low inflation in prospect locally or concerns that the mining boom is topping out and there is not enough upside momentum in other areas of the economy to pick up the slack. It is noteworthy that three of the big four local banks (with around 85 per cent of the mortgage market) are forecasting at least one more interest rate cut, while the fourth, Commonwealth Bank, is forecasting rates on hold over the forecast horizon.

On the other hand, as always in economics it seems, there are some strong views that have some serious players forecasting interest rate hikes over the next 18 months or so. AMP Capital Investors, Ausbil Dexia, BNP Paribas, BT Financial Group, HSBC, Society Generale and UBS are all forecasting rate hikes from the Reserve Bank. Perhaps these forecasters are looking at the strengthening US economy, ongoing momentum in China, the surge in wealth on the back of rising stock and house prices as reasons for their view.

From the two lists above, it is curious that the institutions biased towards more interest rate cuts are dominated by Australian based firms. Westpac, National Australia Bank and ANZ Bank, along with Macquarie and St George, are forecasting cuts. Are they seeing flows in their loan books or other internal information that is helping to support such a dovish view?

The most hawkish on interest rates in Australia are foreign-based institutions that have their headquarters in some of the worst performing parts of the world economy – the UK, Switzerland and France!

Each scenario or forecast is no doubt well founded and valid in its own right – and just which ones will come to prevail is the 64 lira question.

It is important to remember also that market pricing is not infallible. As we see every day, stock, bond, currency, commodity and futures pricing changes as news unfolds. Indeed, just a couple of months ago, the market was pricing in a 2 per cent cash rate as the low point of the interest rate cycle which, as has been outlined, seems very unlikely to pass and has been priced out. Things change, news is often surprising, as are the moves of policy makers. Market positioning from investors and hedge funds can also see markets move dramatically one way or another.

While it does appear the interest rate cutting cycle is over in Australia (something flagged here two months ago – see ‘Why rates have no further to fall’, January 22), the risks to financial markets and therefore growth from the chaos in Cyprus or likely policy tightening in China or even the fiscal policy challenges in the US are real. If any of these scenarios eventuate (plus a few others that come to mind), the market might be ‘wrong’ again and quickly put interest rate cuts back into the market that the Reserve Bank would inevitably deliver.

But for now, with some saying rates down and others saying rates up, the most likely scenario is something in the middle; that is, no change from the Reserve Bank for many months to come.