Markets have gone 'too far' in pricing in RBA rate hikes next year

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When it comes to the prospect of rate hikes from the Reserve Bank of Australia (RBA) next year, there’s been a divergence in market opinion in recent months.

Gone are the days of almost everyone thinking that rates would be on hold for the foreseeable future, but what started as a trickle for rises has now turned into a flood, with an increasing number of analysts turning hawkish.

HSBC, TD Securities, ANZ and the National Australia Bank (NAB), among others, think rate hikes will arrive by the middle of next year, suggesting that the Australian economy will grow fast enough to spur on wage and inflationary pressures.

Others, however, do not share such an optimistic view, forecasting that the economy will lose momentum in the months ahead, keeping the RBA firmly on hold.

Bill Evans from Westpac is one notable economist who remains firmly in that camp, suggesting that there’ll be no need for the RBA to lift interest rates for a few years yet.

Paul Dales and Katie Hickie, economists at Capital Economics, are also holding firm, forecasting that growth and inflation will fall short of the RBA’s expectations next year, forcing it to leave interest rates at 1.5% throughout 2018.

“We believe that the financial markets are wrong to price in the possibility that the Reserve Bank of Australia (RBA) will raise interest rates twice next year,” the pair wrote in a note today.

This chart from Capital Economics shows the dramatic shift in cash rate expectations among market participants, seeing the prospect of rate hikes by the end of next year go from none to potentially two in just the past few months.

Source: Capital Economics

While Dales and Hickie say this shift is understandable given the prospect of tighter monetary policy from other major central banks, increasingly optimistic overtones from the RBA, along with recent strength in Australian labour market data, they maintain the view that a downturn in residential construction, along with continued pressure on household budgets, will keep economic growth underwhelm next year.

“The downturn in the housing market will mean that dwellings investment will continue to fall. And the slump in the annual growth rate of real household disposable income to just 0.6% in the second quarter is consistent with a softening in consumption growth.

“What’s more, the recent surge in the demand for labour has almost been matched by a surge in the supply of labour. That’s meant the amount of spare capacity hasn’t fallen much, with the unemployment rate only edging down from 5.9% in March to 5.6% in August.

As such, we doubt that GDP growth next year will top 2.5%. And we suspect that underlying inflation will remain below, or very close to, the bottom of the 2-3% target.

If Dales and Hickie are on the money, they say that the RBA will have to “change its tune” on the outlook for interest rates next year.

As for when the RBA will signal that higher rates will arrive, the pair say it won’t be for some time yet.

“In our view, communicating that interest rates will soon rise is going to be an issue for 2019 and not 2018,” says Dales and Hickie.

“So if we are right in thinking that the economic news won’t live up to the RBA’s lofty expectations, then at some point market rate expectations will have to fall back.”

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