Westpac says the gap between US and Australian interest rates will soon hit 'uncharted territory'

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US interest rates are going a lot higher, says Westpac, forecasting that the US Federal Reserve will lift rates three times this year, and a further two times next year, as US economic growth accelerates.

“We [previously] envisaged three FED fund hikes in 2018 with rates going on hold in 2019,” says Bill Evans, Westpac’s Chief Economist.

“We now expect two further Fed hikes in 2019, in March and June, [leaving] the Fed Funds rate at 2.625%.”

Evans says the forecast change reflects recent fiscal stimulus packages passed by the US Congress.

“There has been a significant change in US fiscal policy,” says Evans.

“Congress has supported a $300 billion spending package over the 18 months from April 2018. That follows the recently approved Tax Package estimated at a current cost of $1.5 trillion over 10 years.”

At a time when the US economy is already humming, Evans says this increases the likelihood that the Fed will need to deliver even more policy tightening that what would have otherwise been the case.

“With the introduction of the new spending package we have raised our forecasts for GDP growth in the US from 2.5% in 2018 and 2.2% in 2019 to 3.0% and 2.5% respectively,” he says.

“With potential growth in the US generally assessed as around 1.7% these revised growth rates will pressure the output gap.

“The unemployment rate is likely to fall below 3.8% by year’s end meaning that the unemployment rate will have held below the full employment rate for nearly 2 years.”

With economic growth likely to pickup and unemployment well below what is regarded as the full employment rate, Evans says that should help to gradually lift US inflation and wage pressures.

Given his expectation that the Reserve Bank of Australia (RBA) will leave its cash rate steady both this year and next, Evans says the spread between US and Australian overnight interest rates will widen to a new record level.

Source: Westpac

“With two more Fed hikes expected in 2019, we now anticipate that the differential will reach negative 112 basis points by June 2019,” he says.

“That is uncharted territory with the previous record being negative 50 basis points in the late 1990s.”

Evans also expects the spread between Australian and US government 10-year bond yields will also fall to -0.3% by March next year as US rates top out near 3.5%.

With interest rates in the US likely to be higher across the curve, Evans retains the view that the Australian dollar will fall from current levels, forecasting that it will sit around 70 cents by March 2019.

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