RBA cash rate could go below 1.9%, with 5.1% mortgage rate possible: Christopher Joye

RBA cash rate could go below 1.9%, with 5.1% mortgage rate possible: Christopher Joye
Christopher JoyeJune 3, 2012

How low could the RBA’s cash rate go? Much lower than most folks, including the financial markets, think.

The global economy is schizophrenic right now. On an underlying basis, there are powerful forces shifting the centre of economic gravity away from the old world of North America and Europe towards the 2.6 billion people living in China and India. 

The IMF estimates that over the next five years the eurozone will only contribute 7.7% of total global growth. In contrast, China is expected to account for around three times that amount, or 22.6%, of the world’s total expansion. The same pattern applies when one compares the major advanced economies – or the so-called “G7” – with their emerging and developing counterparts.

Notwithstanding the media and financial market fixation with the G7, these nations only made up one-third of global growth between 2000 and 2011. The IMF believes that this share will fall further to just 28.6% between 2012 and 2016. By way of comparison, developing countries accounted for 49% of global growth over the last decade, with their contribution forecast to rise to more than 60% over the next five years. 

While the industrialisation, urbanisation and rising middle classes of Chindia are driving "decoupling" from the North Atlantic nations, the unprecedented global interconnectedness brought about by the internet and digital communications is pulling us in the opposite direction. The 24-hour, real-time, and often sensationalist news cycle, with its bias towards the information-rich open societies in the G7, seems to be propagating even greater global synchronisation in financial market behaviour and real economic cycles. 

Nothing highlights this better than the disconnect between Australia’s raw economic data and its contemporaneous financial market signals. 

In May, Australia’s unemployment rate fell from 5.2% to 4.9%, blind-siding most analysts. Business investment in the first quarter also smashed consensus expectations, while plans for capital spending over the next few years were much better than pessimists anticipated. Wages and overall consumer spending are also tracking around their long-term historical trends. Finally, housing credit and, increasingly, business credit are expanding broadly in line with purchasing power. 

Yet financial markets, and many asset prices, are projecting on to this ostensibly healthy picture a seemingly cataclysmic outcome. In particular, the interest rates required on Australian government bonds have plummeted to all-time historical lows. On Friday night the yield on three-year Australian government bond futures fell to below 2% for the first time ever. 

This is ordinarily a very worrying portent: three-year government bond yields are now more than 175 basis points below the current RBA cash rate (technically called an "inversion" of the yield curve). That is, the market thinks the RBA will cut its official target cash rate to levels we’ve never seen before. Specifically, the futures market is now suggesting that the RBA’s cash rate will drop to as low as 2.15% by the end of this year. That’s more than six standard RBA rate cuts. 

All commentators, economists, and policymakers have struggled to keep pace with this extreme global uncertainty. In June last year bank economists, including Westpac and yours truly, were forecasting further RBA rate hikes. In that month Westpac’s Bill Evans presciently swivelled 180 degrees and called for a 100 basis point reduction in the cash rate by the end of 2012. Bill got the direction right, but has now been compelled by evolving circumstances to dramatically adjust his view again; he's added four more RBA rate cuts, or 100 basis points worth in total, to his original 2012 expectation. 

Last week the RBA was believed to be resistant to cutting rates in June. That’s understandable given the staff only recommended a 25 basis point cut in May and were pushed by the board to double it. Since May, the RBA has seen the currency depreciate substantially – it is now about 13% below its all-time US dollar highs – the jobless rate decline, and capital spending exceed expectations. But dismal data from overseas is now likely to force the RBA to follow May with more rate relief tomorrow. 

Economists at NAB, Westpac, CBA, JP Morgan, and Market Economics, among others, have at various points changed their June calls from no move to a cut on Tuesday. Senior commentators, such as Terry McCrann on Friday night, and David Bassanese last week, both argued the central bank would exercise the option to wait in June. 

But McCrann, on Sunday, and Bassanese, in today’s paper, have embraced a cut. Bassanese puts it best: “To my mind, the facts have changed. As a result, my previous base-case view that the RBA would not cut interest rates again this month also needs to change.” 

The situation in Europe is telescoping towards a binary outcome: either we get fiscal integration, which will, rather ambitiously, involve regional deposit guarantees, individual nations ceding authority over budget spending, and so-called “euro-bonds” that allow countries to raise money backed by the commitment of the entire eurozone, or the currency union as we know it today will slowly disintegrate. 

While each contingency has different ramifications for the Australian economy and the response of local policymakers, it is instructive to consider what might actually happen in a downside scenario.

