Why a big lift in interest rates is not on the cards

Right now, many in the financial markets are expecting a two percentage point bump in interest rates by June next year.  But I have my doubts. The RBA is unlikely to raise rates meaningfully until annual wage growth rises above three per cent – which is a long way off.  So, to me, it looks like the market is jumping at shadows.

One global macroeconomic research house wrote recently of the strong Australian employment data:

“The further decline in Australian unemployment rate takes the labour market closer to full employment, setting the RBA up to hike rates in June … the unemployment rate fell from 4.2 per cent to 4.0 per cent, matching the lowest rate on record … The faster tightening in the labour market should boost wage growth in the years ahead and will surely push the Bank toward an earlier start in its hiking cycle. We therefore reiterate our forecast that the Bank will hike rates in June, earlier than most anticipate.”

As you will soon discover, however, the RBA continues to quash that speculation.

But first, a little background. In the mid 90s while working for Ord Minnett, I conducted a little historical research into the efficacy of bond futures yield curves. I wanted to know how accurate they were at predicting future interest rates.

As at the close of 16 March 2022, the ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve looked as follows:

Jun-22 0.22%
Jul-22  0.355%
Aug-22 0.555%
Sep-22 0.720%
Oct-22 0.920%
Nov-22 1.135%
Dec-22 1.295%
Jan-23 1.335%
Feb-23 1.510%
Mar-23 1.675%
Apr-23 1.830%
May-23 1.980%
Jun-23  2.080%

These are some hefty interest rate increases expected by professional investors. Of course, one must remember professional investors and traders don’t have mortgages and, if they do, they don’t think much about them because interest rates – high or low – will have very little bearing on their lifestyle. They are therefore free to imagine all sorts of silly scenarios.

The rest of Australia however thinks about their mortgage constantly, and even though it’s two and three-year bonds that determine mortgage rates here, if the rest of Australia were trading short term futures, the yield curve wouldn’t look anything like the steep curve professional traders have priced in.

And that might just have something to do with the market’s accuracy when it comes to the yield curve as a predictor of where rates actually go.

You see, back in the 90s, I then looked back in time at the futures implied yield curves of Germany, Japan, the UK, Italy and the US. Using 30 and 60 day futures, as well as two, three, five, 10 and 30 years bonds, where available, I mapped the implied yield curves at set dates over a decade. These curves, locked in time, reveal where the experts then thought interest rates would go. 

I then plotted contemporaneous rates – where they went.

What I discovered might give mortgage holders today some comfort. With an almost 100 per cent hit rate the futures implied yield curve, which is a proxy for where experts collectively believe interest rates are going to be in the future, was wrong. And not by a small margin. Across time and across geographies, I couldn’t find a yield curve that got rates right. And the further out along the yield curve one ventured the less accurate it became. In other words, it started badly and only got worse.   

Today, the collective wisdom of a bunch of Australian interest rate futures traders and investors says interest rates will rise by two per cent in fifteen months.

Even the RBA – the august institution responsible for setting rates – thinks the market experts are smoking something. And the release of the Minutes of the Monetary Policy Meeting of the Reserve Bank Board reveals little reason to believe anything other than the poor historical track record of the market’s ability to predict interest rates will be preserved.

“Turning to the decision for the cash rate, members remained committed to maintaining highly supportive monetary conditions to achieve the objectives of a return to full employment in Australia and inflation consistent with the target. As agreed at previous meetings, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target band. While inflation had picked up, members agreed it was too early to conclude that it was sustainably within the target band. There were uncertainties about how persistent the pick-up in inflation would be given recent developments in global energy markets and ongoing supply-side problems. Wages growth also remained modest, and it was likely to be some time before aggregate wages growth would be at a rate consistent with inflation being sustainably at target. The Board is prepared to be patient as it monitors how the various factors affecting inflation in Australia evolve.”

Despite the obvious evidence to the contrary, the market still prefers to believe in fairy tales.

The RBA is unlikely to shift on rates until annual wage growth rises above three per cent, which is a long way from its present rate of 2.3 per cent.

Those with mortgages needn’t be overly concerned and perhaps that sanguine view can be adopted by equity investors too.


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