Prepare For A Bumpy Ride As Rates Rise
Investors get ready: we may be entering another “taper tantrum” period in which markets fret about rising interest rates and send equity markets southward.
Indeed, just when it seemed there was little left to excite markets – with measures of volatility and risk plumbing rock bottom levels – a few more central banks have started murmuring about the possible need to begin the process of withdrawing the emergency levels of monetary stimulus put in place almost a decade ago.
Over the past week global bond yields have lifted, equity markets have wobbled, and the US dollar has sunk as it seemed interest rates in countries other than the United States might start to rise also.
Why the commotion? Even uber-dove super Mario over in Europe is now talking about a shift from deflationary to inflationary pressure on the continent. The Bank of England and the Bank of Canada are also inching toward policy tightening. Indeed, the markets now attach a 70% probability to a Canadian rate hike next month, and expectations are rising that the European Central Bank will be winding down its balance sheet by year-end. In the United Kingdom, post-Brexit weakness in the Pound has supported the economy and lifted inflation, meaning interest rates also don’t need to be as low as they are.
But we need not panic. To my mind, acceptance of the need to finally begin re-normalising policy would be a very healthy development. I’ve long argued central banks should stop stressing about low inflation – which is likely to stay low due to weak commodity prices, slowing population growth, global competition and technology - and celebrate the fact unemployment rates have declined and deflationary scares seems well and truly over.
Against this backdrop, a gradual re-normalisation of monetary policies across the global would greatly ease the risks of another financial bubble building anytime soon, and leave central banks with greater ammunition to fight the next cyclical downturn when it inevitably arrives.
It’s just prudent policy. And the Fed has already admirably demonstrated that markets will accept policy re-normalisation if done in a measured and well-telegraphed way.
Finally, more central banks appear to coming around to this view – raising the prospect of policy tightening even though inflation in many of their economies is still a bit lower than they would like.
It’s fair to say markets have certainly become complacent up until now – meekly accepting that only the US Federal Reserve seemed intent on tightening policy, and even then albeit very gradually. So if other central banks are jumping on the tightening bandwagon, some market adjustment will be necessary.
That said, a decent pull back in equities has been long overdue and should represent a great buying opportunity as we transition to the next stage of the bull market driven – not by higher valuations and low interest rates – but rising corporate earnings across the globe.
What about Australia? Will the Reserve Bank also jump on the bandwagon quickly?
Not so fast.
To my mind the nature of global growth is shifting – from commodity–intensive Chinese demand to more technology based services demand across a broader array of economies. Sadly, this growth composition does not favour Australia meaning local economic growth and labour market improvement is likely to lag that of our global peers. It’s nice global growth seems to be improving, but it won’t necessarily lift us out of our quagmire.
Of course, Former Reserve Bank Board member John Edwards grabbed some headlines recently by suggesting the RBA could lift rates eight times (from 1.5% to 3.5%) over the next few years if its currency bullish economic forecasts prove correct.
But in reality nothing of what he said should surprise us. After all, it all hinges on the proviso that the RBA’s economic forecasts prove correct. What are these exactly? The RBA continues to envisage the economy picking up to a 3 to 3.5% pace of growth over the next few years, sufficient to pull down the unemployment rate toward 5% and lift underlying measures of inflation safely into the 2 to 3 per cent target band.
In other words, the RBA’s central case forecasts assume the economy returns to a more or less fully employed “equilibrium”. If that’s the case, it certain makes sense for official interest rates to gradually move back to long-run neutral level also – which now consider to be around 3.5%.
Edwards’ comments were effectively a tautology.
The big “if”, however, is if the RBA’s forecasts prove correct. On this score, I’m still not at all confidence growth to will pick up all that quickly – even with an improving global economy – as we still face the home grown challenges of a looming housing sector downturn, cautious consumers and stubbornly weak business investment intentions.
The best case scenario for us is if other central banks start lifting rates, which in turn helps drag down the Australian dollar to more competitive levels. I’d be more confident on local economic growth – and the prospect of RBA tightening – were the $A around the mid-US60c level, rather than the mid-US70c.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.