Why Next Year’s Interest Rate Moves Will Shock You

I’d like to start today by sharing a 2,000 year old Chinese parable.

It goes like this…

A Chinese farmer gets a horse, which soon runs away.

His neighbour says, ‘That’s bad news.

The farmer replies, ‘Good news, bad news, who can say?

The horse comes back and brings another horse with him. Good news you might say.

The farmer gives the second horse to his son. When riding it he is falls off and breaks his leg badly.

So sorry for your bad news,’ says the concerned neighbour.

Good news, bad news, who can say?’ the farmer replies.

In a week or so, the emperor’s men come and take every able-bodied young man to fight in a war.

The broken leg spares the farmer’s son this fate.

Good news, of course.

What’s this got to do with interest rates you ask?

Well I think next year every Reserve Bank of Australia (RBA) meeting will be like this.

Whether rates go up or rates go down it will be a case of good news, bad news, who can say?

You see, we’re actually sitting in an economic sweet spot right now.

But it comes with an unfortunate twist. The longer we stay in it, the worse the outcome will eventually be when we leave it.

At ‘some point.’

Yet no one knows when that ‘some point’ will be.

But I think external factors next year will start to end this stand-off. It won’t be a crash. In fact it will be the opposite. An economic boom.

And interest rates will shoot up faster than anyone thinks…

Nothing lasts forever

First what do I mean by economic sweet spot?

Well let’s look at the cold hard facts.

Economic growth remains good. Not ‘mining boom’ strong but certainly not weak.

According to Trading Economics, the Australian economy expanded 0.8% in the June quarter of 2017, much stronger than a 0.3% growth in the first quarter and matching market consensus.

The solid expansion was due to strength in domestic demand and net exports.

Unemployment remains low at only 5.5%

Inflation remains contained. In fact, September’s numbers were the lowest since December 2016.

Trade wise, things are ticking over nicely too.

Again from Trading Economics:

Australia’s trade surplus doubled to AUD 1.75 billion in September of 2017 from a downwardly revised AUD 0.87 billion in the prior month and beating market expectations of AUD 1.2 billion. It was the largest trade surplus since May, as exports increased by 3 percent to AUD 32.96 billion while imports was flat at AUD 31.21 billion.

This all sounds fantastic.

But check out the 30 year interest rate chart.

Australian Interest Rate 16-11-17

Source: Trading Economics

[Click to open new window]

Interest rates are at down at ‘panic’ levels.

They’ve never been lower.

This is not a sustainable situation.

As you know, economies move in cycles. That means the numbers move up or down in a trend. They don’t just stand still frozen in time.

Unless we’ve reached some magical equilibrium point, a world where strong economic growth can live with low interest rates and low inflation, something’s got to give.

Interest rates have just got to move.

And I think next year it will all kick off.

Let me tell you why… 

Three reasons interest rates are going up

I’m of the opinion we will see four or five interest rates rises next year. At least one every quarter.

There are three reasons for this.

The first reason is continuing economic growth. I’ve talked before how I see a coming infrastructure boom. This will take place in Australia, China, the USA and South East Asia.

There’s trillions of dollars of plans already drawn up. And an infrastructure gap according to consulting firm McKinsey & Company:

From 2016 through 2030, the world needs to invest about 3.8 percent of GDP, or an average of $3.3 trillion a year, in economic infrastructure just to support expected rates of growth.

Emerging economies account for some 60 percent of that need. But if the current trajectory of underinvestment continues, the world will fall short by roughly 11 percent, or $350 billion a year.

The size of the gap triples if we consider the additional investment required to meet the new UN Sustainable Development Goals.

Commodity prices are already starting to rise. If the infrastructure melt-up plays out in 2018 like I think it will, then we could be set for a resources sector resurgence.

That will help the currently struggling mining states of Western Australian and Queensland, putting further downward pressure on unemployment and further upward pressure on inflation.

The second reason is the desire of the RBA to ‘normalise’ rates as fast as possible.

The threat of an economic crisis in the world is always there. And Australian only scraped through the GFC in 2008 by having the power to drastically decrease interest rates as a response.

Government spending combined with this monetary easing resulted in a recession-free GFC for Australia, one of the only countries in the world to do this.

Lastly, there’s the situation in the US. If the Federal Reserve continues to tighten US interest rates, Australia will be under pressure to do the same.

You see the last time US interest rates were lower than the US level, the Australian dollar plummeted to US48 cents. That was 16 years ago.

That’s not a good outcome for Australian economy, and it’s one the RBA will be mindful of.

Forewarned is forearmed

If you’ve got a mortgage or have recently bought a house, coming interest rate rises are something you’ve got to prepare for.

Whether this means fixing a part of your mortgage, or building in a buffer by paying more than you have to now.

If you’re looking for investment opportunities, perhaps the resources sector is a place to start looking again?

As the Chinese parable said at the start, good news can be bad news and bad news can be good news. Better to have a broken leg, than being sent to war.

It all depends on the circumstances and timing of the event. And how it relates to you personally.

Make sure a resurgent Australian economy isn’t bad news for you.

Good Investing,

Ryan Dinse,
Editor, Money Morning

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

Money Morning Australia