INTEREST RATE OUTLOOK

Mar 21, 2018
Michael Matusik

Forget trying to read the economic entrails, let alone the RBA’s warbling when it comes to interest rates.

A good way to anticipate the likely direction of interest rates is the yield curve.

The yield curve is 10 year government bonds minus 90 day bank bills.

Recent history suggests that when the difference between long-term and short-term rates is below 0.50% then official interest rates often fall.

Our first chart clearly illustrates how accurate the yield curve has been in the recent past when it comes to RBA cash rate movements. In simple terms there are two types of interest rates – short-term rates (the ones that central bankers control) and long-term rates (the ones that markets control).

Short-term rates, whilst in some cases are now rising; are still set very low in an attempt to stimulate the economy.  For example as at February 2018 the United States Federal Funds Maximum Target Rate was 1.38%, the Japan Policy Rate was -0.10%, the Euro Area Refinancing Rate was 0.00%, the United Kingdom Bank Rate was 0.50%, the Canada Target Rate was 1.25% and the Australia Target Cash Rate was1.50%.

Long rates (i.e. government bonds) are now much higher, with for example, the Australian 10 Year Bond Rate averaging 2.86% during February this year.

We are incorrectly led to believe that interest rates only respond to inflation.

However, deflation can also take rates higher, but for a different reason – a shrinking economy makes the private and public sectors more susceptible to default.

Another thing that many don’t realise is that our banks now source around a third of their funding from overseas and the amount of money we borrow from international markets has increased markedly since the GFC.

Chart 2, below, shows the official RBA cash rate and cost of a variable home loan for owner-occupation from a bank.

Our third chart this post shows the difference between the cost of a variable home loan in Australia and the RBA’s official interest rate setting. One of the major reasons for the widening difference is that the cost of overseas credit is more expensive than locally sourced funds.  Our high level of debt is a factor.

Plus overseas interest rates are rising and this is expected to continue.

The reason they are rising is because the market thinks that there is an increasing chance that the money borrowed will not be fully repaid, so the cost of borrowing long-money is rising to reflect this higher perceived risk.

This increased cost is factored into our home loan rates.

This trend, coupled with already high levels of debt, suppressed wages and rising expenses in Australia, could become a serious brake on our economic growth.

That is why I think that the RBA could be forced to drop the cash rate – not increase it – over the next twelve months.

I would not be surprised to see the cash rate fall by 0.5% to 1.00% by the end of fiscal 2019 in an attempt to keep mortgage rates steady.

With a close federal election coming up soon, those in power will do almost anything to keep the gravy train moving.


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Until next time,

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Michael Matusik

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