Are we there yet? – on cash rates

Synopsis –  over the past 18 months, central banks have delivered the most aggressive rate hikes in a generation, but cash rates in Australia, US and elsewhere are still below pre-GFC levels. "How high will interest rates need to go?" asks Ashley Owen

For both Australia and the US, there are probably more rate hikes ahead. Even though both the RBA and the US Fed have ‘paused’ on rate hikes at their latest meetings (13 June for the Fed, 4 July for the RBA), it is likely that more rate hikes are in store. In the short term, jobs markets are still strong, wages are rising, and consumer spending is still strong.

There is still too much cash sloshing around our economies. Whether or not there are recessions in the coming year (which would bring temporary rate cuts to stimulate growth), interest rates at the short end, and especially the long end, are likely to be heading toward higher levels in the medium term.

In order to assess ‘Are we there yet?’, what we are really asking is ‘How high will cash rates go?’ There are two subsidiary questions.

• The first is: ‘What is the ‘neutral’ or ‘natural’ rate of interest?’.
• The second is: ‘Will central banks need to take rates above the ideal neutral rates in order to bring down, and keep inflation at target levels?’

The future is impossible to predict, of course, but what we can look at is expectations. In financial markets, it is expectations of future events that drive asset prices, much more than the actual events themselves when they eventually occur. (For example - elections, invasions, bankruptcies, trade wars, tax changes, rate hikes, profit announcements, take-overs, and many other key events).

Fortunately, expectations are relatively easy to observe and measure. For expectations of future interest rates, we can use ‘yield curves’. 

The next two charts show the yield curve in the US (left) and Australia (right). (We focus on the US because our local markets are affected much more by US events than local events). The yield curves show interest rates for different terms – from cash on the left through to long term fixed rate government bonds to the right.

Different colour dots/lines represent the set of interest rates at different points in time. The starting point in these charts is the end of December 2021 (maroon yield curve at the bottom of the charts before the 2022-3 rate hikes).

By  Ashley Owen, CFA

On both charts, short term cash rates jumped with the rate hikes. Long term rates also jumped up with rising inflation, peaked in October 2022, and have been more or less flat since then (relative to the big initial jump). In October 2022 there was a pivot to less aggressive rate hikes from central banks.

The October 2022 pivot ended the spike in bond yields, and sent share markets soaring, on the goldilocks assumption that inflation will fall back to target neatly without deep recessions.  In the June quarter 2023, the whole yield curve in both markets rose across all maturities from the end of March (red) to the end of June (purple).

This means the market (investors as a whole) is now expecting more rate hikes, and stickier inflation.

The rises in yields across the board in the June quarter produced losses in bond markets for the quarter (although bond yields/returns were flat in Europe and Japan).  

On both charts we have also included the likely long term ‘neutral’ interest rates (grey) which are still well above the current set of interest rates, especially for longer terms. The grey dots represent where interest rates would normally sit (or average) when inflation is running at (or averaging) around 2% in the US and 2-3% in Australia.

This brings us to the first question.

There has been much discussion and debate in monetary policy circles about what is the ideal neutral cash rate in an economy to keep inflation at target levels and at the same time maintain full, or near-full employment.

Over the past four decades of post-Keynesian monetarism, the working hypothesis has been that the neutral cash rate is around the expected long term nominal average rate of growth of the economy.

This comprises the expected long term average real rate of economic growth (say 2.5%-3% pa for both Australia and the US, comprising population growth plus productivity growth plus changes in participation rate), plus the expected long term expected average inflation rate (say 2% in the US and 2%-3% in Australia).

This would imply long term average neutral cash rates of at least 4.5%-5%, and is consistent with the historical average cash rates over the past four decades in Australia and the US.

However, the recent debate has been about whether certain factors will reduce the neutral cash rate in future. These include: the global decline in population growth, declining union membership and power, the decline of productivity growth, and declining/aging population - especially in contracting/old population economies like Europe and Japan.

On the other hand, other factors are at work that may increase inflationary pressures – including de-globalisation/’de-coupling’/’de-risking’/on-shoring of global supply chains, rising cost of capital for fossil fuel producers, increasing monopoly pricing power, and military build-ups in all major markets, even in Japan and Germany for the first time since WW2.

Only time and experimentation will tell us what the neutral cash rate is for each country. (That’s all we need – more central bank experimentation!)

Our base case is that neutral cash rates for Australia, US, NZ, and Canada (all have strong immigration and favourable demographics) are probably little changed.

