Last week – former RBA Board member – John Edwards – said Australia could see as many as eight rate hikes over the next two years.

We wondered what he might be smoking.

Eight rate hikes in two years!

Imagine the impact… we will dimension it for you:

Let’s say you have borrowed $500,000 (not uncommon in Sydney where the average home price is around $1.0M)

And let’s say you are paying today’s rate of 5.88% over 30 years. Your repayments are $2,959 per month

But let’s bump that rate up to 7.88%…

Your repayment is $3,627…. just over $8,000 a year more.

There goes the kids school fees.

We cited data points such as weak retail sales; the lowest wage growth in two decades; poor business investment; our falling national income; and of course – our record levels of private debt opposite housing.

We were not sure what part of that equation screamed rates are on the way back up?

Edwards contingency was Australia accelerating back to annualised 3% GDP growth.

And if so – this would set for the scene for the RBA to start normalising rates from today’s record lows.

My problem with this (lazy) assumption was identifying where the growth was going to come from?

Another commodity boom? A resurgence in iron-ore and perhaps natural gas?

Maybe Shell’s ‘Prelude’ project off the shelf of WA is enough to drag us there…

Today the numbers are not obvious… not to me anyway.

But perhaps I am looking in the wrong places. Let me know.

From mine, the key to any economy achieving sustained economic growth rests with productive business investment.

Today that’s not in a healthy spot.

To illustrate our point – we shared the following ABS chart:

This is your foundation to greater job and wage growth. However, we are sitting at lows not seen since 2001.

What gives?

Aren’t rates below zero in real terms?

Where are the so-called “animal spirits” the government likes to encourage?

Put it all together – and it was no surprise (to me) our brains trust decided not to raise rates this week:

Here’s some language from the Sydney Morning Herald:

  • Governor Philip Lowe’s statement says while the bank expects the economy to gradually strengthen, growth in consumer spending remains subdued, “reflecting slow growth in real wages and high levels of household debt”

Sounds all too familiar.

But this is important — as consumption currently represents around 60% of Australian GDP.

The article adds:

  • In an apparent reference to risk of pushing up the dollar should the bank lift interest rates, Dr Lowe said the fall in the dollar since 2013 had helped the economy transition out of the mining investment boom.
  • “An appreciating exchange rate would complicate this adjustment,” his statement says

Correct Phil.

A stronger dollar is also deflationary… and works against the central bank’s objective of 2.0% to 2.5% inflation.

As such, you can be sure the RBA are quite keen to keep the AUD below 75c.

Bubble Trouble…

The other ongoing pain point for our bank (there’s a few) is the (obvious) housing bubble we find in Sydney and Melbourne (less so in other capital cities).

According to the statement – housing prices had been “rising briskly” in some markets, although there are some signs that these conditions are starting to ease; in some other markets, prices are declining”.

Briskly refers to the two aforementioned cities:

  • “In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years,” Dr Lowe said. “Rent increases are the slowest for two decades.”

Ahhh…. the old supply and demand property argument.

For me, this fails the sniff test.

You see, whilst supply and demand is a factor with respect to prices — there is no stronger factor than artificially low rates (ie below zero in real terms).

As I like to say — “hand someone free money on a platter – and they will generally take it”

However, the challenge for a central bank is you cannot control what they do with that money.

Record low levels of business investment is case in point. After all, should business be seizing the cheap capital and investing it?

Well they would if they felt real demand was there.

It’s not.

In our case – capital has been grossly misallocated which is adding to the problem around growth.

That is, most of the debt taken has plowed straight into unproductive assets (ie housing). And what’s worse, the activity has been encouraged (by both banks and the government).

Commercial Banks Likely to Raise Rates

Whilst the RBA are not likely to raise rates anytime soon – that doesn’t mean that commercial banks will not start increasing rates. In fact, they already have…

For example, mortgage rates for investors have been edging higher since September.

Australia’s largest domestic lender – the Commonwealth Bank – raised rates for investors and interest-only borrowers last April. Again, from the SMH:

  • Fixed rates on interest-only loans will rise by 25 basis points, while investor home loans that are principal and interest will rise by 25 basis points. Investor loans that are interest only will rise by between 25 and 50 basis points.
  • The big four banks have been lifting rates on investor and interest-only loans after the Australian Prudential Regulation Authority moved to tighten lending in those areas amid concerns about heightened risk in the housing market.
  • The regulator wrote to all banks last month, outlining new requirements for banks to reduce interest-only lending to 30 per cent of total mortgage lending.

And whilst this has had a small effect on the market – it has not been enough to curb the rampant speculation.

On the other hand, if the RBA were serious about curbing speculative money going into house – the answer is simple – start raising rates.

Then watch the impact on the housing market.

Trust me, prices would not be headed higher… irrespective of so-called demand fundamentals.

Key is the US 10-Year Treasury

What our central banks can ‘control’ is one thing – however the money market for debt is another.

By this I am talking about what we see with bond markets and specifically the US 10-Year Treasury.

The price of this bond – and its effective yield – will impact every financial asset (including your mortgage).

In short, if the price of these bonds fall (and yields rise), then our banks will be forced to pass on the higher costs. Remember – 50% of our debt is sourced offshore.

Recently we shared this chart for the 10-Year Treasury:

The message with this chart is simple: speculators want to see this chart rising.

If this chart rises – borrowing costs fall.

The recent small move higher in the US 10-Year has provided some relief for home borrowers. However, the sharp fall from last year was enough for banks to start raising rates.

If you are worried about the direction of rates – then you should read this post.

Here, we talk more to the role of the 10-Year note and what we see with real yields (and specifically TIPS as they apply to Fed rate decisions).

This is what speculators should be watching most closely – less so the inane dribble we hear from the RBA.

Putting it All Together… 

The RBA is caught between a rock and hard place.

We explained how our “do nothing” central bank are simply not able to raise rates here.

Nothing has changed.

Factors such as (but not limited to) weak business investment, low wage growth, falling incomes and record (housing) debt has the RBA cornered.

And then of course we have the strengthening (deflationary) higher Aussie dollar.

We don’t expect much action from the RBA in coming months… just a lot of lip service. I suppose that’s why they are paid.

However, we are very much interested in what we see in bond markets.

… trade the tape

When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.

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