The unusually big lift in bond yields around the world over the past month is causing us to revisit our interest rate forecasts. We still expect interest rates to stay low over the long-term, but with a significant blip in the low interest rate phase featuring through late 2016 and early 2017. As far as central banks are concerned, we now see a high risk that the US Federal Reserve will lift its funds rate by 25bps at its mid-December policy meeting. We also see a likelihood of another 25bps lift in the Fed funds rate in the first half of 2017. We also no longer expect the RBA to cut its cash rate in mid-2017. Instead we expect the RBA cash rate to be stable at 1.50% throughout 2017.
The factors that have caused us to change our central bank rate forecasts are signs of better growth in the United States not linked to the US election outcome. In Australia too, there are signs that reasonably strong economic growth will persist longer than we thought likely previously. There are also the first signs that the RBA is thinking aloud about very high household debt and while it considers that households can probably manage their debt burden it is probably unwise to encourage the build-up of even higher household debt.
Changes in financial market pricing since the US presidential election have also been in part attributed to the possibility of more of pro-growth fiscal policy changes under President Trump. We recognise that bond yields have risen particularly sharply since the US presidential election result, but our views about central bank interest rate changes are largely independent of the upward movement in bond yields which seem to be over-reacting given that it is still far too early to assess what a Trump presidency may mean for interest rates.
Last week we wrote about the uncertainties surrounding what the impending Trump presidency will mean for the US economic outlook. As we wrote, it is likely to take many months before it becomes clear whether the parts of Trump’s policy proposals that might be deemed positive for growth over time – lower tax rates, more government infrastructure spending and lower company regulation – or those that look negative for growth – immigration controls and trade protectionism feature more prominently in Trump’s actual policy program in office.
Regardless of what the Trump-effect eventually turns out to be on economic growth and interest rates, something else has been happening independently of the US election. US economic growth has been showing signs of picking up pace through 2016, from under 1% annualised pace in Q1, to 1.4% in Q2 and 2.9% in Q3. Moreover, the US economy still seems to be accelerating early in Q4. Retail sales have registered very strong increases in both September (upwardly revised to 1.0% m-o-m) and October. US housing activity seems to be enjoying resurgent strength in September (existing home sales up 3.2% m-o-m and new home sales up 3.1%) and October (housing starts up 25.5% m-o-m. the strongest monthly gain since 1982). The US labour market is still looking very strong too with little spare capacity.
While US inflation is still reasonably well contained, pipeline inflation pressures are showing signs of life. The Federal Reserve has a relatively compelling argument that official interest rates are now too low for an economy performing quite well. We see the Fed lifting its Funds rate in December and probably raising the Funds rate again at its second or third policy meeting in 2017.
As far as the RBA is concerned, there are no US-style reasons to think about raising the cash rate. Household spending growth is OK, but not particularly strong. Housing activity is very strong in parts – New South Wales and Victoria – but ranging to very weak in other parts – Western Australia and regional parts of South Australia and Queensland too. Retail spending although a touch better in August and September actually fell in volume terms in Q3. Inflation is low and stable and wages growth is still very soft.
The rest of the world is travelling a little better, however, with growth stabilizing in Australia’s biggest export market, China, and signs of stabilizing or improving growth in the US, Europe and Japan. Australia’s export volumes and prices are looking better.
The RBA has no compelling reason to consider cutting the cash rate further, but it has one increasing reason preventing it from cutting the cash rate any further – the low interest rate fuelled investment housing boom continuing to blow out Australian household debt to income ratios to record high levels. While the RBA is not concerned that households have taken on more debt than they can manage, it recognises this could become the case if debt levels continue to balloon the way they have been. Higher bond yields may do some work feeding through to higher lending rates and dampening household appetite for debt, but it will probably require signs that the household debt to income ratio has stabilised or even pulled back a little before the RBA would become comfortable about cutting its cash rate again. It is unlikely these conditions will develop over the next 12 months or so.
Our latest Australian cash rate forecast is no change at 1.50% through to at least February 2018. Bond yields have pushed too high on this cash rate forecast but we cannot rule out further upward pressure on bond yields before they eventually top out and then settle to say nearer 2% for the 10-year bond yield later in 2017.