Economics & Markets

The biggest threat to low interest rates

By Diana Mousina
Economist - Investment Strategy and Dynamic Markets Sydney Australia

The latest Consumer Price Index brought to light a particular risk to Australia’s low inflation rate. Here, Senior Economist Diana Mousina outlines the potential cause for concern and what this may mean for interest rates.

Rising commodity prices represent the biggest short-term risk to Australia’s low inflation rate, with the latest Consumer Price Index showing little else to cause concern.

A risk to the outlook in the near term is around what happens to commodity prices. We’ve seen quite strong commodity prices over the past few weeks, for things like oil, aluminium and nickel.

The price of Brent Crude has jumped 20 percent since February on concerns the US will impose sanctions against Iran, and a decline in output in Venezuela. Meanwhile, nickel and aluminium prices have surged on concerns about Russian supplies of the metal following US sanctions against Russian aluminium producer Rusal.

Some of those things are related to US sanctions on Russia, but also on some supply concerns over the near term for some of those commodities. The risk with high commodity prices is that markets get spooked by inflationary fears, and that’s something we saw at the beginning of the year.

Earlier this year the Dow Jones industrial average suffered its biggest single-day point drop, which saw global markets follow suit, on fears of higher than expected inflation in the US.

The markets quickly recovered but general jitteriness remains.

If we do see commodity prices continuing to gain, then we may see equity markets drop a little bit because markets will be worried that central banks will need to raise interest rates too fast, too soon.

The March quarter data that came out last week, showed that underlying inflation is running at 2 percent on an annual basis. The Reserve Bank of Australia targets annual inflation growth of about 2 to 3 percent.

Looking across the different components driving inflationary pressures, the strongest signs of higher inflation are around government regulated prices, like healthcare, utilities and education; whereas price growth across other parts of the consumer basket, such as consumer durables, are still running at low levels.

Inflation would need to be closer to 2.5 percent before the RBA is likely to raise interest rates.  We do not expect the RBA to raise rates until February next year at the earliest.

We probably need to see wages growth a little bit stronger to push inflation to that 2.5 percent.

Adding strength to the argument against an interest rate rise, is falling house price growth. We predict a drop of up to 10 percent in some parts of Australia.

We are looking for about a 5 to 10 percent drop in overall home price growth but we do expect that to be focused in the apartment market, particularly in Sydney and Melbourne, where there has been an increase in supply.

Interest-only lending has declined as a share of total new loan growth because banks have been tightening their lending standards, particularly for investors.

We expect that more households will shift from interest-only to principal-and-interest loans over the next few years, so this means households will be paying a larger share of their income on housing.

This will have a negative impact on the retail sector and consumer sector. We do think the economy is strong enough over all to handle this downward pressure for consumer spending, but it is another risk for the economic outlook.

“There are two main reasons for the gap,” Oliver says. “The first being that the US has been borrowing more since the government agreed to raise the debt ceiling this year.”

“The second is that the US tax overhaul has meant that many US companies that used to keep their money overseas, usually in US dollars are bringing that money back to the US. Taking it out of the European markets dries up the supply available for short-term lending in the Eurodollar market.”

“So these things have all led to a bit of a squeeze, an increase in bank funding costs,” Oliver says.

In the short-term, this may be bad news for some Australian investors because it means that Australian banks may be paying more to borrow.

On a global level it could impact on illiquid sections of the high yield bond market as well.

“The longer this goes on, the greater the risk that Australian banks may raise their variable mortgage rates,” says Oliver. “Maybe not for owner-occupiers, but maybe for investors. So there is a bit of a risk around that.”

On the flip side though, if banks were to raise rates for investors it may be a factor for the Reserve Bank of Australia to further delay raising interest rates.

AMP Capital is now predicting the RBA won’t raise rates until 2020.

“So there are short term risks and it’s worth keeping an eye on them,” Oliver says.

“It’s also worth bearing in mind though that this is not the same kind of issue as what occurred during the GFC. Back then it reflected stresses in the banking system. This time around it seems to reflect the US government borrowing a bit more, and US companies bringing that cash back to the US.”

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While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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