The US is probably at or near its hypothetical ‘neutral’ cash rate, but jobs markets are tight, wages are rising, and spending is still strong, so cash rates will probably need to raised further, as the Fed warns.

In Australia, the RBA’s rate hikes started later, were less aggressive. Cash rates are lower (still probably some way below ‘neutral’), and inflation is higher here than in the US.

Rates on fixed rate treasury (government) bonds tend to sit above cash rates to reflect a ‘term premium’ for being locked in for the term of the bond.

The longer the term, the higher the term premium above cash. Historically, rates on 10 year bonds in Australia and the US have averaged around 1% to 1.5% above prevailing cash rates in their respective markets. Hence the upward slope of the estimated neutral interest rates curve (grey) in the charts.

While most media commentators are obsessed with the question of ‘recession’, investors are more interested in the impact of rate hikes on corporate profits and dividends. Share markets are already pricing in mild cuts to profits, but they are assuming the profit dip will be short and shallow.

If the US economy has a serious slowdown (eg major collapses in employment, spending, production, profits, and inflation) then the Fed would cut rates to re-stimulate. That was what the end of March downward-sloping yield curve (red on the charts) said about the US. In the recent June quarter, expectations changed. In the US, the change between end of March (red curve) and end of June (purple) indicated that the inflation is turning out to be stickier than hoped, and will require the Fed to lift rates well above 5% over the next year.

This is a rather bearish outlook from bond markets. On the other hand, share markets have soared back to expensive levels since the October 2022 pivot, on the assumption of ‘soft landings’ for economies, inflation, and interest rates, without deep recessions, and with little impact on profits and dividends. On a number of measures, share markets have probably run somewhat ahead of themselves in assuming profits and dividends will not significantly weaken in 2023-4, due to the lagged impacts of rate hikes and mortgage refinancings. The share and bond markets cannot both be right. 

In Australia, the cash rate is still a distance below the likely ‘neutral’ rate, and inflation is not coming down as quickly as it is in the US, so we may see a few more rate hikes from the RBA. Whether or not there is a recession in the short term, interest rates and bond yields are heading upward in the medium term (say 3-5 years) toward the grey ‘neutral’ interest rate curve.

One major difference between Australia and the rest of the world is that the majority of home loans in Australia are floating rate, which are much more directly and immediately impacted by rising cash rates.

We are yet to see the full impact of recent rises on mortgage repayments and household spending. We also have some 800,000 fixed-rate ‘starter loans’ converting to much higher floating rates this year. This will more than double their monthly repayments, cut into discretionary household spending, and increase mortgage stress.

A further factor is the emerging construction slowdown. It may well be that the RBA’s work has already done enough to cause big reductions to household spending, jobs, and inflation in 2023, but it will take a few more months for the lagged effects to fully reflect the RBA’s rate hikes to date. 

How does Australia rate on household debt levels? See ‘How do we rate – the Debt Olympics

The longer end of the yield curve is important for another key reason. In corporate finance theory, the yield on 10 year government bonds is the so-called ‘risk-free’ rate that underpins asset valuations, especially for ‘income’ assets like real estate and infrastructure.

Even if the neutral cash rate is as low as say 3.5% or 4% in the US and Australia, the term premium of around 1.5% on 10 year bonds would take the neutral yield on 10 year treasuries to 5% to 5.5%. This is 1% to 1.5% above current levels, and it would mean valuations on income assets would fall significantly.

Over the past two years, listed property and infrastructure funds have already sold off heavily (lagging listed shares badly) in anticipation of possible downward revaluations to the underlying assets caused by rising bond yields and discount rates. However, unlisted, or ‘private’ market valuations have their heads in the sand.

In the middle of 2023 we are only now starting to see downward valuations start. Several large US unlisted funds have frozen or gated redemptions to prevent investors from getting out before the downward revaluations. 10 year treasury yields are just 4% in Australia and 3.8% in the US, but both are probably heading above well above 5% in the medium term as cash rates return to ‘neutral’.

We can expect more pain in unlisted/private property and infrastructure funds.   

This article is written by Ashley Owen, CFA and the views expressed are his own.

Ashley is a well known Australias market commentator with over 40 years experience.

Formal qualifications:
• LLB, LLM - University of Sydney
• BA (economic history, international relations) – Deakin University
• Grad Dip, Applied Finance & Investment - Securities Institute of Australia (FINSIA)
• CFA Charter – CFA Institute

Membership & associations:
• CFA charter holder
• Signatory to the UN Principles for Responsible Investment
• Occasional member, Education Advisory Board Working Committee of the CFA Institute (US)