Why The RBA Would be Foolish to Cut Interest Rates Next Week

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In Australia and the US, it’s all about the potential moves in interest rates.

US stocks were flat overnight as the market weighed up whether, and when, the Fed would raise rates. The laughable game of cat and mouse continues, as Bloomberg reports:

Federal Reserve policy makers took a step toward raising interest rates later this year but stopped short of signaling that the move could come as soon as September.

Federal Open Market Committee members upgraded their assessment of the economy in their monetary policy statement, released on Wednesday after their two-day meeting. They declared that near-term risks to the outlook have diminished and said labor utilization has shown “some increase,” though inflation remains too low.

Acknowledging recent domestic economic strength alerts market participants to increasing policy maker optimism, yet it also leaves the Fed room to defer a hike should inflation fail to materialize, global risks intensify or U.S. indicators slump.

And the game goes on. It’s a Tom and Jerry market. Here’s how it works…

The Fed thinks the economy is recovering and makes noises about raising rates at some time in the future. The market reacts to this by adjusting prices of various financial assets, which is sort of a de-facto tightening.

Stocks sell off, a few pieces of economic data come in weaker than expected, and so the Fed gets all nervous about its tightening path and tells the market it will hold off for a while.

This good news is applauded, stock prices rise, and financial markets loosen up.

The Fed then thinks: ‘Hey, things aren’t too bad actually. Maybe we need to tell the market to settle down and get a rate rise back on the table.’

Which is what they’re trying to do again now, albeit very tentatively. So tentatively, in fact, that the market barely reacted. Investors are calling the Fed’s bluff.

Gold shot up about US$20 an ounce on the news. It sold off leading up to the Fed’s meeting in the expectation that Yellen and co would be a bit tougher on interest rates. What were gold punters thinking?! When has that ever happened?

The ABC Bullion Investment Seminar

Speaking of gold, I mentioned that I went to the ABC Bullion investment seminar in Sydney the other day. There is clearly a lot of interest in precious metals in Australia, evidenced by the 500-plus people that turned up to see the show.

That makes me confident in my view that we’re in a corrective period for gold. Whenever any asset garners a lot of interest, you can generally bet that prices have peaked…at least for the short term.

ABC Bullion had to stop selling tickets a few weeks ago due to interest in the event…which coincided with the peak in gold company stock prices after a very strong run.

But we’re now about three weeks into the correction. Some quality gold stocks have fallen in price by 20% or more. This is a healthy development. The heat has to come out of the sector before it can move higher again. This is just the way markets work.

If you’re interested in learning what I think are the top gold picks in the sector to buy on this pullback, click here.

Or if you’re simply interested in learning more about buying physical gold (or silver), and the role that it can play in a diversified portfolio, check out ABC Bullion’s website.

In addition, they are the only company I know of in Australia that offer a gold and silver saving program, which allows you to set up a regular ‘savings’ plan by buying small amounts of precious metals monthly.

I should point out, neither The Daily Reckoning nor your editor is in any way affiliated with ABC Bullion. I’m just mentioning it because it’s a unique service that may be of interest to you. If not, no harm done!

I learned a few things at the investment seminar. Perhaps the most interesting one is that this year’s Melbourne Cup is made with ABC Bullion refined gold, and was spun by a bloke called ‘Sparrow’ in a small shop in Sydney’s Marrickville. It’s the first time in years an Australia company has made the cup. And it’s the first time in years too that the cup was made from Australian gold. It came from Evolution Mining’s [ASX:EVN] Cowal gold mine in NSW.

As I said, gold is likely to continue to consolidate its recent strong gains for a little while yet. Especially because it’s unclear if or when the RBA will cut interest rates again.

Although many now think more cuts are a certainty. There is some insane debate around low inflation giving the RBA another excuse to drop rates. Yesterday’s inflation data release showed headline inflation of 0.4% for the June quarter, meaning consumer prices went up ‘only’ 1% over the past year, the slowest pace since 1999. Apparently, such a low inflation rate could justify another rate cut.

One article I read earlier this week even suggested that the price competition food retailer Aldi is bringing to the market could force the RBA’s hand…

As I said, the argument is insane. Since when does healthy price competition threaten to slow an economy and bring about an interest rate cut? But such is the quality of economic debate these days that an idea like this even saw the light of day.

Thankfully, there are saner voices out there. Like former RBA board member Warwick McKibbin. From the Financial Review:

Former Reserve Bank of Australia board member Warwick McKibbin has urged the central bank to ignore “market hysteria” over the weakest inflation figures since 1999, warning that adopting the zero-rate policies of Japan and Europe won’t fix the economy.

Speaking after official data showed consumer prices rose just 1 per cent over the past year — the weakest result in 17 years — Professor McKibbin said focusing only on keeping inflation within its target range would also lead to more house price distortions.

How everyone can’t see this is beyond me. Cutting rates makes debt cheaper and more attractive. As such, it increases house prices. But the larger amount of debt carried by the household sector comes at a cost of high aggregate interest payments.

If more money is devoted to housing repayments, there is less money available for spending elsewhere. So cutting rates and pushing house prices higher is hardly the solution.

And judging by the performance of the stock market, household sector spending is in good shape. Check out the chart of the consumer discretionary index over the past three years…

Source: BigCharts
[Click to enlarge]

It’s now trading at the highest level since early 2008. Is this telling you that the economy needs an imminent rate cut?

Of course not. If the RBA cuts rates next week, it’s being irresponsible. But it wouldn’t be the first central banks to act that way…


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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