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How high will interest rates go? Economists, markets at odds with billions at stake

Lewis Jackson  |  06 May 2022Text size  Decrease  Increase  |  
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Is Australia the lucky country? Can the Reserve Bank be trusted? These are the questions at the heart of a widening gulf between economists and traders over the cash rate's future.

Investors in the cash rate futures market are betting interest rates will hit 2.9% by year end, a level not seen in almost a decade. But economists at high street banks and investment houses expect roughly half that, around the 1.5% mark.

If the futures market is right, variable-rate borrowers and businesses could see interest bills jump double-digits in eight months. Monthly repayments on a million-dollar mortgage would soar over $6,000 in some circumstances.

David Plank, head of Australian economics at ANZ, respects markets pricing but says “it’s pretty normal for market expectations to overshoot where the cash rate actually gets.

“We’ve seen in previous cycles that the market gets carried away,” he told Morningstar.

Economists like Plank are more modest about the cash rate’s future path for two reasons. Firstly, Australian wage growth is slower than global peers, and a web of enterprise bargaining agreements are likely to keep it that way. That should help restrain inflation. Secondly, with much of Australia’s $2 trillion in mortgage debt at variable rates, small cash rate hikes should slow economic activity enough to bring down inflation.

Futures traders are sceptical about this lucky country narrative, says Plank. They see Australia as only lagging the runaway inflation experienced by the US, where interest rates are tipped to hit 3% by December.

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“There’s a bit of a Pavlov’s dog response, the US markets price in more and we price in more,” he says.

“Lot of offshore investors are listening to the RBA claiming things are different and not believing it. Plenty think the RBA will eventually have to capitulate and tighten a lot more than it thinks it will.”

Early signs of a capitulation were on display Tuesday when the Reserve Bank surprised forecasters with an outsized 0.25% hike. Making clear more would follow, Governor Philip Lowe acknowledged “embarrassing” forecast mistakes and that “we should have done better”. The bank’s updated numbers, released on Friday, see inflation peaking at 6% this year, up from the 3.25% it reckoned in February. Wages growth was also bumped up.

Economists modestly shifted upwards following Tuesday’s mea culpa. Westpac now expects 1.75% by year-end, up from 1.25%. Commonwealth Bank raised its December target from 1% to 1.35%. ANZ eased up to 1.6% from 1.5%.

Andrew Lilley, a rates strategist at investment bank Barrenjoey, says economists unsure about the future let themselves be swayed by a Panglossian Reserve Bank. As old forecasts are binned, they’re reluctant to perform the U-turn required.

“When you’re not exactly sure what’s happening it’s very easy to listen to the man who has a monopoly on what the RBA is going to do,” says Lilley. “The problem is there is a tendency of people overusing that comfort and looking at what Phil Lowe said last instead of what has changed since he said it.”

“Bank economists move slowly, the market moves faster. The market doesn’t have to pay attention to a narrative, it just has to get the number right.”

Futures markets have long taken an aggressive stance on the cash rate’s path. A rate hike in 2022 was priced in as far back as nine months ago, a time when Governor Lowe was insisting rates were likely to stay flat until early 2024.

Despite the track record, most of the ten fixed income traders, economists and analysts Morningstar spoke to believe the futures market’s forecasts are excessive.

There’s an enormous amount of uncertainty out there and market pricing can “turn on a dime” should the data change, says John Likos, director at fixed-income researcher and manager BondAdviser.

“Historically, cash rate futures are terrible at predicting interest rates,” he says while acknowledging they often fare better than economists.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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