Interest rate hikes on the way

[makapaaa]

<TABLE border=0 cellSpacing=0 cellPadding=0 width=452><TBODY><TR><TD vAlign=top width=452 colSpan=2>Published September 12, 2009

</TD></TR><TR><TD vAlign=top width=452 colSpan=2>Wealth Insights



</TD></TR><TR><TD vAlign=top width=452 colSpan=2>Interest rate hikes on the way
The start of a rate tightening cycle may cause jitters in share markets, but initial moves will be gradual

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By Shane Oliver
AMP Capital Investors

<TABLE class=picBoxL cellSpacing=2 width=100 align=left><TBODY><TR><TD> </TD></TR><TR class=caption><TD></TD></TR></TBODY></TABLE>LAST year and early this year, interest rates worldwide were cut to emergency levels to combat the fallout from the global financial crisis. Monetary easing and fiscal stimulus have been successful.
And with the financial crisis fading into history and economic conditions on the mend, it's only a matter of time before interest rates start to move up to more 'normal' levels. This will naturally cause some consternation. But there are several points to note.
First, 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 global financial panic and an economic implosion. Rising interest rates will signal a return to normality - better economic conditions and improving job prospects. They will only start rising because abnormally low rates have done their job and leaving them in place would encourage too much debt and new asset bubbles.
Second, 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.
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</TD></TR><TR><TD bgColor=#fffff1><TABLE border=0 cellSpacing=0 cellPadding=0 width=124 align=center><TBODY><TR><TD vAlign=top>The Reserve Bank of Australia will soon start to raise interest rates gradually... Similarly, while Asian and emerging countries generally suffered 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 six months.



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</TD></TR></TBODY></TABLE></TD></TR></TBODY></TABLE>Australia's downturn has been much 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 housing, consumer confidence, business confidence, business investment and forward-looking labour market indicators, suggest recovery is becoming self-sustaining.
So the Reserve Bank of Australia will soon start to raise interest rates gradually. We expect the RBA to start moving before year-end and see the cash rate reaching 5 per cent by end-2010. Similarly, while Asian and emerging countries generally suffered 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 six months.
In contrast, the US, Europe and Japan have had 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 in raising rates. The Fed is unlikely to start moving until around mid-2010.
Third, just because interest rates are starting to rise doesn't mean they are going straight back to previous highs. With inflation relatively benign, global growth uncertain and household debt high, 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 in the 2002 to 2008 tightening cycle.
The initial move higher 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 5.5 to 6 per cent, 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 one percentage point or more higher than was the case before the credit crisis began. Given this, it is likely the normal level for the cash rate may have fallen to around 5 per cent. Our view is that the 5 per cent 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 per cent or more - until 2011 or 2012.
Another way to assess whether monetary policy is tight is when the yield curve becomes inverse - the cash rate rises above 10-year bond yields - as it is usually only then that economic growth starts to become vulnerable. With 10-year bond yields now at 5.4 per cent, the cash rate has to go before monetary policy can be described as tight. The same is true in the US, where the Fed Funds rate is now near zero and the bond yield is 3.5 per cent.




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[makapaaa]

Interest rates and shares
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 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.
Several considerations are worth noting.
First, rising interest rates from a low base are not normally bad for shares initially as they go hand in hand with improving economic conditions. (Co-incidentally, falling interest rates in a recession are not good for shares initially, as happened last year.) This was evident, for example. during the initial stages of monetary tightening in the late 1970s and early 1980s, the 1984 tightening through to 1988 and through much of the 2002-2008 tightening.
Second, rising interest rates are only really a major problem for shares when rates reach onerous levels, contributing to an economic downturn - for example, in 1981 to early 1982, late 1989 and late 2007 to early 2008. They are also a problem when rate hikes are aggressive, as in 1994 when the cash rate was increased from 4.7 per cent to 7.5 per cent in just four months.
This is consistent with a typical investment cycle, when rising interest rates only start to become a serious problem for shares when they reach high levels - that is, well above normal levels and above long term bond yields - and inflation is rising.
Finally, given the high short-term correlation between Australian shares, and indeed most share markets, and US shares, what the Fed does is arguably far more important than local interest rates.
So, in terms of the current situation, while the initial move to raise interest rates may create some jitters, it's unlikely to be enough to derail the cyclical bull market in shares:
Rising interest rates will reflect economic recovery rather than herald a downturn, and the improving profit outlook will provide an offset.

Even when interest rates start to rise, they will still be very low, and with inflationary pressure so subdued, it will be some time before rates reach onerous levels.

US monetary tightening is still nine months or so away.
The key risk would be if central banks move too early and too aggressively to reverse monetary stimulus, as happened during the 1930s in the US and in Japan in the 1990s. This is certainly a risk, but policy-makers seem more than aware of the risks of 1930s style premature tightening - as evident by their commitment at the recent G-20 finance ministers meeting to maintain stimulus.
Interest rates and the Australian dollar
The Australian dollar is already up sharply from its US$0.60 low last year. With the already wide interest rate differential between Australia and the US set to widen further and commodity prices likely to see more upside, the upward pressure on the Australian dollar is likely to intensify. Another go at parity against the US dollar is likely in the next 12 to 18 months.
Against this backdrop, there is a strong case for investors to maintain a high exposure to fully hedged international equities, as opposed to unhedged international equities that will be adversely affected if, as we expect, the Australia dollar continues to rise.
The commencement of an interest rate tightening cycle in Australia, and later on in other countries, may cause some jitters in share markets. However, initial moves will be gradual. Interest rates will still be very low for some time, and with inflationary pressures very benign, it will probably take several years for interest rates to reach levels that are restrictive enough to hurt the economic outlook and shares.

The writer is head of Investment Strategy and chief economist at AMP Capital Investors

 

[Watchman]

Let people buy first and then move in to up !

 

[Cestbon]

If interest rate move up 3% many will have to move out of the flat taking loan from bank.