jobless rate

While economists and the RBA say the jobless rate will climb towards 6 per cent, I speculated that it might start falling this year.“This would be a game-changer,” and will force the RBA to remove its extreme stimulus.”

So it proved. The official statistician reported that employment surged last month by the most in 12½ years. As expected, fixed-rate bond prices are getting smoked as long-dated interest rates advance off their historically low base.The yield on three-year Australian government bonds is now up 120 basis points off its April 2012 record of 1.96 per cent.It leapt 20 basis points after Thursday’s jobs data alone.Importantly, three-year yields are above the RBA’s current cash rate for the first time since July 2011.

This tells us pessimistic bond market bandits are starting to countenance the RBA normalising ultra-loose policy.But don’t expect any swift moves from Martin Place. The RBA is already behind the eight ball, and it is likely to remain sluggish.There will be tremendous community and political resistance to any rises before the election.The low-rate lobby is loud, and over-represented on the RBA’s growth-seeking board.

All else being equal, higher interest rates mean softer share prices (since rates are used to discount cash flows back to the present), weaker housing demand as purchasing power diminishes, and fixed-rate bond losses as prices decline to make buyers indifferent to the better yields on offer.

Of course, loftier rates are not a universal evil. They usually signal that the RBA thinks our economic prospects are rosy.The risk is that demand outstrips the nation’s capacity to produce the things we desire, which precipitates inflation in the prices of the goods and services we buy, and a relative corrosion of our incomes.Raising rates does effect a transfer of wealth from net borrowers to savers. Some might say that it rewards thrift while thwarting hedonists.

These are just a few of the reasons why getting an edge on the RBA’s next step captivates the hearts and minds of financial markets.This is especially true in Australia, where household debt is comparatively high and mostly priced in variable terms.As I’ve explained before, the RBA acknowledges it has difficulty forecasting even the near future.

This is why I’ve argued that deep “pre-emptive” rate cuts based on rubbery predictions of what might pass are internally inconsistent and arguably hazardous to financial stability.

The community, and investors more specifically, are being conditioned to expect crisis-level rates every time markets get the yips.Since the doomsday risks that rationalised the RBA’s insurance have not materialised, it is likely to focus more energy on “now-casting”.This means figuring out the real state of the present, or our jumping-off point into the uncertain future. And it’s not as easy as it seems.

Almost all the data we get on the economy’s actual pulse – inflation, jobs, gross domestic product, credit, wages, house prices – are reported with a chunky lag of between one and three months, and then subject to major revisions.

To get a lead on delayed data, the more talented analysts build “real-time” measures of demand across the economy.They then construct “financial conditions indices” that purport to tell us how stimulatory RBA policy settings really are.This way one can get a bead on where rates might be heading.UBS’s interest rate strategist Matthew Johnson produces several real-time indicators.

These include a monthly “demand index”, which incorporates 110 different inputs (like job ads and business surveys), and a “financial conditions index”, which employs 60 variables, and signals how supportive interest rate and currency levels are, given the state of his index.

“The UBS financial conditions index strips out the current business cycle to give us a read on how expansionary or otherwise interest rates and the currency are. It is, therefore, a predictor of growth, inflation and interest rates,” Johnson explains.

“The dollar might, for example, be elevated because our growth prospects are peachy. Financial conditions could be very stimulatory in the absence of tighter monetary policy.

“But equally the currency could be high because central banks want to diversify their reserves away from the US, Europe and Japan, even though Australia’s growth pulse is weak.“So a strong currency could coincide with restrictive financial conditions without further interest rates relief.”

To create the indices, Johnson leverages off the RBA’s own research, which he has improved through iterative application.

According to this analysis, Australian demand started deteriorating in the second half of 2010 through to the third quarter of last year.

Demand has, however, been recovering since, although it remains below the model’s estimate of trend.One needs the demand index to work out whether current rates and the trade-weighted currency are collectively enhancing or detracting from growth.UBS’s financial conditions index implies that RBA policy settings were restrictive in August 2011 when the cash rate was at 4.75 per cent.“Financial conditions have subsequently eased markedly, which suggests a pick-up in growth over the next two to three quarters,” Johnson says.

“Conditions are now around as easy as they were during the years prior to 2008 when growth was healthy.”“One reason rates are lower today is because of our strong currency.”

Notwithstanding the recent bounce, UBS’s research still implies an equilibrium RBA cash rate trough of just above 2.5 per cent (ie, more cuts), a big change from only a month ago.

“Due to the recent easing in UBS’s financial conditions index, our RBA cash rate model, which takes all other indices into account, has lifted the target cash rate bottom from 2 per cent to 2.6 per cent,” Johnson says.

“The financial market has already delivered a strong easing of monetary conditions via equities and house price inflation, so the RBA need not reduce their policy rate as far.”

My own sense is the next move is more likely up than down. UBS’s chief economist, Scott Haslem, agrees.