While rising rates may cause periodic jitters in sharemarkets and will likely slow down their pace of advance, they won’t be a major problem for shares until rates reach onerous levels. This is unlikely for several years given lingering economic uncertainties, massive excess capacity globally and low inflationary pressures.
The key interest rate to watch is the US Fed Funds rate which is likely to take longer to start rising. A rising interest rate differential in Australia’s favour will accentuate upwards pressure on the dollar, with another go at parity likely in the next 12-18 months.
Last year and into early this year interest rates around the world were cut to emergency low levels to combat the fallout from the global financial crisis.
Monetary easing along with fiscal stimulus has been successful. With the crisis fading into history and economic conditions on the mend it’s only a matter of time before interest rates start to move up towards more ‘normal’ levels. This will naturally cause some consternation.
However, there are several points to note. Firstly, the fact the interest rate cycle is likely to start turning up should be seen as a good thing. Interest rates only collapsed because of the global financial panic and economic collapse. Rising interest rates will signal a return towards normality – better economic conditions and improving job prospects. They will only start rising because abnormally low rates have done their job and leaving them indefinitely at emergency lows will only encourage too much debt to be taken on and new asset bubbles.
Secondly, countries that have had relatively mild downturns and/or are likely to return to more normal conditions more quickly are likely to move well in advance of countries that have had deeper downturns and have more fragile financial systems and recoveries.
Australia’s downturn has been far milder than expected and a bit of a non-event by global standards. The failure of the expected recession to materialise along with improving trends in most housing indicators, consumer confidence, business confidence, business investment, and in forward looking labour market indicators along with increasing signs that the unemployment rate may be at or close to a peak suggest the recovery is becoming self-sustaining and the Reserve Bank of Australia will soon start to gradually raise interest rates. We now expect the RBA to start moving before year end and see the cash rate reaching 5% by the end of 2010.
Similarly, while Asian and emerging countries generally had a sharp downturn in growth they are recovering very quickly and, led by China and India, are also likely to start raising interest rates in the next 6 months.
By contrast, the US, Europe and Japan have had very deep downturns, greater increases in unemployment and will likely take longer to recover given various structural problems including the constrained flow of credit and the desire by households to reduce debt. Given this along with the likely absence of inflationary pressure for years to come and the need to unwind quantitative monetary easing first, they are likely to be slower to start raising rates. The Fed is unlikely to start moving until around mid next year.
Thirdly, just because interest rates are starting to rise doesn’t mean they are going straight back to previous highs. With inflation being relatively benign, uncertainty remaining regarding global growth and still high household debt levels making them much more sensitive to higher interest rates, the process of raising rates is likely to be gradual. In Australia, the RBA is likely to move in occasional spurts then pause to assess the impact, much as we saw through the 2002 to 2008 tightening cycle.
The initial move higher in interest rates will simply be aimed at returning interest rates to more normal levels now the emergency has passed. But what is ‘normal‘? In Australia’s case it has been thought the normal level for the cash rate is around 5.5% to 6%, which is around Australia’s nominal long-term potential growth rate. However, the gap between bank lending rates and the official cash rate is now 1 percentage point or more higher than was the case before the credit crisis began. Given this, it’s likely the normal level for the cash rate may have fallen to around 5%. Our view is that the 5% level for the cash rate in Australia won’t be reached until the end of 2010 and that monetary policy won’t move into tight territory (judged to be 6% or more) until 2011 or 2012.
Another way to assess whether monetary policy is tight is when the yield curve becomes inverse (where the cash rate rises above 10 year bond yields) as it is usually only then when economic growth starts to become vulnerable.
With 10 year bond yields now at 5.4%, the cash rate will have a long way to increase before monetary policy can be described as tight. Similarly in the US where the Fed Funds rate is now near zero and the bond yield is 3.5%.
The relationship between rising interest rates and the share market is ambiguous. While higher interest rates place pressure on share market valuations by making shares look less attractive, early in the economic recovery cycle the impact is offset by improving earnings growth. The chart below shows the official cash rate and share prices in Australia since 1980, with cash rate tightening cycles shaded. Sometimes rising interest rates seem to have been bad for shares, as in 1994 for example, but others times this has not been the case, for example between 2003 and 2007 shares went up as interest rates rose.
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