Between a drop and a hard place

David Potts

October 8, 2011

Illustration: Rocco Fazzari

As the Reserve Bank goes to one extreme on interest rates, it seems the market is determined to go to the other.
IN THE Reserve Bank's gilded cage, the hawks have had their wings clipped and the doves don't seem to be in a hurry to fly.
Only the resident galah in any pet shop is talking about a cut in interest rates, in those memorable words of Paul Keating.
Except this time it's not the economists, who are mostly talking about the opposite happening next year - cutting rates to boost the economy when it's going through its biggest-ever income boost does look a bit lemming-like - but money speculators.
Rates are dropping like flies without the RBA lifting a finger. Only on variable home loans have they stayed put and even then the banks are knocking off up to 0.8 of a percentage point, making the going rate more like 7 per cent.
They're even discounting fixed rates - which have already fallen - if you ask nicely.
In the bond market, there's been a rally of sharemarket proportions. Since the start of the year, the returns on government bonds have soared 25 per cent.
I can't remember such a spirited contradiction between what the Reserve Bank is saying and what the market is doing. Somebody is going to get hurt badly.
But for now it seems the galahs will have their day. The RBA is keeping, er, an eagle eye out for the inflation reading on October 26 which is bound to be subdued.
For the first time since it began hiking rates, in its latest board minutes the RBA has dropped a hint that it's prepared to change its mind. Eating humble pie is especially difficult for a central bank, which has a mystique of infallibility to preserve.
Dropping rates at the whim of the market one minute, only to have to hike them the next because of what the economy is doing, wouldn't be good for its credibility.
It has already admitted the economy is weaker than it thought, as the June quarter gross domestic product figure inconveniently proved the day after its previous board meeting. Things haven't improved since then, except that, much to everybody's surprise, especially retailers, the Australian Bureau of Statistics says retail sales are picking up.
Talk about one from left field.
Nor can the RBA ignore the potentially gargantuan investment boom, which - if it's going to be half as good as it looks - will knock the socks off the economy.
That would be inflationary, for which it would quite rightly cop the blame.
The good news is that inflation is also lower than the central bank thought, due to a technicality. All right, a statistical slip-up at the ABS but who hasn't miscounted at some time?
However, there's the little problem of rising wages when productivity is falling, which is almost the definition of what causes inflation. That would keep any decent central bank awake at night.
The suddenly weaker dollar is going to ruffle a few feathers, too.
Only a month ago, the RBA was saying a strong dollar was ''having a noticeable dampening effect'', which was a reason for not raising rates.
This makes its fall an unfortunate - and what might prove a telling - complication.
If rates can't rise because the dollar is strong, they can't fall because it's weak.
So while the RBA is at one extreme, the markets have gone to the other.
Pricing in a 1.6 percentage-point drop by May - that's 6½ rate cuts, or one a month, including January when the board is on holidays - borders on hysteria.
And who knows what to make of the yield on 10-year bonds of 4.2 per cent (two rate cuts under the RBA's official overnight cash rate, no less) or only 3.6 per cent on three years.
Does the market really believe inflation will be so low for a decade that a 4.2 per cent return is hunky-dory?
By the way, the three-year yield is why fixed-rate home loans have been tumbling. And, yes, there's room for them to drop further.
The banks must be having a field day borrowing well below the cash rate, then lending to the RBA for more at no risk.
But then, as they say, birds of a feather flock together.

Saturday, 8 October 2011

.As the Reserve Bank goes to one extreme on interest rates, it seems the market is determined to go to the other.

Between a drop and a hard place

David Potts

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