In the GFC, the RBA's cash rate dropped to 3%, which combined with the boost to the first-home owners’ grant helped house prices surge 13% in 2009. The cash rate is currently only 75 basis points higher at 3.75%. Of course, actual lending rates are much more important than the RBA's theoretical target. And they are, crucially, 125 basis points above the lows touched in April 2009. 

If – and it is an almighty "if" – the global economy does indeed lurch into recession, I think the RBA will slash its official cash rate way below the levels seen in 2008 and 2009. In fact, I am thinking 1.9% or less. 

Take home loan rates as a benchmark. After the double cut in May, the current discounted home loan rate in Australia is about 6.35%. The trough achieved during the last crisis was 5.1% in April 2009. At surface level, the RBA would need to slash its cash rate 125 basis points to 2.5% to get lending rates back to their crisis marks. 

But the rub is that this supposes a 1:1 pass-through by the banks. In a best-case scenario, the RBA will only assume two-thirds pass-through. That means to get 125 basis points of lending rate reductions the RBA will have to cut its cash rate by an extra 65 basis points (or about 190 basis points in total). In turn, this implies a terminal cash rate of 1.9%. That might just get you a 5.1% mortgage rate. 

There is, however, a second wrinkle, which was highlighted to me by a UBS strategist during a chat on Friday. Recall that a lot of bank funding comes from retail deposits that are transaction accounts. These deposits already earn zero per cent interest rates – it is tough (although not impossible, as the Swiss have proven) to shove them lower. Accordingly, the banks may pass on less and less to maintain their net interest margins. The lower pass-through would also be amplified by a blow-out in credit spreads, which would further elevate bank funding costs in the absence of taxpayer guarantees. 

If you are seriously bearish on global growth prospects, as many claim, and think that the eurozone crisis is going to push the world into recession, then you should prepare yourself for a very low RBA cash rate. Forget Westpac’s 2.75%, or the 2.15% currently pencilled in by the financial markets. 

Based on the analysis above, the RBA cash rate is going to have to fall to less than 1.9% merely to replicate the lending rate lows achieved in 2009.

A final argument in favour of an ultra-low RBA cash rate is the fact that this time around fiscal policy will be hamstrung by concerns about a diminution in Australia’s prized AAA credit rating. Given the sharp increase in Australian government debt since 2007, it will be much more difficult for the Commonwealth to repeat its last cash splash. So most of the responsibility for supporting the local economy will fall on to Martin Place’s narrow shoulders.

As the May meeting demonstrated, nobody, including the RBA governor and his staff, can know with confidence what exact decisions the RBA's board will coalesce around at 12.30pm tomorrow, or in the ensuing months. The only constant we can rely on is that heightened global uncertainty will persist for some time. And, as during the last crisis, cash will be king.

Christopher Joye is a leading financial economist and a director of Yellow Brick Road Funds Management and Rismark. The author may have an economic interest in any of the items discussed in this article. These are the author’s personal views and do not represent the opinions of any other individual or institution. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations.

Editor's Picks

Spyre Group brings successful Queensland blueprint to Melbourne with Hampton Ltd
Saxon Street by Milieu to bring new housing and urban design to Brunswick’s cultural core
Construction begins at Fishermans Bend Innovation Precinct
Gurner reveals new plans for final Jam Factory stage
Tian An launches North Village, Auburn Square second stage

