Source: Daniel Munoz/Reuters
Market Herald logo

Subscribe to Art of the Essay

Be the first with the news that moves the market

There has always been a certain mystique in the workings of financial markets and what they portend. Discussed on talkback radio, the morning show or even by an ex-economist on network television, a message of doom or revelation is proffered. A real crystal ball of wisdom waiting to be exposed by a savvy few with decades of insight.

Oddly enough, there is rarely a reconciliation process in the ensuing months to check how reliable, or otherwise, those market soothsayers were.

Let me say just one thing about markets: They are an excellent gauge of positioning at any point in time. And that’s about it.

The professional financial markets span commodities, interest rates, foreign exchange and equities.

The myriad participants include retail and institutional investors, central banks, speculators, producers, hedgers, hedge funds, sovereign wealth funds and high frequency arbitrageurs.

At any particular price point there is demand and supply equilibrium. As new information is gathered, imbalance occurs until a new price equilibrium is achieved. The recent surging of energy commodities is a great example of this. Some may say the state of fear and greed is well represented when markets become volatile and trading ranges extend.

This basic high school explanation for price action in an efficient market does not explain the calamity across seemingly unrelated markets recently. In reality, there is now such a gargantuan amount of risk capital to be invested yet not enough liquidity. This leads to price volatility beyond what might be viewed as “fair value”.

Ten-year US Treasury notes were yielding 0.5 per cent in mid 2020 as pandemic fears reached a crescendo. Government bonds are seen to be a safe haven for investors during periods of uncertainty.

With Fed funds around 0.1 per cent at the time, was the market “predicting” that the world would not recover from COVID for most of those ten years, or that there would be a depression from which we may never recover or need to raise rates?

Yet at the same time equities and property very quickly experienced one of the sharpest gains of all-time; hardly the stuff that economic ruin might warrant.

Clearly, financial market pricing encompasses more variables that are not directly related to future moves in official interest rates. Furthermore, official rates only have a limited effect on longer dated instruments.

Because markets overshoot and undershoot fair value, we must use additional methods to determine the path of money market rates.

After such a prolonged period of incredibly easy monetary and fiscal policy, there now exists universal inflation sweeping the globe that requires swift rate normalisation and balance sheet wind-down.

Monetary policy is largely focused on the price and availability of credit, meaning the household borrower is a key player. The debt-to-income ratio of borrowers represents elasticity of rates versus householder spending and borrowing intentions. This is a favourite indicator for central banks and economists.

Following the now infamous jawboning of RBA Governor Philip Lowe throughout much of 2021 to imply official rates would not be raised until 2024 “at the earliest”, there was a dramatic pick up in private sector credit of around eight per cent. Property investment surged.

In less than six months following this, the RBA is poised to begin tightening monetary policy in June.

The Australian Prudential Regulation Authority has highlighted concerns about high debt-to-income lending in the past year with borrowers taking on debt of more than six times their annual household incomes. Such loans comprise about a quarter of all mortgages issued in the latter months of 2021.

The stress to household borrowers will be profound.

Many Australian fixed rate loans will be rolled in 2022 at 150 to 200 basis points higher than 2021 levels.

RBA analysis from its recent Financial Stability Review revealed that about 40 per cent of mortgagees can factor a 200-basis-point rate rise into their current servicing profile.

More concerning, however, are the one-in-five who would experience a 20 per cent increase and another one-in-five suffering a staggering 40 per cent loan servicing slug. The RBA sees the resultant stress pushing real home prices 15 per cent lower. Consumer confidence and spending — key economic drivers — are certain to fall sharply as households brace.

Australian money markets have priced in a massive 310 basis points of official rate hikes through 2023 — over 50 per cent more than that factored into RBA modelling. 

The conclusion is quite clear.

Based on information available, market settings are far in excess of where the RBA will hike official rates in order to bring inflation back towards three per cent.

It is likely that first-quarter CPI data will reveal annualised inflation at around five per cent and possibly higher next quarter as surging energy prices are recorded.

Nevertheless, the RBA does not want to risk placing Australia into a recession so soon after seeing it through the worst of the pandemic, in which demand for commodities and a low Australian dollar delivered an economic boom and full employment.

The war in Ukraine has hampered the utilisation of traditional disinflationary benefits in a globalised world; namely technology and decentralised online purchasing. Perversely, once the conflict ends, it is likely energy prices will fall sharply and many supply bottlenecks will be resolved. Markets often price-in worst-case scenarios so the outcome of the war will play a significant role in global inflation levels.

The “terminal rate” is where economists expect official rates to peak before turning lower as the business cycle reverses and activity slows.

In Australia, the market is pricing a terminal rate of 3.25 per cent at the end of 2023, yet economists generally predict between 1.25 and 2.5 per cent.

This is the most important reference for borrowers in Australia. The higher the terminal rate, the more expensive home loans will become and the risks of recession rise. Inflation is dealt with quicker, however.

Head of Australian Economics at Commonwealth Bank, Gareth Aird, believes households are particularly susceptible to rising rates. “We estimate there are over one million borrowers who have never experienced an increase in mortgage rates,” he said.

“A shallow rate hike trajectory is our base case.”

CBA sits at the lower end of estimates for official rates, seeing 1.25 per cent through 2023 as the RBA assesses the impact on household finances and consumer demand.

My feeling is that the RBA will hike to 1.5 per cent in 2022 and two per cent in 2023 if conditions warrant, which will be a mild reduction of stimulus. This should be sufficient to bring inflation under three per cent. Australia will avoid recession due to the incredible strength of commodities exports.

This year, however, may prove less constructive for many other countries with limited sources of food and energy. High inflation and extreme oil and gas prices have all but locked in recession for many parts of the globe later in 2022.

Australia, at least for now, remains the “lucky country”.

Neale Muston has worked as Head of Fixed Income, Asia Pacific, for Merrill Lynch Japan, and as Managing Director at Morgan Stanley Australia and senior derivatives trader at JP Morgan Australia. He has previously written for The Sydney Morning Herald.

More From The Market Herald

" Voters are getting better educated — this isn’t good news for democracy

Graduates excel at motivated reasoning, and that means they are less prone to changing their minds.

" Voices of us: Why we need independents in our system of governance

The views of twenty-five million people don’t neatly divide into our so-called two-party system.

" Pamela Anderson, Amber Heard and the limits of the feminist redemption plot

There's nothing quite like rewatching a woman's life collapse in the name of righting history.