Here's another indicator that suggests the RBA will cut rates

Paramount Pictures, Don Simpson/ Bruckheimer. IMDb
  • The spread between US three month and 10-year yields has predicted every US recession in the past 50 years.
  • Last week, this spread turned negative for the first time since 2007.
  • Australia’s yield curve between three months and 10 years has also turned negative. However, it’s had a terrible track record for predicting Australian recessions.
  • But it does have an excellent track record for predicting RBA rate cuts.

The yield on Australian three-month bank bills are now higher than those for Australian 10-year government bonds, similar to what’s been seen in the United States where yields on three-month treasury bills are also higher than for 10-year notes.

The inversion of this part of the US yield curve has garnered plenty of attention, reflecting that it has preceded a US recession on every occasion over the past 50 years.

However, while the US curve has an excellent track record for predicting US recessions, the same cannot be said in Australia.

The Australian curve has inverted on several occasions in over the past decade, yet Australia hasn’t recorded a recession — defined as two consecutive quarters of negative real economic growth — since the early 1990s.

However, while that suggests the recession signals from the recent Australian curve inversion should be treated with plenty of caution, it still has plenty of information for investors on the outlook for the RBA cash rate.

As Richard Grace, Chief Currency Strategists at the Commonwealth Bank explains, whenever three-month Australian yields have been higher than 10-year yields, the RBA has almost always cut rates since 1990.

“The Australian yield curve inversion has, in the past, signalled RBA rate cuts in six out of the last seven yield curve inversions,” Grace said in a note released today.

“The one exception was during the 2003-2008 mining investment boom, but this inversion eventually ended with the RBA cutting interest rates when the 2008-09 global financial crisis hit.”

Commonwealth Bank

So the curve has an excellent track record for predicting interest rate cuts.

It’s also a pretty good indicator on where the Australian dollar will move next, at least against the greenback.

“The AUD/USD has typically declined when the Australian yield curve has inverted,” Grace said. “Again, the exception was during the 2003-2008 mining investment boom.”

Given interest rate differentials are a major factor that help determine currency valuations, the link between rate cuts and Australian dollar weakness are not all that surprising.

As things currently stand, financial markets are now fully priced for two 25 basis point rate cuts from the RBA by August next year. The first of those is fully priced to occur in August this year.

The Commonwealth Bank, unlike several other forecasters who have recently changed their RBA calls, still sees the next move in Australia’s cash rate as higher, albeit not until late 2020 at the earliest.

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