Related Projects

16-22 Maud Street, Newstead QLD 4006
16-22 Maud Street, Newstead QLD 4006
16-22 Maud Street, Newstead QLD 4006
Price
Contact agent
35-37 Mount Street, Prahran VIC 3181
35-37 Mount Street, Prahran VIC 3181
35-37 Mount Street, Prahran VIC 3181
Price
Contact agent
118-124 Benelong Road, Cremorne NSW 2090
118-124 Benelong Road, Cremorne NSW 2090
118-124 Benelong Road, Cremorne NSW 2090
Price
Contact agent
118-120 Matthew Flinders Drive, Cooee Bay QLD 4703
118-120 Matthew Flinders Drive, Cooee Bay QLD 4703
118-120 Matthew Flinders Drive, Cooee Bay QLD 4703
Price
Contact agent
26-62 Kinross Road, Thornlands QLD 4164
26-62 Kinross Road, Thornlands QLD 4164
26-62 Kinross Road, Thornlands QLD 4164
Price
Contact agent
9-11 Baroonba Street, Whitebridge NSW 2290
9-11 Baroonba Street, Whitebridge NSW 2290
9-11 Baroonba Street, Whitebridge NSW 2290
Price
Contact agent
18 Ransley Street, Penrith NSW 2750
Perle, East Side Quarter, Penrith - 18 Ransley Street, Penrith
18 Ransley Street, Penrith NSW 2750
Price
Contact agent
Ernest Cavanagh Street, Gungahlin ACT 2912
Raya, Gungahlin - Ernest Cavanagh Street, Gungahlin
Ernest Cavanagh Street, Gungahlin ACT 2912
Price
Contact agent
39 Browning Street, South Brisbane QLD 4101
39-41 Browning Street, South Brisbane - 39 Browning Street, South Brisbane
39 Browning Street, South Brisbane QLD 4101
Price
Contact agent
675 Gardeners Road, Mascot NSW 2020
Kiara North, Mascot - 675 Gardeners Road, Mascot
675 Gardeners Road, Mascot NSW 2020
Price
Contact agent
187 Salvado Road, Jolimont WA 6014
Jolie, Jolimont - 187 Salvado Road, Jolimont
187 Salvado Road, Jolimont WA 6014
Price
Contact agent
47 Maning Avenue, Sandy Bay TAS 7005
Grace Residences - 47 Maning Avenue, Sandy Bay
47 Maning Avenue, Sandy Bay TAS 7005
Price
Contact agent
Cove Lane, Narooma NSW 2546
Cove, Narooma - Cove Lane, Narooma
Cove Lane, Narooma NSW 2546
Price
Contact agent
52-56 Ramsay Street, Five Dock NSW 2046
Ava, Five Dock - 52-56 Ramsay Street, Five Dock
52-56 Ramsay Street, Five Dock NSW 2046
Price
Contact agent
2375 Gold Coast Highway, Mermaid Beach QLD 4218
The Alfred - 2375 Gold Coast Highway, Mermaid Beach
2375 Gold Coast Highway, Mermaid Beach QLD 4218
Price
Contact agent
129-131 Russell Ave, Dolls Point NSW 2219
ALLURE COLLECTION - 129-131 Russell Ave, Dolls Point
129-131 Russell Ave, Dolls Point NSW 2219
Price
Contact agent
62 Constitution Avenue, Parkes ACT 2600
The Eastbourne on Commonwealth Park - 62 Constitution Avenue, Parkes
62 Constitution Avenue, Parkes ACT 2600
Price
Contact agent
155 Old Burleigh Road, Broadbeach QLD 4218
Sandpiper, Broadbeach - 155 Old Burleigh Road, Broadbeach
155 Old Burleigh Road, Broadbeach QLD 4218
Price
Contact agent
33 Vulture Street, West End QLD 4101
33 Vulture Street, West End QLD 4101
33 Vulture Street, West End QLD 4101
Price
Contact agent
19 Governor Terrace, Murarrie QLD 4172
Park Hill Village Collection, Murarrie - 19 Governor Terrace, Murarrie
19 Governor Terrace, Murarrie QLD 4172
Price
Contact agent
122 Marine Parade, Miami QLD 4220
Nalu, Miami - 122 Marine Parade, Miami
122 Marine Parade, Miami QLD 4220
Price
Contact agent
34 Jacaranda Place, Indooroopilly QLD 4068
34 Jacaranda Place, Indooroopilly QLD 4068
34 Jacaranda Place, Indooroopilly QLD 4068
Price
Contact agent
167 Old Burleigh Road, Broadbeach QLD 4218
167 Old Burleigh Road, Broadbeach QLD 4218
167 Old Burleigh Road, Broadbeach QLD 4218
Price
Contact agent
21 Queens Way, Yeerongpilly QLD 4105
Yeerongpilly Green - 21 Queens Way, Yeerongpilly
21 Queens Way, Yeerongpilly QLD 4105
Price
Contact agent
445-449 River St, Ballina NSW 2478
Solhaven - 445-449 River St, Ballina
