The Reserve Bank meets this morning to vote on interest rates. It’s widely anticipated they will cut rates, the first such reduction since August 2016.
Amazingly, the economy moves into this easing cycle without first having experienced any preceding interest rate hike. I don’t know the history of Australian interest rates, but I reckon that’s unprecedented!
It certainly is since the early 1990s, as shown in the chart below. That is, each expansion was strong enough to sustain a series of interest rate hikes before the slowdown kicked in.
But as you can see from the chart, each slowdown required rates to move lower and lower. Since the cash rate last peaked in November 2010 at 4.75%, there hasn’t been a single interest rate hike.
Keeping rates on hold has been the new form of monetary tightening.
Source: RBA chart pack
What’s extraordinary about the latest period of rates remaining on hold is that it occurred while the economy experienced a large rise in the terms of trade.
The terms of trade (ToT) is a relative measure of the purchasing power of our exports. When it rises, it means the value of our exports rise relative to the value of the goods and services we import.
A rise in the ToT translates to a rise in our national income. It’s a form of external stimulus.
As you can see in the chart below, the ToT went through a structural shift in the early 2000s. That’s why the cash rate increased to just over 7% prior to the GFC.
The GFC resulted in a short and sharp correction in the ToT, and a BIG decline in the cash rate. Subsequent Chinese stimulus saw the ToT jump to new all-time highs, and the cash rate followed, rising to 4.75% in November 2010.
Source: RBA chart pack
Then the ToT entered a more prolonged decline, and as you can see, interest rates fell too — from 4.75% to 1.5% in August 2016.
But here’s where the cash rate and the ToT go their separate ways. After hitting a low in late 2015/early 2016, the ToT started to recover. But the RBA never increased the cash rate in response.
Now, with the ToT still relatively high, we are on the cusp of another easing cycle!
It must mean the domestic economy is in all sorts of trouble, right?
RBA has overreacted, and shouldn’t cut the cash rate
This is where I believe the RBA has overreacted, and why it shouldn’t cut the cash rate right now.
The way I see it, the election had a major impact on the local economy. The belief that Labor would win government was so strong that it changed people’s behaviour. As a result, the economy showed signs of slowing earlier in the year.
The RBA (with the help of the market) reacted to this data by communicating an ‘easing bias’. Last month, around half of the surveyed economists believed we’d get a pre-election rate cut.
But then the coalition won. Sentiment turned completely. Banks, credit, and the housing market all turned, seemingly overnight. The ASX 200 hit multi-year highs. Based on the ‘ASX 200 net total return index’ the share market probably hit an all-time high. (I say probably because this index only started in 2011.)
Here’s the chart below…
Source: RBA chart pack
The chart told you in late 2018 the economy faced some issues. But given the same thing was happening in global markets, the issues were not exclusively domestic.
The Fed engineered a global stock market recovery in early 2019. Since that time, the Aussie stock market has given no indication that the economy is in serious trouble.
And while you could argue that’s because the market is pricing in interest rate cuts, I would counter by saying that the market wouldn’t be at all-time highs unless the economy (and therefore company earnings) were holding up.
As far as I can tell, the RBA is therefore making a big mistake by cutting rates during a period of relative economic strength. And even if they now agree with that view post-election, I’d be surprised to see them stay on hold.
The market is expecting a cut, and if it doesn’t get one, the RBA will come under fierce criticism.
It’s not like the market can’t handle it though. Have a look at the chart above again. Aussie stocks are in a very strong upward trend. The current pullback has not even brought stocks back to the 50-day moving average. This is a strong bull market, not a fragile one.
Gold tells you all you need to know
Meanwhile, gold tells you all you need to know about the wisdom of central bankers. Overnight, gold surged again as the US Federal Reserve suggested it may cut rates too. Gold in Aussie dollars is trading around $1,900 an ounce, an all-time high.
The Aussie dollar, in terms of gold, has never been worth less. By the judgement of the market, the RBA has never been held in such low esteem.
Editor, The Rum Rebellion