Rate hikes? Yawn. When’s the first cut?

The noise in financial markets is about the upcoming RBA meeting. When the board convenes in February, after a long summer break, will they hike or not? There are arguments for and against, and financial markets have a rate hike priced in as a maybe.

But whether the board does or does not tighten monetary policy on February 7, the hiking cycle is pretty much done. Rates have risen from 0.1% to 3.1%. They are much nearer their peak than their trough. The smart observer looks beyond the near-term noise. When’s the first rate cut?

Timeline

It may seem strange to speak of rate cuts when the most recent inflation indicator gave us a figure of 7.3%. But futures markets are telling us that the time until rates once again bend downwards is not that far away.

According to rate markets, the first month with a chance of a rate cut is November this year, mere months away. This next chart reveals the most recent prediction of when the first rate will be: in 10 months’ time. The chart also shows that since April 2022, predictions of the time until the first rate cut have been volatile, varying from 8 months to 18 months away from the date of prediction.

(NB: Dots that lie on an apparent diagonal line on the graph show periods when the expected date of the first rate cut is not changing, but getting closer one day at a time. )

So the most recent change in rate cut expectations is: sooner. What’s more, peak interest rates are now expected to be lower than before. Rates more than 4% are no longer forecast — the peak is now just over 3.7%, and a full cut to interest rates is priced in as a certainty by June 2024.

That says something about how weak the global economy is expected to be by late this year. The World Bank has downgraded forecasts for growth dramatically, from 2.9% to 1.7%, and according to a Wall Street Journal survey of business and academic economists, the US economy is expected to shrink, entering recession later this year.

Falling costs

Low growth in global activity will take the strain out of global supply chains and let prices fall. A small change in demand can lead to a large change in prices: if a Chinese factory can make 1 million T-shirts but has orders for 1.1 million, it can raise T-shirt prices until 100,000 buyers drop out. That could be a big lift in prices during a period when all the other T-shirt factories are at their limits! But if the number of T-shirt orders falls to 900,000, the Chinese industrialist will cut T-shirt prices sharply, eager to make sure stock doesn’t remain unsold.

In this way, seemingly small changes in demand around supply constraints can cause huge changes in price. We saw this with shipping prices. When there were more containers than ships to carry them, the price of taking a box from China to Europe rose five-fold. Shanghai to Rotterdam could cost US$14,000 (A$20,000). That price has now fallen to around US$2000 (A$2850), according to the Drewry Container Index.

Oil too is a lot cheaper now than it was a year ago. Europe’s warm winter foiled Putin’s plan to starve the West of energy, and now the price of fossil fuels is subtracting from inflation pressures. If the northern hemisphere summer doesn’t require lots of air conditioning and coincides with a recession, energy prices could slump.

That will put a lot of negative numbers into the ABS inflation spreadsheet, potentially bringing down inflation more quickly than expected. China is the other moving piece here. If it successfully emerges from under its zero-COVID blanket, the additional demand could prevent coal oil and gas prices from falling much further.

House prices

Australian house prices are expected to keep falling for the rest of the year. Major banks reckon another 5-10% could come off prices. That affects the Australian economy in two main ways. One is that fewer houses change hands, depressing the surprisingly large part of our economy devoted to real estate transactions. Conveyancers, lenders, agents: all lose work. That shrinks the economy.

Another is that people spend less. Not only new homebuyers, who often want an electrician and landscape gardener after they get the keys, but also existing homeowners, whose spending is depressed by falls in their wealth.

Another 10% off house prices will move prices back to early pandemic levels, albeit not as low as the pre-pandemic depths of 2018. Such a move could cause quite a dislocation in consumer confidence of homeowners — and in economic activity — and might well be the proximate cause of the RBA reversing course and starting to cut rates.