Caton's Corner - Interest rates to go up again... and they should

Financial market volatility

These are disturbing times for investors. Financial markets have been in a funk since July. The US share market has again fallen by more than 10% since 2008 began, and is now lower than it was a year ago. This is its worst ever start to a year. The Australian market fell for twelve days in a row, something that hasn't happened for more than 25 years. This fall culminated in a massive 7% drop, the worst for 18 years, on 22 January. Since the start of the year, the ASX200 was down by more than 14%, although it has since recovered some of this loss.

This was the third (and worst) major downward move in the past six months. The first, from mid-July to mid-August, followed the 'sub-prime' blow-up, and the subsequent jamming up of credit markets. The second, from early October to late November, had a similar cause, overlaid with concern about possible US economic weakness. The third fall, which began in mid-December, and is still ongoing, reflects concern that the US economy may be lurching into recession, overlaid with continuing concerns that there are more sub-prime-related losses to be announced. With respect to the latter concerns, it is clear that 'it's not over 'til it's over'. So far, announced losses at major financial institutions are over $130 billion, and estimates of the total losses to be realised cluster between $200 billion and $500 billion. But consider this: since the peak in share markets in mid-July, more than $6 trillion has been wiped off the value of shares worldwide. Doesn't that seem to be, if anything, an over-reaction?

There has been a question mark over the US economy for almost a year now and it is, remarkably, still unanswered.

The main source of economic weakness in the US has been the housing sector. From a peak in early 2006, housing starts are down by more 50%. You have to go back to 1966 to find the last time that happened outside of a recession.

There are ominous signs elsewhere in the economy. Employment growth in the year to December stands at just 1%; it has never been as low except during a recessionary episode. A three-month moving average of the unemployment rate is up by 0.34 percentage point from its recent trough; a rise of 0.3 or more has always connoted a recession in the past. And one more thing; the consensus view of economists and analysts has never forecast a recession before it begins. Recessions always take (most of) us by surprise.

It's not hard to figure out why this is so. Recessions just don't happen very often. In the US there have been just two in the past 25 years; in Australia there has been only one. So if a forecaster never predicted a recession in his working life he/she wouldn't be wrong very often. It's a bit like Australia and Test cricket. Australia doesn't lose very often, so it may be smart never to forecast a loss. But by the time we're five down in the second innings, and still need more than 230 to win, it's time to consider the possibility of loss!

In the case of the US economy, it’s not all gloom and doom. The total output of the economy grew by 2.8% in the year to Q3 2007, and growth in Q4 2007 was almost certainly positive also. A recession is not yet a certainty. I would put the chance right now at close to 50%. The critical question is: to what extent have markets already priced in recession. This is very difficult to answer. From its 1 November peak, the US market fell by 15%. During recessions, the market usually falls by at least 20%.

As long as recession remains a possibility, markets will remain jittery, and sensitive to each new piece of weak news. They will also be sensitive to what the US central bank, the Federal Reserve, does. The Fed's recent surprise rate cut of 3/4% sent a clear message that it is aware of the deterioration in the economy, and that it will cut rates further if it deems it necessary. That rate cut, and a further one of 50 basis points just one week later, appear to have 'stopped the rot' in the US share market, at least temporarily.

The Fed is not the only member of the cavalry riding to the rescue. President Bush has announced plans for short-term fiscal stimulus, as was used in both the 1975 and 2001 recessions. Such stimulus is expected to be around 1% of GDP, and includes both individual tax rebates and some tax incentives for businesses. Economic stimulus has become a key issue of the 2008 Presidential campaign. Any successful short-term stimulus will need to be enacted quickly, and it may be less than fully effective. The problem with rebates is that they tend to be saved, or used to pay down debt (Americans have a lot of that!), rather than spent.

History is not always the best forecasting tool, of course. But it does suggest that once a recession is 'written in the stars' then all that policymakers can do is affect the depth and duration. In the current conditions, they can probably do enough to ensure that any recession is reasonably mild, which may mean that markets have already fallen enough.

The US share market is thus likely to continue to be volatile for some time, reacting to earnings reports, the economic news and the Fed’s actions. This volatility will probably continue until it is obvious that employment growth is no longer worsening. My personal view is that the market is likely to revisit the January low. The good news is that, just as the US share market falls before recessions, it generally turns before the recovery is evident to all. Every significant market correction eventually presents a buying opportunity.

And another thing
As if Australian investors didn't have enough to worry about, there is still the chance of a further rise in official interest rates here. If it happens, the first opportunity will be on 5 February. The Reserve Bank is in a real dilemma. Concern about the US economy, and about financial markets, would suggest that caution is required. On the other hand, the Australian economy has been growing strongly, with consequent upward pressure on inflation. Underlying inflation is currently running at close to 3.5%, which is significantly above the RBA's target range. If this were all it knew, the RBA would raise rates without a second thought. If rates do go up, mortgage rates will rise again, the Australian dollar will be put under more upward pressure, and the share market will not be helped. My personal view is that the Bank will decide, on this occasion, that domestic considerations are more important. Barring another financial-market meltdown, the cash rate is now likely to be raised on 5 February, with clear implications for mortgage rates.

Chris Caton

Chief Economist

Dr Chris Caton writes a regular column providing topical financial commentaries, economic overviews, and assessment of investment issues. You can access some of Caton's previous articles by visiting Caton's Corner on the BT website.