445-449 River St, Ballina NSW 2478
Price
Contact agent
52 Sunset Boulevard, Surfers Paradise QLD 4217
52 Sunset Boulevard, Surfers Paradise QLD 4217
52 Sunset Boulevard, Surfers Paradise QLD 4217
Price
Contact agent
6 Jack Brabham Drive, Hurstville NSW
Horizon Hurstville - 6 Jack Brabham Drive, Hurstville
6 Jack Brabham Drive, Hurstville NSW
Price
Contact agent
49 Seena Drive, Edgeworth NSW 2285
49 Seena Drive, Edgeworth NSW 2285
49 Seena Drive, Edgeworth NSW 2285
Price
Contact agent
Lot 118 Ocean Steamers Road, Port Adelaide SA 5015
Lot 118 Ocean Steamers Road, Port Adelaide SA 5015
Lot 118 Ocean Steamers Road, Port Adelaide SA 5015
Price
Contact agent
203 Ashmore Road, Benowa QLD 4217
203 Ashmore Road, Benowa QLD 4217
203 Ashmore Road, Benowa QLD 4217
Price
Contact agent
41 Warrs Road & 7 Horizon Drive, Maribyrnong VIC 3032
41 Warrs Road & 7 Horizon Drive, Maribyrnong VIC 3032
41 Warrs Road & 7 Horizon Drive, Maribyrnong VIC 3032
Price
Contact agent
774 Ripley Road, Ripley QLD 4306
774 Ripley Road, Ripley QLD 4306
774 Ripley Road, Ripley QLD 4306
Price
Contact agent
6 Homelea Court, Rivervale WA 6103
6 Homelea Court, Rivervale WA 6103
6 Homelea Court, Rivervale WA 6103
Price
Contact agent
7002 Ripley Road, Ripley QLD 4306
7002 Ripley Road, Ripley QLD 4306
7002 Ripley Road, Ripley QLD 4306
Price
Contact agent
136-148 Fox Valley Road, Wahroonga NSW 2076
136-148 Fox Valley Road, Wahroonga NSW 2076
136-148 Fox Valley Road, Wahroonga NSW 2076
Price
Contact agent
3 Delos Way, Sorrento WA 6020
3 Delos Way, Sorrento WA 6020
3 Delos Way, Sorrento WA 6020
Price
Contact agent
77 Sutton Street, Redcliffe QLD 4020
77 Sutton Street, Redcliffe QLD 4020
77 Sutton Street, Redcliffe QLD 4020
Price
Contact agent
119 Queen Street & 86 King Street, Bendigo VIC 3550
119 Queen Street & 86 King Street, Bendigo VIC 3550
119 Queen Street & 86 King Street, Bendigo VIC 3550
Price
Contact agent
181 Prospect Road, Prospect SA 5082
181 Prospect Road, Prospect SA 5082
181 Prospect Road, Prospect SA 5082
Price
Contact agent
593-595 Albany Highway, Victoria Park WA 6100
593-595 Albany Highway, Victoria Park WA 6100
593-595 Albany Highway, Victoria Park WA 6100
Price
Contact agent
1-28, 40 Civic Way, Rouse Hill NSW 2155
1-28, 40 Civic Way, Rouse Hill NSW 2155
1-28, 40 Civic Way, Rouse Hill NSW 2155
Price
Contact agent
93-97 Bay Street, Brighton VIC 3186
93-97 Bay Street, Brighton VIC 3186
93-97 Bay Street, Brighton VIC 3186
Price
Contact agent
22-38 & 27-31 The Avenue, Coburg VIC 3058
22-38 & 27-31 The Avenue, Coburg VIC 3058
22-38 & 27-31 The Avenue, Coburg VIC 3058
Price
Contact agent
1F Ashline Street, Wollert VIC 3750
1F Ashline Street, Wollert VIC 3750
1F Ashline Street, Wollert VIC 3750
Price
Contact agent
Lots 100 & 900 Kentucky Court, Cockburn Central WA 6164
Lots 100 & 900 Kentucky Court, Cockburn Central WA 6164
Lots 100 & 900 Kentucky Court, Cockburn Central WA 6164
Price
Contact agent
1260-1272 Malvern Road, Malvern VIC 3144
1260-1272 Malvern Road, Malvern VIC 3144
1260-1272 Malvern Road, Malvern VIC 3144
Price
Contact agent
472 Regency Road, Prospect SA 5082
472 Regency Road, Prospect SA 5082
472 Regency Road, Prospect SA 5082
Price
Contact agent
273A Gorge Road, Paradise SA 5075
273 Gorge Road, Paradise SA 5075 - 273A Gorge Road, Paradise
273A Gorge Road, Paradise SA 5075
Price
Contact agent
426-440 New South Head Road, Double Bay NSW 2028
426-440 New South Head Road, Double Bay NSW 2028
426-440 New South Head Road, Double Bay NSW 2028
Price
Contact agent
270 The Esplanade, Miami QLD 4220
270 The Esplanade, Miami QLD 4220
270 The Esplanade, Miami QLD 4220
Price
Contact agent