Recall the good and the bad for interest rates over 2010. Reflecting the two-paced world economy, official cash rates were left unchanged (and extremely low) in the United States, the eurozone, Japan and Britain, but raised in Australia, China and India.
In the US, government bond yields fell to multi-year (and even record) lows during August, when fears developed that low inflation would morph into deflation, but on several occasions during 2010 bond yields soared in some European countries because of sovereign debt problems.
The big influences on interest rates in 2010 are likely to be growth rates in the US and China, and inflation fears in Australia.
My guess is the US economy will exceed consensus growth expectations, with each of consumer spending, exports and business capital spending contributing.
In the second half of the year, the Fed could contemplate its first step towards normalising the cash rate – leading, perhaps, to a sharp sell-off in bonds and a stronger US dollar.
There are many uncertainties in the outlook for China, where monetary policy has been tightened to restrain inflation and property speculation while encouraging consumer spending as one way of rebalancing the economy.
The safest assumption, perhaps, is that China’s growth will slow modestly in the second half of the year, reducing the boost to commodity prices and our economy generally.
When the Reserve Bank of Australia (RBA) last raised our cash rate (to 4.75 per cent in November), its move was pre-emptive: prospective inflation was within the target range and consumer spending was a little soft.
My guess is the cash rate will remain unchanged until the June quarter. However, over the second half of the year, the deteriorating outlook for inflation – as wages pressures build up while productivity growth is near zero – could see the cash rate raised progressively to 5.5-5.75 per cent, with the variable interest rates charged to borrowers increasing by an equivalent amount.
Over much of 2010, Australian 10-year bond yields traded mostly within the range of 2-2.5 percentage points above US yields.
I suggest this spread will narrow in 2011 as US growth speeds up; even then, our yields could move higher on the back of rising US bond yields.
And Australians are likely to continue enjoying attractive returns on at-call money and term deposits.
Of course, 2011 will have its share of surprises for interest rates (and investment markets more generally). The major economies all have big budget deficits to finance. China may make mistakes in its efforts to cool inflation and property speculation. Europe’s debt problems could take a new twist.
My major concern is that, by end-2011, the RBA will be concerned by the outlook for inflation.
Praemium non-executive chairman Don Stammer
