The RBA left its cash rate unchanged at 1.50% at its September policy meeting and the accompanying statement and subsequent minutes still imply a bias to leave the cash rate unchanged for a few more months. Factors dictating leaving the cash rate unchanged include low inflation (2.1% y-o-y in Q2 with underlying measures around 1.8%); very low wages growth; very high levels of household debt and the relatively high Australian dollar exchange rate. However, there are factors pointing to the need to start lifting interest rates including the increasingly severe distortion of investment decisions from leaving interest rates too low for too long; undue encouragement for the already heavily indebted household sector to borrow more; clear signs that parts of the economy are growing strongly; the tightening labour market as employment growth puts on its strongest burst since the beginning of the century. Another factor likely to influence future RBA decisions is momentum building in the global economic recovery and the first signs of internationally-based upward pressure on local inflation emanating from rising producer price or factory gate prices in many economies including Australia’s key import supplier, China.
The RBA has maintained an economic view over recent quarters that can be characterised as Australia’s economic glass is more than half full and in time annual inflation will lift to the middle of its 2-3% target band. In its guidance on the future course of interest rates the RBA has been clear that the next move in rates when it comes is likely to be upwards and that the current interest rate setting is unusually accommodative. It has also made it clear that a neutral interest rate setting is around 3.00% to 3.50%, although that estimate can change depending upon factors such as the strength of the currency, it is clear that the neutral setting for interest rates (the minimum target for the RBA if its current economic forecasts come to fruition) is at least 100bps above the current 1.50% cash rate.
Apart from these local factors leaning towards higher interest rates next year, global bond yields appear to be moving higher too. The US Fed has confirmed it sees another 25bps rate hike late this year (the fifth in the current cycle) and another three 25bps hikes in 2018. The Bank of Canada has recently delivered its second cash rate hike. Central banks are also either reducing QE asset purchases or in the case of the Fed are about to start reversing QE with regular net bond sales. We see a high risk that bond yields may rise around 100bps or more from their current levels over the next six months. Higher interest rates may cause financial markets to question whether the global economic recovery will falter. These occasional doubts about economic growth prospects in both the US and Australia imply a flatter yield curve developing with short-term rates rising quicker than longer-term rates for a period.