Back in May 2013, when PIMCO (one of the world’s largest bond fund managers) first uttered the phrase "the new neutral", it was in relation to Australia's policy rate, the cash rate. At that time, we estimated the neutral policy rate – the level that neither stimulates growth nor slows it – to be about 3 per cent for Australia, and we have stood by that view. More than four years later, the Reserve Bank of Australia explicitly referenced 3.5 per cent as its estimate of the neutral cash rate in its meeting minutes released on July 18; board members also acknowledged significant uncertainty around this estimate.
Whether it's 3 per cent or 3.5 per cent, the clear takeaway from both of these estimates is that we should expect interest rates in Australia to be significantly lower going forward than in rate cycles before the global financial crisis.
Handbrake on rates
Australian households have binged on debt since the GFC, taking advantage of increasingly lower mortgage rates. Recently, these rates have started to rise for certain borrowers due to regulatory changes designed to limit the potential for systemic risk.
Based on PIMCO's analysis, Australian borrower confidence is dominated by two factors: the level of borrowing rates and recent changes in house prices. Given the latest data – with mortgage rates inching higher and house prices cooling somewhat – it appears that an important inflection point is approaching, which will limit the RBA's flexibility for increases in policy rates.
PIMCO's calibration for a 3 per cent new neutral rate is largely based upon the same factors that the RBA identified, with one apparent differentiator: the perceived sensitivity to debt-service ratios. We see a much higher starting point in household debt. So an increase in mortgage rates of 2 percentage points (the amount needed for the RBA to bring the cash rate to its estimate of neutral) would require the average householdto set aside a proportion of disposable income on par with the most restrictive historical extremes of (un)affordability in Australian housing.
Given these dynamics, any hiking cycle in Australia is unlikely to start for at least six to 12 months.
It is important to consider the global economic environment expected to be in place at that time. China's 19th Communist Party Congress is scheduled to conclude before the end of 2017, and the probability is high of additional economic growth volatility in its wake.
Also, the value of the Australian dollar will be key: The RBA has pointed out that the depreciation of the Australian dollar since 2013 has assisted Australia's economic transition away from mining, but it is also important to note that the currency has appreciated by over 15 per cent since early 2016.
The combination of higher mortgage rates for specific borrowers plus the increase in the Australian dollar means that monetary conditions have already tightened meaningfully since the beginning of 2017.
When the RBA disclosed its neutral rate estimate a couple of weeks ago, many investors assumed the bank was on the brink of raising the cash rate, and bond yields and the Australian dollar climbed sharply.
These events represented more than a misreading of a central bank comment; they also signaled that the RBA, like central banks globally, is seeking to introduce more policy freedom. Now that the most aggressive phase of global accommodative monetary policy appears to have passed, central bankers around the world will try to ensure that the markets are prepared for a potential return to new neutral policy settings.
The valuation of every asset globally has benefited from low interest rates thanks to central bank policies since the GFC. The removal of accommodative policy settings will therefore have ramifications for all asset prices, not just bonds and property prices.
When it comes to Australian interest rates, however, we believe the hurdle for RBA action on the policy rate (in either direction) remains high, and when the time eventually comes to neutralize policy, the RBA's path to the new neutral – just like that of the Federal Reserve – will be a slow and measured one. As a result, there is little for investors to fear; instead, it is important to maintain portfolio construction discipline – keeping allocations in line with long-term objectives – and adjust expected returns accordingly.
Robert Mead is co-head of Asia portfolio management at PIMCO