OPINION: MORE increases in interest rates are likely in the year ahead as the RBA seeks to move rates towards normal levels. The normal level is now judged to be around 5%.
Australian interest rates have further to rise
The Reserve Bank of Australia has again increased the cash rate by another 0.25% taking it to 3.75%. While much will no doubt be made of the fact the RBA hasn’t increased rates three months in a row since the 1980s, it should be noted that 3.75% is still very low for the cash rate in an historical context. See the chart below.
Source: RBA, AMP Capital Investors
Bank mortgage rates also remain historically low. Assuming the average bank standard variable mortgage rate moves up by the 0.25% hike in the cash rate this would take them to around 6.5%. Apart from in recent months, the last time it was lower than this was briefly just after the 9/11 terrorist attacks and prior to that was in the early 1970s.
While the latest Statement from the Reserve Bank is non-committal regarding interest rates going forward, the RBA’s generally upbeat tone suggests that more rate hikes are likely if the economy continues to recover as expected. This is consistent with our own composite leading economic indicator which is pointing to 4% economic growth over the year ahead.
Source: Thomson Financial, AMP Capital Investors
While there was a case to hold fire this month, in terms of the big picture with economic growth heading back above trend there is no need for interest rates to remain at historically low levels, and so interest rates are on their way back towards a more normal level.
The ‘new normal’ for the cash rate
The normal level for the cash rate is basically the level below which monetary policy stimulates the economy, but above which it acts to slow the economy. So, the big question is, what is the ‘normal’ level for the cash rate? This is important because it may provide a rough guide as to where the RBA is likely to take the cash rate in the next year or so, and it also suggests a level that once we go beyond, monetary policy will begin to constrain the economy and be more of a concern for the share market.
In the past, the normal rate was thought to be around 5.5% to 6%. In theory the normal level of interest rates should be around a country’s potential nominal GDP growth rate. So if Australia’s long term inflation rate is going to be at the mid point of the inflation target (ie 2.5%) and potential real GDP growth is around 3% then this would imply a normal rate of 5.5%. Surprisingly, the average level for the cash rate over the period since inflation targeting began is 5.5%.
However, several considerations suggest the normal level of interest rates may have changed. Two factors are likely to be pushing it up and these are stronger population growth on the back of higher immigration levels, and the boost to national income and mining investment from the commodity boom, which we suspect has much further to go. Against this though, several other factors suggest the normal interest rate may have declined:
· Bank lending rates are running at higher levels relative to the cash rate than has been the case in the recent past. For example, over the 10 years to December 2007, the gap between the standard variable mortgage rate and the cash rate was 1.8 percentage points. It is now 2.8 percentage points. Assuming the gap remains this high, the RBA won’t need to increase the cash rate as much to attain a given level for private sector borrowing rates. The 1 percentage point blowout in the spread between the mortgage rate and the cash rate would suggest that the normal cash rate is now 1 percentage point lower than it was two years ago.
· Secondly, the level of household debt to income has increased in recent years with the result that households are likely to be more sensitive to interest rate increases than in the past. In other words, the RBA won’t have to increase the cash rate as much to achieve a given slowing in the economy.
· Finally, the Australian dollar is running well above the average level that prevailed since the float of around $US0.70, and this will be having a constraining impact on the economy similar to monetary tightening.
Weighing up these conflicting forces suggest to us that the normal cash rate has fallen to around 5%.
With growth improving but underling inflation falling thanks to excess capacity globally, the strong Australian dollar bearing down on import prices and uncertainty remaining regarding the strength of the global recovery, our assessment is that the RBA can continue taking a very gradual approach in raising the cash rate. In fact, having increased the cash rate 3 months in a row there is a case for the RBA to see what the impact has been before moving again, which suggests that the next hike may not be till next March.
Our view remains that the 5% level for the cash rate in Australia won’t be reached until the end of 2010 and in the absence of inflationary pressures, monetary policy won’t move into tight territory until 2011 or 2012.
Interest rates and shares
There is an ambiguous relationship between rising interest rates and the share market. While higher rates place pressure on share market valuations by making shares appear less attractive, early in the economic recovery cycle this impact is offset by improving earnings growth. The chart below shows the official cash rate and share prices in Australia since 1980, with cash rate tightening cycles shaded. Sometimes rising interest rates have been bad for shares, as in 1994 for example, but other times this has not been the case. For example between 2003 and 2007 shares went up as interest rates rose.
Shading indicates cash rate tightening cycles.
Source: Thomson Financial, AMP Capital Investors
Several considerations are worth noting.
Firstly, rising interest rates from a low base are not normally initially bad for shares as they go hand in hand with improving economic conditions. (Just like falling interest rates in a recession are not initially good for shares, as occurred last year.) For example, this was evident during the initial stages of monetary tightening in the late 1970s/early 1980s, the 1984 tightening, through 1988 and through much of the 2002 to 2008 tightening.
Secondly, rising interest rates are only really a major problem for shares when rates reach onerous levels (ie above normal), contributing to an economic downturn, eg in 1981-early 1982, late 1989 and in late 2007 to early 2008. They are also a problem when rate hikes are aggressive, as in 1994 when the cash rate was increased from 4.75% to 7.5% in just four months.
Finally, given the high short term correlation between Australian shares and US shares, what the Fed does is arguably far more important than local interest rates.
So, in terms of the current situation, the rise in Australian interest rates from 3% to now 3.75% is not likely to derail the cyclical bull market in shares as:
· rising interest rates reflect economic recovery rather than a sign of an eventual growth downturn and so the improving profit outlook will provide an offset;
· interest rates are still at generational lows and with inflationary pressures so subdued it will be some time before interest rates reach onerous levels. In fact this is not expected until 2011 or 2012 when the cash rate will rise above the ‘normal’ level of 5%; and
· US rate hikes are unlikely until mid 2010 at the earliest.
Interest rates and the Australian dollar
The Australian dollar is already up sharply from its $US0.60 low last year. With the interest rate differential between Australia and other major countries getting wider, and commodity prices likely to see more upside, the upwards pressure on the $A is likely to intensify.
Source: Thomson Financial, AMP Capital Investors
We remain of the view that the Australian dollar will breach parity against the $US sometime in the next six months.
Concluding comments
Interest rate hikes next year in Australia are likely to be more gradual, taking us up to around 5% by year end. Only when rates move noticeably beyond this and US interest rates rise above normal will interest rates be at levels judged restrictive enough to hurt the economic outlook and hence shares.
By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
Australian Property Journal
