Interest rates sure to rise? Don't be so certain

Inflation will be the key to whether the US Federal Reserve (pictured) keeps raising rates. Picture / AP

While some predict an end to the days of cheap money, it's too soon to make that call, writes Mark Fowler

It's that time of the year again. In the last couple of weeks, a number of market commentators have declared the end of the bond market run and are predicting a challenging year for investors as interest rates are forecast to go higher.

These bold predictions are fuelled by both a changing economic backdrop and a shift in thinking from global central banks, now in favour of removing some of the accommodative policy settings and gradually increasing interest rates.

The question for some time has been, would central banks be able to continue to keep interest rates low and foster a sustained recovery, whilst still keeping material inflation at bay?

The answer to that question to this point has been yes, but how are we actually measuring inflation? It may be cheaper to fly to Hawaii or stock up on those infamous avocados, but real assets have skyrocketed post the global financial crisis.

In the case of our domestic property market, the coalition Government suggests this comes down to supply and demand side imbalances. In 2017, 37 per cent of homes sold were in excess of $1 million. The reality is that the rapid price appreciation we've seen in this cycle is due to the record low interest environment. So how do interest rates go materially higher in a domestic sense, when we are running record levels of indebtedness that only feel sustainable in a low interest rate world? The blunt answer is: they don't.

In the absence of a private sector turnaround, driven by productivity gains that enable employers to pay higher wages and sustain a higher cost of capital, this appears unlikely. NZ business confidence is currently tracking at eight-year lows and wage inflation in 2017 failed to really materialise, coming in at 0.7 per cent for the December quarter. Furthermore, the Reserve Bank of New Zealand has made it clear that despite GDP growth being forecast around 3 per cent, they still expect core inflation to remain at the lower end of the 1-3 per cent band, which is hardly a game changer. If you overlay this with a cooling housing market, neither of these seem like drivers that will fuel rapid interest rate increases.

This does not seem like an economy ready for businesses to cope with considerably higher costs of capital

There's no doubt that our longer end of the interest rate curve is closely correlated with offshore drivers, and for many, the US will continue to raise rates in 2018, whilst Trump attempts to implement both tax reform and large scale infrastructure projects. However, whether these changes are actually inflationary will be the key to the Federal Reserve continuing on a path of raising interest rates. Without a reasonable lift in productivity performance from the private sector, and a Government that's unlikely to throw the kitchen sink at fiscal spending, I suspect our economy is still reliant on low volatility of asset prices.

This does not seem like an economy ready for businesses to cope with considerably higher costs of capital, nor Mums and Dads to handle higher levels on residential mortgage rates. It may yet be a challenging year for bond investors and those refinancing debt, but I'm not convinced just yet.

• Mark Fowler is head of portfolio strategy group & fixed income — Hobson Wealth Partners

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