Money markets increasingly expect maybe only one more RBA cash rate cut by year-end

You may have noticed a moderately improved sentiment in the tone of the financial press at the beginning of January. As the fiscal cliff was "expertly" negotiated (i.e. taken down to the proverbial wire by self-interested US politicians patently uninterested in bi-partisan co-operation), many analysts are expecting moderate growth for the Australian economy and a reasonable year ahead. 

Commodity prices have not tanked as was feared, and iron ore in particular has bounced back phenomenally. This has totally and utterly confounded – in fact, virtually silenced – the perma-bears who so gleefully predicted not even four months ago that the iron ore spot would fall to just $60/tonne. 

Instead, on Friday the iron ore price bounded merrily through $153/tonne. That is a spectacular miss by any measure of the term, and far more importantly is wonderful news for anyone who wants the future of Australia’s economy and job markets to be a prosperous one. 

It also seems that the prospects for stocks are markedly improved as the persistently low interest rates gradually wrench risk-averse Aussies away from fixed-income investments.  That said, we still have the small matter of a US debt ceiling vote to be resolved before we can see any hint of a blue sky. 

Yield curve flattens 

I’ve been particularly interested to note the marked shift in the yield curve over the past five trading sessions. At close of trade on Tuesday (January 8) the ASX 30 Day Interbank Cash Rate Futures February 2013 contract was trading at 97.075.

You can see the progressive tightening in interbank cash rates since 2011 in the chart below as the Reserve Bank anticipates a rocky road ahead and an awkward transition from the capital investment phase of the mining boom to the production phase.

Cash rate flattening out?

In slightly plainer English this implies only a 41% expectation of another interest rate decrease to 2.75% at the next RBA board meeting in February. So while the market is still pricing in a fair likelihood of another imminent cut in the cash rate, the percentages are way down on the 66% we saw as recently as December 27 before “Taxmageddon” was negotiated.

Previously the implied expectation showed that on balance interest rates were likely to be cut twice more to just 2.5% by the middle of 2013. Markets no longer deem that quite so likely – the yield curve now flattens out more quickly by July 2013 and at well above 2.5%, indicating that we may well only see one more interest rate cut. 

This by no means bad news for mortgage holders and property investors, for the cash rate is already very low, and rates yet closer to the zero bound are indicative of a sick economy.

Not a prediction 

Of course, the yield curve is not an actual prediction of the future. 

Instead, it is a weighted implied expectation – in other words, it prices in the possibility that we have already reached the bottom of the easing cycle and that rates will fall no lower than 3%. But it also prices in the possibility that the US falls back into recession, growth in China stumbles badly and the interest rates are dropped to the bottom of the zero bound. 

As for what we might reasonably expect? While noting that the only certainty about predictions is that they will probably be wrong, it seems very likely to me that whether or not we have reached the nadir of the easing cycle, we are likely to see a prolonged period of low interest rates.

The Reserve Bank is hoping that the gap left behind after the incredible boom in mining capital investment finally reaches its peak will eventually be plugged by construction and investment in housing. However, there doesn’t seem to be much evidence of that happening to date, as the construction index finished 2012 in negative territory. 

While some property markets will continue their gentle slide into 2013, most forecasters believe that a cash rate of just 3% is likely to begin to stimulate activity in those major property markets with strong demand and low vacancy rates. 

Keep an eye out for sentiment beginning to improve in Perth, Brisbane and Sydney. As for whether Darwin will continue its stellar run, who knows? I was in Darwin a little while ago visiting Mindil Beach sunset markets and everyone seemed happy enough, but then again it was a Friday night in the lead-up to Christmas. Reported vacancy rates are still tight, so growth could continue.

Some will try to second-guess the hotspot markets for 2013 again this year, or even look to capital city markets with meagre population growth. Personally I look away from those markets that are showing low absolute annual population growth such as Tasmania (+800 persons in the year to June 2012), Northern Territory (+3,500), Australian Capital Territory (+6,900) and South Australia (+16,500).

Instead, over the long term I look at those states which house the major capital city markets and where populations are absolutely booming: New South Wales (+78,900), Western Australia (+78,000), Queensland (+86,000) and Victoria (+89,000). 

In spite of what most pundits seem to indicate these days, the future is (thankfully) unknown to us, and therefore we will only really know what happens when it actually does. It wouldn't be much fun if we could really see into the future, would it?

The short term is inherently unpredictable, but it’s a brave person who believes that populations in the major capital city property markets growing at such a furious pace won’t result in prime location land and property prices move higher over the next few decades.

Pete Wargent holds a range of finance and property qualifications and is the author of Get a Financial Grip – a simple plan for financial freedom.