Wednesday, 16 November 2011

Interest Rate Futures - Not So Great Expectations

The interest rate futures market in Australia has staged a stunning rally in recent months, and has rallied even more early today on the end of day stock rout in the US and growing concerns (if they could grow any more) of a horrible outlook for global economic activity into 2012.

There’s absolutely no doubt that global conditions will be problematic, at best, in 2012 – the worst case frankly does not bare thinking about.

With the local economy hovering at or a little below trend, inflation set to plummet to or below the bottom of the RBA target band and the unemployment rate on track to hit 5.75% sometime in 2012, the market continues to price in aggressive interest rate cuts from the RBA.

This is exactly as it should be.

As my good mate Christopher Joye points out, , I think that the RBA will cut and cut hard over the next 6 to 12 months. My judgment is that a 3.5% cash rate in mid-2012 would be required to match the disinflation pressures hitting Australia and easier monetary policy would work to keep the economy on an even keel as it is buffered by stormy global conditions.

As far as I know, the lowest cash rate forecast from market economists is 3.75%. This is not a significant difference to my forecast, but it is substantial compared to this morning’s futures market pricing.

At the moment, the futures are pricing in the following profile for the cash rate (rounded to the nearest quarter per cent):

Dec 2011 4.25%

Mar 2012 3.50%

Jun 2012 3.00%

Sep 2012 2.75%

Dec 2012 3.00%

This looks a little too aggressive simply because the economy is not that bad and while inflation is set to fall, it is unlikely to get to 1%, a rate that would fully justify the current interest rate profile.

There is no doubt the market was clearly superior to market economists in anticipating the start of the rate cutting cycle which kicked off earlier this month. It may well be superior with the extent of the cutting cycle if something near to a worst case emerges in the global economy through the course of 2012.

1 comment:

  1. Before we get too carried away singing the forecasting praises of the boys and girls in the futures market let's not forget that only a few months ago they were pricing 3.5% by Dec 2011! They were quite happy then pricing in five 25bps cuts from Sept to end of far we've had one.
    I know you don't agree (and I understand your reasons for doing so) but the RBA minutes made it very clear how close a call it was in Nov and could certainly be read as suggesting that antyhing more this year is unlikely.
    So it's at least reasonably possible that the "clearly superior" market was clearly miles off!
    By the way, should just say that I love the blog...keep up the great work please.