Interest rates have shown some signs of basing and starting to rise over the past month. The main force driving the move seems to have been enough momentum building in US growth and prospective inflation to make it more likely that the US Federal Reserve will lift its funds rate by 25bps if not at next policy meeting in November then at the one beyond in December. At the same time, the Reserve Bank here in Australia, is providing more signals that it may be some time before it considers any adjustment to its 1.50% cash rate. Data readings in both the US and Australia over recent weeks have been consistent with relatively firm economic growth. The forces drifting longer-term interest rates upwards may persist in the near-term but it is unlikely in our view that interest rates will rise far as other forces – persistently low inflation, excessive global savings relative to investment needs, and central banks with even bigger purchases of assets – all return in 2017 to push down interest rates to new low points.
Longer-term interest rates have blipped higher this past month. Australia’s 2-year government bond yield is up 14bps to 1.69%, while the 10-year bond yield is up 23bps to 2.19%. The bond yield curve has tipped and has developed a more positive shape and bond yields of each maturity now sit above the 1.50% cash rate. Australian financial markets are starting to remove any expectations of further cuts to the cash rate and beyond 2017 are building in expectations of small increases in the cash rate.
This process of bond yields rising may run further over the next month or two. Over the next few weeks the Australian Q3 CPI report will probably show that annual inflation stayed very low – around 1% y-o-y on all measures and well below the RBA’s 2-3% target band. Earlier this year very low quarterly inflation readings drove the RBA cash rate cuts in the May and August policy meetings just after the inflation reports. This time, the RBA is operating to a slightly differently worded mandate that provides the flexibility to overshoot or undershoot its inflation target for almost as long as it likes. More importantly the tenor of the RBA’s comments about the economic growth outlook has changed over the past three months and it is tentatively optimistic that the headwinds to Australian growth from falling export prices and mining investment are largely spent while the rebalancing of growth drivers for the Australian economy has progressed pretty well. These days, when the RBA says that interest rate settings are about right for the economy, it actually means it.
The key point is that the RBA’s November 1st policy meeting is likely to come and go without a rate cut and even if the Q3 CPI report in late October shows very low annual inflation. The absence of a November cash rate cut may add more upward momentum to Australian bond yields. That momentum will probably be reinforced as bond markets everywhere start to factor in the strong likelihood of a rise in the US Fed’s funds rate in December. Of course, both the absence of a November rate cut in Australia and a December rate hike in the US are dependent on the relative strength of the economic data in both countries and the absence of any big disruption in global financial markets, but the current run of data is on balance quite strong and while there are pockets of over-valuation in some financial there is no obvious precipitating factor for a crisis to develop in the next month or so although there are simmering issues in banks in Europe and China and Australian housing that make the possibility of crisis developing in 2017 a small but growing risk.
Our base case is now no November Australian rate cut but a rate hike in the US in December. How much further upward pressure on Australian bond yields these events will produce is a little hard to assess, but we view a reasonable estimate is perhaps as much pressure as has already been exerted over the past month, or another 20bps or so on the 10-year bond yield taking it above 2.40%.
By Christmas it is likely that Australian home lending institutions will have suffered upward pressure on their funding costs the equivalent of at least one 25bps RBA rate hike. We see considerable pressure developing on home lenders to at the very least start to lift interest rates on their fixed interest rate home loans with some pressure to lift their variable rate home loan interest rates too.
Australia’s housing market is precariously poised. On many measures some cities such as Melbourne and Sydney are in what appears to be bubble territory with prices continuing to escalate on the basis that there are enough home buyers, mostly investors of the local or foreign kind, who believe that prices will continue to rise regardless of increasing residential rental vacancies, falling yields, tightening local lending conditions and more draconian controls being placed on investors getting their money out of countries like China. At the same time new homes are starting to be built in numbers that outweigh the growth in people available to buy and rent them. The cracks are showing in an increasing number of failures to settle buy off the plan purchases, although such is the power of the bubble that new and even riskier funds rise briefly to buy new unit developments that could sit mostly empty for a long period ahead.
Add even a small lift in home loan interest rates in to the precarious housing mix and it becomes a near-certainty that housing activity will diminish and home building activity will fall at some point next year. As housing activity declines retail spending growth, not particularly strong to begin with, comes under downward pressure. In these circumstances, annual GDP growth is likely to moderate and what growth there has been in employment turns tail too. The unemployment rate tends to drift up.
This potential weakness developing in the Australian economy is the key reason why we see the RBA considering more interest rate cuts from around May or June next year. The longer term forces of secular stagnation in the global economy, notably still falling producer prices and more savings being generated than the world can invest add potency to the lower for longer interest rate outlook.
Australian bond yields are rising for the time being. They may rise further over the next month or two, but next year the forces pushing interest rates lower are likely to return and powerfully in our view.