Yahoo Finance Why the next interest rate move could be down
A slowing economy, weaker jobs growth and falling inflation have some predicting the RBA has finished hiking rates.
In the wake of the Reserve Bank’s (RBA) decision to hold interest rates steady at its April board meeting, Australian financial markets are now pricing in no more rate hikes. None. Nil. Zilch.
According to market pricing, the interest-rate-hiking cycle is over. It ended with the rate hike in March 2023.
This begs the question, what happens next to interest rates?
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Over the next six months or so, there is a very strong probability that interest rates will remain on hold. After that, financial market expectations are that rates will be cut. Yes. Cut, from late 2023 and into 2024.
The market traders who ‘price in’ the outlook for official interest rates are ignoring the guidance of the RBA and a series of market economists - who still reckon the next move in rates is up - and are buying money market securities on the expectation rates will be cut.
Perhaps the best way to show the medium-term pricing outlook is via the yield on the 3-year government bonds, which is around 2.80 per cent, 80 basis points below the current official cash rate. 3-year bond yields peaked at 3.75 per cent in late 2022.
The 3-year bond is a risk-free security issued by the government. In other words, the government borrows the money for a three-year term. The yield over that term is a market benchmark for broad expectations for official interest rates over that period.
Why are traders pricing in interest rate cuts?
There are many reasons why the market pricing is so aggressively aimed at rate cuts.
Most basically, the economy is slowing. GDP growth has already eased from an annual pace in excess of 5 per cent to 2.7 per cent. On current projections, and with retail spending falling in real terms, annual GDP growth is set to drop to a weak 1 per cent pace during 2023.
This is seeing the labour market showing the early stages of a slowdown. Job advertisements and vacancies are in a clear move lower, which has seen employment growth ease in trend terms over the past six months. While the unemployment rate is yet to increase, the economic growth outlook points to it rising to around 4.5 per cent in late 2023 and 2024. The economists at Westpac reckon the unemployment rate will hit 5 per cent.
Inflation is also falling. While the actual inflation rate is still well above the 2 to 3 per cent target of the RBA, it has eased globally and, in Australia, commodity prices are materially weaker now than at their peak in the middle of 2022. Wages growth is also not at a pace that threatens to feed into inflation in any concerning way.
There is hot debate among economists on the outlook for inflation – how quickly will it fall?
This is why each reading on inflation, including the monthly results, are so critical to the monetary policy and interest rate outlook. Markets are implicitly expecting inflation to fall more rapidly than the RBA is currently forecasting.
It is also the case that there is a lot of policy tightening in the pipeline, much of which is yet to impact on growth and inflation.
The market knows that when the full effect of 350 basis points of rate hikes comes through from the 2022 and 2023 tightenings, growth will have even more downside risks from the hard data already pointing to slower growth.
This means not only are no more hikes needed, but that some reversal of the restrictive stance of monetary policy will be needed to avoid the risk of recession. This feeds the view that interest rate cuts will be needed.
Budget also working to help inflation fall
It is also noteworthy that the Albanese government has a tight hand on budget policy, which will help to cool demand and inflation pressures in the economy. The latest numbers from the budget - which will be updated next month - show that real government demand will fall 2.2 per cent in 2022-23, followed by a fall of 1.0 per cent in 2023-24.
Fiscal policy is clearly restrictive and working hand in hand with the RBA to get inflation lower.
It is important to recall that the market ignored RBA governor Philip Lowe’s late-2021 guidance that rates would be on hold at 0.1 per cent until 2024.
Before Lowe acknowledged the error of this call, the 3-year bond yield had risen to around 1.75 per cent. The markets were right and the RBA was wrong.
It looks like we are in for a repeat of this in 2023 and into 2024, this time with the market pricing in rate cuts when the RBA reckons it needs to hike some more.
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