Change of view on interest rates

Fri, 24 May 2019  |  

Having been the only economist to correctly anticipate an interest rate cut from the RBA when close to 50bps of interest rate hikes were priced in to the market last year (See Bloomberg 17 August 2018), I have agonised over the exact months the cuts would be delivered and then how many rate cuts would be needed to reflate the economy.

Recently, I was of the view that the RBA would need to cut 100bps from now, to a level of 0.5%, but I did so with relatively low confidence. This is why I recommended all clients to close their long interest rate positions on 17 April 2019 (when the implied yields were 1.10% for the mid 2020 OIS; 1.35% on 3 year yields and the Aussie dollar was just over 0.7000 at the time).

Like in most good trades that were massively in the money, I left a little money on the table while I reassessed the outlook.

Since calling for interest rate cuts from the RBA, a lot of water has passed under the bridge, especially in the last few weeks.

Events mean I am changing my view on interest rates and have been placing / will be looking to implement new trades.



Have taken account the election result of 18 May, the APRA change in lending standards and indeed, the RBA signal that it will cut rates to 1.0% in the next few months and the stunning change in market pricing, the case for the cash rate to be cut below 1.0% has faded.

In a tactical forecast, I now expect the RBA to cut the official cash rate to 1.0% in the September quarter 2019 (no point trying to get the month right when there is no money to be made from such a call), which I now see as the bottom of the interest rate cycle.

The reasons for my view change are:

The election result was important. It now likely that the RBA mandate will not materially change. There was some prospect a Labor Treasurer would elevate the importance of the 2 to 3% inflation target, which would have encouraged the RBA to cut more aggressively, but with the status quo, the RBA will cut less than if there was a change on government.

The election result also means that any downside to housing from the negative gearing and capital gains tax changes, however moderate these would have been, are gone. (I anticipated a Labor win – how bad was that!) There are also some signs that housing is about to reach a bottom which means that the RBA might tread carefully when considering a sub 1.0% cash rate.

The APRA changes to lending is also a relaxation of credit standards – a further minor boost to housing is likely as a result, which of course means less is needed from RBA rate cuts.

Banks funding costs have also fallen which has seen some retail lending rates already fall and there is a strong chance the bulk of the next 50 basis points of official interest rate cuts will be passed on, giving a reasonably big bang to the economy.

It is also clear the lower AUD, now below 0.7000, will give the already buoyant export sector a lovely boost. Commodity prices are much higher than assumed, which will be another income-positive effect on the economy if they can remain at lofty levels (even a 15% to 20% fall from today is ‘lofty’).

Another issue has been a very gentle uptick in wages in both nominal and real terms. To be sure, wages growth is weak and they are a constraint on household incomes and spending, but wages are rising 2.3% (up from a low of 1.9% in the middle of 2018) with real wages now up around 0.75% as inflation falls, and are now only a little below the long run trend.

While conditions in the global economy remain problematic, pragmatic central banks seem keen to maintain super-stimulatory monetary policy as a means to sustaining the expansion enjoyed for close to a decade. The transmission to the Australian economy from overseas should be positive.

There are a range of lower profile issues which are erring into the positive side:

The ASX is rising, giving a positive wealth effect to shareholders and superannuants – and this is a partial offset to the loss of wealth from the falls in house prices.

Consumer sentiment appears to be stabilising at OK levels. This bodes well for future spending.

Infrastructure spending appears to have a strong pipeline over the next couple of years, which will put a reasonably high floor under GDP growth.

The trade:

In simple terms, I would be looking to short the short end (mid 2020 to mid 2021 … current pricing in the OIS market is around 0.85 to 0.90%).

Of course, short the 3 year bond anything under a yield of 1.20% as the stunning rally fades after the sugar hit of easier policy from the RBA and the government is digested. I’d also look to short the 10 year around 1.60% - but with a little less conviction.

Look to get long the AUD, especially vs USD and EUR (at levels around 0.6900 and 0.6200 respectively).

This view will be further tested and built upon on coming weeks, but the interest rate cutting cycle will likely be over by the September quarter 2019 and this will have a material impact on financial markets.

Early days of course with this idea, but after a market rallies to levels no one could ever have imagined, I prefer to get out and let those who were wrong try to keep a headline by jumping on an already overpriced market.

I think there may be a turn in the interest rate cycle next year with a hike or hikes in the second half of 2020, but I will leave that for another day.

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The Reserve Bank of Australia needs to be congratulated for publishing research which implicitly confirms that it made a mistake when setting monetary policy in the period mid-2017 to early 2019.

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The costs to the economy includes lower GDP growth and higher unemployment, that lasts for at least for several years.

A few terms first.

According to the Saunders/Tulip research, “leaning against the wind”, a term widely used in central banking, is “the policy of setting interest rates higher than a narrow interpretation of a central bank’s macroeconomic objectives would warrant due to concerns about financial instability”. In the RBA’s case, the “narrow interpretation” of the RBA’s objectives are the 2 to 3 per cent inflation target and full employment.

In the context of the period since 2017 and despite the RBA consistently undershooting its inflation target and with labour underutilisation significantly above the level consistent with full employment, the RBA steadfastly refused to ease monetary policy (cut official interest rates) because it considered higher interest rate settings were appropriate to “lean against” house price growth and elevated levels of household debt.