Wanting an Interest Rate Cut Tomorrow is ‘Un-Australian’

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Nothing illustrates the lows to which Australia has sunk better than the whiff of an interest rate cut. Nothing illustrates the short termism and rent seeking behaviour of our institutions better than the approach of the first Tuesday of the month.

Over the weekend the afr.com ran with a headline that went something like, ‘markets increase bets on an interest rate cut’. Then this morning upped the ante with this: ‘Banks tipped to pass on RBA cut’.

So it’s a done deal now? It’s just a question of whether the banks will pass it on.

Like most mainstream business media, the AFR is nothing more than a distribution channel for companies and industries to promote themselves. Young journo’s, ignorant of how it works, simply rewrite press releases or bank and broker research and notch it up as an article published.

When it comes to interest rates, nearly everyone has a vested interest in seeing lower rates. We certainly do. Lower rates means higher stock prices, which means we sell more newsletter subscriptions. It’s a no-brainer that editors of media publications will pump the ‘low rate’ angle for all it’s worth.

After all, Fairfax, publisher of the AFR, now makes a large chunk of its profits from its property advertising division, Domain. Of course they want to see lower rates!

Take the first headline I mentioned above. Sure, the odds of an interest rate cut fell during the week. On Wednesday, market pricing suggested there was a 67% chance of a rate cut. But by Friday the odds had fallen back to 49%.

Yet that didn’t stop Fairfax from running with the misleading ‘markets punt on rate cut’ headline. They did earlier in the week, but then reversed it.

Then came this morning’s offering, a rewrite of a bunch of opinions from analysts employed by banks. The banks will pass on any rate cut, they say. Yes, and the wolf won’t take the sheep on offer, either.

My gripe is not really with the banks though. It’s with the stupidity of the whole interest rate debate in this country. We are so addicted to lower rates we can’t even have a proper debate about it.

The analysis goes along the lines of this: Oh, the economy is weak. What to do? How about an interest rate cut to stimulate things and get us back on track.

No one seems to consider that the sum total of all the other interest rate cuts got us to this point. That is, in a weak state, needing another one.

While the Australian economy is weak thanks to lower commodity prices and a downturn in mining investment, it’s not that weak. Lower interest rates have offset much of the downturn in the commodity sector. There are parts of the economy that are growing quite strongly. It’s only in aggregate that things look gloomy.

But here’s the problem. It’s been a big increase in debt that has contributed to this strong growth. And most of the increase in debt has come via an increase in housing related debt.

According to australiandebtclock.com.au, at the end of 2008 Australian housing debt (which includes owner-occupied and investor related debt) was just under $1 trillion. Now, it’s $1.5 trillion.

That’s a 50% jump in about six-and-a-half years.

That’s $500 billion in extra demand flowing through the banking system and the economy. It’s equivalent to just over $75 billion in additional spending each year. In the context of Australia’s economy, that’s not a huge amount. But it provides a nice little boost.

The problem is that our economy now must service the larger debt pile. While interest rates are low, this is not a huge burden. But if rates were to pick up — and I’m talking about foreign investors reassessing Australia’s risk profile and increasing rates independently of the RBA — then we’d be in trouble.

This is why myopic calls for further interest rate cuts are so stupid. The benefit to future demand is fleeting, yet the increase in risk they present through higher debt levels are permanent.

We’d be much better off taking the minor pain that stable to slightly higher interest rates provide us now, and focus on reforms that will make as a stronger and smarter economy in the long run.

Right now, we remain hopelessly dependent on China. Our primary income earner, iron ore, is totally dependent on China’s steel industry. This is why I constantly write about it. You won’t hear it from the rent seekers who don’t give a hoot about this country’s future.

Data released over the weekend revealed that China’s manufacturing sector continues to shrink. And its steel industry is barely making any money, such is the level of excess production in the industry.

Now China is exporting a record amount of steel and putting pressure on global steel markets. Just recently, the UK shut one of its major steel mills because it just can’t compete.

This will create global trade tensions. In the coming months you’re going to see a major turning point in Chinese steel, and by implication, Aussie iron ore. In my view, we’ll see new lows in the iron ore price before too long, perhaps before the end of the year.

This will put the focus back on the government’s weak budget position and increase their deficit. It will cause the rent seekers to scream even louder for an interest rate cut, despite the uselessness of it.

And it will push us another step closer to recession. Recessions aren’t the end of the world, but they’re much nastier to deal with when you have high debt levels. Remember, asset prices generally decline in a recession while debt levels remain the same. This immediately puts pressure on the national balance sheet.

My guess is that the RBA can see a few metres further than the rent-seekers demanding a rate cut for tomorrow. This will cause them to hold off, if only for another month, to see how the household sector absorbed the recent rise in mortgage rates.

So my punt in tomorrow’s two horse race is for no rate cut. If I get that one right, I might just dabble in the Cup. I’ll consult my racing sources today and give you a tip in tomorrow’s Daily Reckoning.

Regards,

Greg Canavan
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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