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Interest Rate Commentary

While monetary policy divergence between the RBA and the Fed has been the general expectation for most of 2016, global economic conditions are likely to force the Fed to postpone any potential rate hike until next year while many market commentators are forecasting two cuts to the RBA cash rate by year end.

 

However, as the RBA has reiterated numerous times, the lowering of interest rates follows the law of diminishing returns meaning that for each rate cut the economic benefits gained become less and less. This is also commonly referred to as the ‘zero bound’ problem and is a major issue overseas where some interest rates are now in negative territory. Due to this limited effect, global economies have resorted to unconventional monetary policy measures such as large asset buy-back programs known as quantitative easing (QE) which has somewhat distorted financial markets

 

While Australia would need an extreme event to trigger QE (i.e. recession in China), it is likely monetary easing is here to stay for at least the next few years. Given at some point the Fed will increase US interest rates, further cash rate cuts will be needed to devalue the Australian dollar against the US dollar to support exports. It is only a question of when these rate cuts will occur.

 

The domestic yield curve is flat and overall yields across the curve are low compared to long term averages. In November 2015 there was a progressive increase in yield from ~2.60% to a high of 2.99%. But since this time the flight to quality meant the 10-year yield gave back the changes in Q4 2015 and more recently the Australian Government 10-Year Bond Yield has continued to drop to record lows (new low of 1.864% as at 6 July 2016). The 3-year bond has followed a similar pattern and broke out of its yield range (1.90 – 2.10%) in November / December 2015 reaching a high of 2.18%. It has since collapsed to reach a low of 1.46% on the 26th of June 2016. On the 15th of July 2016 the ASX 30 Day Interbank Cash Rate Futures June 2016 contract was trading at 98.39 indicating a 60% expectation of an interest rate decrease to 1.50% at the next RBA Board meeting (down from 62% last week).