Australian interest rates may head lower

05:30, Jul 29 2014

The Reserve Bank of Australia may be forced to cut the official cash rate before the end of the year to beat back of a wall of foreign money that has driven the Australian dollar higher, according to a bond market veteran.

Goldman Sachs Asset Management's bond expert Phil Moffitt, a 30-year veteran of the bond market and one of Goldman's most senior Australian partners, was speaking at the sidelines of the A$935 billion ($1.03 trillion) asset managers' client conference in Sydney.

Moffitt said the confluence of weak domestic growth, an expected fall in inflation as the carbon tax is discarded and the high currency was pointing towards a potential cut in the official rate cut below its current 2.50 per cent setting.

"The game plan has been the RBA to hold rates stable, and accept the currency is overvalued, in anticipation of the Fed moving [to lift US interest rates]," he said. 

"But the more the Fed works to pacify market expectations of a rate rise, the stronger the local currency gets and the harder it is for the RBA to manage."

Moffitt says the Federal Reserve will be forced into hiking rates sooner than expected, which should aid the RBA's desire for a fall in the currency.


But strong demand for Aussie dollar fixed income assets will ultimately prove too much of a force for the central bank to ignore.

Double whammy


A potential fall in the inflation rate later in the year could ultimately set up the RBA to act.  

"They may take the opportunity later in the year with inflation coming down because of the [repeal of the] carbon tax and the soft domestic economy to cut rates. That would come at the similar time that we expect US treasury rates to rise," he said.  

The prospect of the Federal Reserve finally moving to normalise interest rates in the largest economy of the world could create a difficult path for the RBA to navigate.

But a rise in US interest rates coupled with a cut in the RBA cash rate could provide the double whammy that drives the Australian dollar down to levels desired by the central bank to aide a rebalancing of the economy.  

Behind the Australian dollar' strength is the demand from international investors for Australian dollar fixed income assets as rates are held low throughout the world.

This is being driven by a range of investors from high net worth clients of private banks to sovereign wealth managers.

Foreign demand not slowing 


The demand is showing no signs of slowing and even if Australian 10 year bond rates fell to 3 per cent which he predicted as a possibility, it would still provide an attractive place for foreign capital.

"One of the reasons why I think they have their hands forced by the currency is even though we are short US rates and the Fed will need to act, is that the ECB and BOJ are going to keep really easy policies.

"The large markets are also places with current account surpluses so they are looking for places to export capital and Australia is one of them."

Moffitt says that current market pricing - which suggests a small probability of the RBA cutting the cash rate before the end of the year - shows his view 'is not that radical".

But it is at odds with the consensus among sell side economists who expect the RBA to remain on hold for the next 12 months.

Moffitt says GSAM's view diverges with the analyst community because analysts are rightly "listening to the RBA" in their comments that rates will be on hold but also because on differences in views on whether the RBA is comfortable the sharp rise in house prices.

"Analysts have assigned a large weight to house price inflation and they're concerned that the RBA is concerned," he said

"Our analysis is to be less concerned because what we think is a risk is not house prices going up, but house prices going up accompanied with a big growth in credit. And that's not really happening."

While local traders are divided on the RBA's next move, the multi-trillion dollar question is when the Federal Reserve will finally lift the Fed Funds Rate from its near zero setting.  

Goldman Sachs Asset Management has a short position in US bonds on an expectation that a US rate rise is coming sooner than the market is expecting.  

"We are of the view that the Fed will be drawn into a rate rise earlier," he said.

With the US economy now growing an expansionary 3.5 per cent rate, unemployment heading to below 6 per cent and the inflation rate above 2 per cent Moffitt says these 'red buttons' are alerting him that the Fed will be forced to act.  

He says the fund's analysts are seeing evidence of tighter labour market conditions as companies demand skilled workers that have been unemployed for a short period of time. The proportion of short term unemployed workers is as low as it has ever been with labour in certain sectors in high demand, an inflationary force.  

"The two places where analysts are seeing demand it is construction and finance. Some of the banks that closed down their mortgage departments and let their assessors and underwriters don't have people on the ground to do mortgages so they have to go out and hire them" 

Sydney Morning Herald