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Economic and Financial Market Update: The Long Road Back

26 February 2021

Summary:

Financial markets have moved at light speed to price higher interest rates;
Certainly the economy has improved;
But the timing of the first hike appears inconsistent with current economic forecasts and central bank talk;
My simple ‘fair value’ model suggests the $A should be trading around 82c.

Financial markets have started to speculate that the RBA will have to raise the cash rate prior to 2024. At the time of writing one quarter percentage point rate hike had been fully priced by the end of next year. The move to start pricing in rate hikes has been a global one.

Thoughts turning to rate hikes are understandable given the greater confidence about the economic outlook. But current financial market pricing looks increasingly at odds with stated global central bank policies. Central banks (including the RBA) have made it clear that interest rates will rise later in this economic cycle than they have done over the past twenty-plus years. So it is possible that interest rates may need to rise earlier than the RBA’s current projection of 2024. That would be because the economy turns out to be a lot stronger than what they have been thinking.

The $A has had a strong start to the year but it is not the only currency to have made a fast start against the ‘big dollar’. There have been a number of factors that has kept the $A strong. Investors have become increasingly confident about the economic outlook. Global central banks have made it clear that they intend to keep interest rates very low for some time yet. There is a (further) big fiscal stimulus on the way in the US. All of this has helped push most commodity prices (notably iron ore) up, a big plus for the $A.

At the time of writing my ‘simple’ fair value model for the $A was at 82c. It is now within spitting distance of that ‘fair value’ target. It might be hard to get through that 80-82c area at least for a while as a lot of good economic news has already been priced in.