THE WEEK AHEAD: Where will interest rates move in 2011?

One of the biggest furphies in 2009 was the claim that Australia had a ‘bubble’ in the housing market. It didn’t and still doesn’t but to some extent you can understand where some commentators were coming from with the claims.

In Europe and the US, home prices generally tanked in 2009 but Australian home prices softened, didn’t crash and then began to grow again. The view was that the day of reckoning had merely been delayed.

Where the commentators got it wrong was by glossing over a key fundamental determinant of housing demand – population. In most advanced nations population growth is very modest. In fact, in many European economies population is barely growing or is flat. In Japan, the population is actually contracting and in the US, annual population growth is around 1%.

But in Australia, population growth had been steadily lifting since the mid-noughties. In June quarter 2004, annual population growth was just 1.2% or an extra 230,000 people. And of that total, migration accounted for an extra 100,000 people.

But those migration levels began to lift markedly over the noughties in response to the PPP policy of Federal Treasury – productivity, participation and population. The PPP strategy is an attempt to soften the blow on the economy from the ageing of the population.

In the year to March 2007, over 200,000 extra migrants came to our shores. And by December 2008 annual migration numbers had lifted to over 300,000 people. Now given that the ‘normal’ number of homes built in Australia each year is around 150,000, a lift in annual migration numbers of around 200,000 would be expected to have a big impact.

And as always appears to be the case, the lift in migration numbers wasn’t universally understood by businesses, government departments and builders. Demand for homes has tended to outpace supply over the past three to four years. In late 2007/early 2008 there was double-digit growth in home prices.

Demand for homes was temporarily choked off by higher interest rates but at the trough, home prices were down just 2.5% on a year ago.

Home prices returned to double-digit levels in early 2010 in response to lower interest rates but a combination of increased home building (more supply), slower migration and higher interest rates again have caused home prices to soften with annual growth now around 6.5%.

It’s important to note that, despite the ebbs and flows of interest rates and building over time, there is no evidence of a generalised over-supply of homes. In fact in the Sydney market the rental vacancy rate stands at just 1.2%.

And affordability? The RP Data/Rismark measure that is well accepted by the Reserve Bank has continued to go sideways over the past six years. Hopefully we will hear a lot less about ‘bubbles’ in 2011.

The week ahead

For those unlucky enough not to be on holidays, there is little economic data to digest in the coming week. In Australia the offerings are confined to population data on Tuesday accompanied on the same day by minutes of the last Reserve Bank Board meeting held a fortnight ago.

In the US there is a bit more to focus on, but all the indicators are congregated on just two days – Wednesday and Thursday.

Turning to Australia first, it is likely that the latest estimates will show a further slowing of population growth. In the March quarter of 2009 Australia’s population was growing at a 2.2% annual rate – the fastest rate in 40 years with both migration and the birth rate boosting the result. But in the latest result for the March quarter of 2010, population growth has slowed to 1.84%– still above the longer-term average but clearly a softer result.

The slowdown in population growth is due entirely to a reduction in migration. When the job market weakened over 2009, the Federal Government thought it would be appropriate to cut back migrant numbers. However the softer job market was very much a temporary situation.

Now businesses are crying out for staff but the government has been slow to respond by allowing migration levels to rise. Clearly this is a situation that must be addressed over the next few months otherwise it risks a marked tightening in the job market, forcing up wages, prices and interest rates.

Hopefully the release of the June quarter population figures on Tuesday will revive the debate on migration and population growth rates. It is very much in Australia’s short and longer-term interest to have a well balanced labour market.

The other event of note in the coming week is the minutes of the December 7 Reserve Bank Board meeting. As widely expected, the Reserve Bank left rates on hold at that meeting. This was well flagged by the Reserve Bank Governor and he also provided guidance that the next move in rates wouldn’t occur any time soon.

Clearly investors will be looking for further guidance in the Board minutes. Investors will also be seeking to identify the ‘hot button’ issues that bear watching. That is, those issues that are in the middle of the Reserve Bank’s radar screen and therefore may be triggers for the next move in rates.

In the US, the main focus is on the housing market. On Wednesday the FHFA home price index is released with data on existing home sales released the same day. Economists expect that home sales rose by more than 5% in October to a 4.7 million annual rate. As always the amount of stock on hand and movement in home prices will also be watched closely.

And on Thursday, economists similarly expect that new home sales recorded a solid lift of almost 7 per cent. Again stock levels and prices will also be in focus. Overall there is evidence that the housing market has found a floor. But with unemployment still high and a significant amount of stock on the market, no one is expecting building activity to lift markedly any time soon.

Also in focus over the week is the final estimate of economic growth for the September quarter. Currently the economy is tracking at a 2.5% annual pace but some economists believe that growth could accelerate to 3.5-4.0% in 2011 given the amount of stimulus being applied to the economy.

The economic growth (GDP) data is due on Wednesday. And on Thursday, orders of durable goods, personal income & spending, weekly jobless claim and consumer sentiment data are all scheduled. Economists tip another solid result for spending, up another 0.4% in November after a similar gain in October. But the measure of business investment – durable goods – may prove soft with most tipping a fall of just under 1% in November.

Sharemarket

While there is still just over a fortnight until the end of the year, it is already clear that Autos & components has been the strongest sector this year (up 62%) but it is dominated by one stock – Fleetwood Corp. Next best has been Pharmaceuticals and biotech’s (up 10.5%), followed by Materials (up 10.1%).

However only six of the 21 sub sectors actually recorded gains over 2010. The weakest performing sector was Consumer durables and apparel (down 19.2%) followed by Retailing and Telecom (both down 18.8%). The insurance sector also took a hit losing 17.3%.

Interest rates, currencies & commodities

There is still plenty of data to be released over the next two months before the Reserve Bank next meets to decide interest rate settings. Financial market pricing suggests a rate hike in February is pretty much a non event. In fact the pricing for a 25 basis point rate hike is just 7% – which is entirely appropriate.

While parts of the economy like mining will do well in 2011, exporters and tourism will continue to do it tough. And then there is the added uncertainty in activity levels given the inherent conservatism being shown by consumers and weakness in business trading conditions. CommSec expects the next rate hike to take place in April with the cash rate lifting to around 5.25-5.50% end of 2011.

Craig James is chief economist at CommSec.