THE WEEK AHEAD: The only way is up for rates

Will the Reserve Bank come off the benches in the coming week and lift interest rates again? Well some would argue that you wouldn’t be asking an economist anyhow for his or her opinion given the recent track record. But others would argue, why does it matter anyway? Rates are likely to go up – if it’s not this month, it will be April or May – certainly the smart money is on rates moving higher.

And that last response would certainly be spot on. Most consumers, borrowers or investors want to plan ahead. It matters little if rates go up in March or if the increase is delayed a month or so. But certainly most people want a general idea about how high rates are likely to go.

Fortunately the Reserve Bank Governor has given us some guidance. He notes that mortgage rates are around 50-100 basis points away from the decade average – a level that the Reserve Bank regards as ‘normal’. And that means the cash rate may end up rising over the year to around 4.75%. We have been saying for some time that rates are likely to get to around 4.50-5.00%, and we haven’t shifted from that view.

Of course the Reserve Bank Governor doesn’t want his observation to be treated as a forecast – it is merely where interest rates are likely to end up if all things go to plan. Of course we know that things rarely do go to plan. After cutting rates to a 49-year low in April last year, how many people expected the Reserve Bank to lift rates an unprecedented three months in a row? And only six months after rates hit their lows.

The Reserve Bank has now effectively paused in its rate hiking cycle for three months. The last rate hike was December so the Bank has had some time to assess the impact of its decisions. In that time there has been a new global risk factor – sovereign debt – more specifically, Greece. But the Reserve Bank says that hasn’t been a major issue for policy settings. Of greater concern is the caution displayed by consumers and businesses in parting with their cash. And add in the fact that the Government’s tax break and first home owners boost expired at the end of last year.

On balance we are tipping the Reserve Bank to lift rates next week. Rates are still historically low and recent indicators show that the economy is getting back to full health. Unemployment has peaked, the pipeline of construction work is at record highs and lofty rises in coal and iron ore prices are expected in the next few months, boosting cash in the economy.

Admittedly it will be another close-run thing, but unless you are a financial markets trader, it hardly matters.

The week ahead

Each change of seasons is ushered in by a barrage of economic data. And it is no different this time around, with the autumn avalanche about to descend on investors.

On Monday the Bureau of Statistics releases the quarterly balance of payments and its Business Indicators publication – covering indicators like sales, profits and inventories. The monthly inflation gauge is also issued together with the Performance of Manufacturing. And the Reserve Bank Governor gives a speech – most likely on regulatory issues.

On Tuesday the Reserve Bank Board meets while data on retail sales, building approvals and government spending is released. On Wednesday the final economic growth estimates for 2009 are presented together with the Performance of Services index. And on Thursday trade figures are released with tourism data on Friday.

We are tipping the Reserve Bank to resume rate hikes on Tuesday, but not with any certainty. The old adage is that monetary policy is an art, not a science, and it will be a judgement call whether rates are ‘snugged up’ again.

The activity indicators should be reasonably encouraging. We expect that retail sales rose by 0.8% in January with dwelling approvals up 3%. And from the business side of the equation, profits probably rose 2% in the December quarter while inventories lifted by 0.8%.

The GDP (economic growth) figures are released on Wednesday and they will confirm that the record economic expansion remained firmly on track in the December quarter. Overall the economy probably grew by around 0.7% in the quarter and around 2% over the year. Consumer and government spending look to be the main growth drivers, but with more imports being purchased, the trade sector will be the major drag on the result.

In the US, the main game is the non-farm payrolls (employment) data on Friday. But earlier in the week personal income, construction spending and the ISM manufacturing are issued on Monday. Car sales data is released on Tuesday with the ADP employment report, Federal Reserve Beige Book and ISM services index all slated for Wednesday. Productivity and factory orders data are released on Thursday.

The US job market is on the verge of creating jobs again, but analysts are divided about whether it happened in February. In fact one analyst believes that 150,000 jobs were created in the month while another is tipping a fall in jobs of the same magnitude. On average economists are tipping a small 20,000 cut in job numbers and an unemployment rate around 9.8%.

Of the other indicators, the gauges of manufacturing and services sector activity are expected to be little-changed in the latest month. Provided there is no major slippage, investors won’t have cause to be disappointed.

Sharemarket

The profit-reporting season has ended for another year, and by and large the results were encouraging. Unfortunately, cost-cutting was a key driver of bottom-line profits. But there was enough in the outlook statements, as well as recent economic data, to suggest that revenues will generally be lifting in the second half of the financial year. After cutting debt and issuing more shares over the past year, the key question for many companies is what to do with all the extra cash. Investors will give some leeway, but they will eventually punish ‘lazy’ companies.

The good news for investors is that the recent flat line performance for the sharemarket, together with stronger earnings, have caused valuations to move to the most attractive levels in six months. In fact the historic PE ratio has fallen from around 15.4 to 13.4 in just over a month.

The main problem for investors is that we are again beholden to the US market. The correlation between the Dow Jones and All Ordinaries started to break down late last year. But again investors have taken to worry about global events, rather than focus on Australia’s strong economy and its dependence on China’s industrialisation. The correlation (or extent of co-movement) of the Dow with the All Ordinaries index over 2010 stands at 0.9, where a reading of 1.0 indicates that the two indexes move in lock-step.

Interest rates, currencies & commodities

The first anniversary of the global rebound is approaching. In early March 2009 equity and commodity markets across the globe hit multi-year lows. And it was almost as if a bell was sounded with all markets seemingly turning on a dime. For the commodity markets, the CRB futures index hit its lows on March 2, 2009. And over the 10 month period to early January 2010, the index had recovered almost 47%. To put the move into perspective, the CRB lifted by a similar margin from 2002-2005 but it took 2½ years, not 10 months.

Futures market pricing suggests there is a 31% chance of the Reserve Bank lifting rates next week. While that seems to rule out an imminent move in rates, ahead of the February Board meeting pricing suggested, pricing suggested a 70% chance of a rate hike – and we all know what happened then. As we warned last week, central banks appear to have new strategy – to ensure that traders and investors don’t get complacent. That was clearly apparent in the surprise decision by the US Federal Reserve to lift the discount rate. Risk is clearly back in vogue – no one should assume that central banks have detailed plans to remove stimulus – their exit plans will evolve as economic conditions evolve.

Craig James is chief economist at CommSec.