Once again we could be facing the prospect that future interest rate cuts will depend on what happens in the US, Chinese and European economies.

In fact there’s a small, but growing chance that rate cuts could have finished, leaving the cash rate at a 49 year low of 3%.

Short of another Lehman Brothers collapse (and the Yanks won’t let that happen again) it’s now clear the markets believe the slump has slowed and is in the process of bottoming.

That could be a case of the lunatics taking over the trading boom: Bloomberg reported straight-faced last night that European sharemarket valuations (price earnings ratios) are at their highest levels since 2004. What did happen to the credit-fuelled binge in 2005-2007?

The Financial Times called the boom a “dash for trash” a month ago; and although it had broadened in the meantime, there’s still the feeling of a poor quality rubber band being stretched beyond breaking point by someone looking for hit. Wall Street, Europe and some Asian markets (especially China, up 50%) have all erased the year’s losses.

The US market has rebounded 25% in the past month (and 37% since the lows of early March) simply on the understanding that the first quarter profit reports were not as bad as feared (Not better, just not as bad, thanks to cost cuts, job losses and lowball forecasts from analysts who had no idea. Analysts are yet to look at where and how companies are to grow earnings from now on).

The rediscovered strength in the sharemarket, which is now entrenched in some parts of the commodities markets, is a major factor as to why our rate cuts here in Australia have stopped. The key international reference interest rate called Libor (London Inter Bank Offered Rate) has now fallen to under 1% as liquidity floods markets.

Here in Australia, while long term bond rates rise in tandem with those in the US, short term rates and liquidity levels have meant the return of confidence to lending: hence the $1.25 billion in loans to BlueScope Steel yesterday.

While the Reserve Bank still has a bias to cut (as laid out in the final four sentences of yesterday’s post meeting statement from Governor Glenn Stevens), short of the economy slumping more deeply, or a major financial collapse, further rate cuts are now problematic at best:

Monetary policy has been eased significantly. Market and mortgage rates are at very low levels by historical standards and business loan rates are below average, reducing debt‑servicing burdens considerably. Much of the effect of these changes is yet to be observed. The stance of monetary policy, together with the substantial fiscal initiatives, will provide significant support to domestic demand over the period ahead.

In assessing whether further reductions in the cash rate are required over the period ahead, the Board will monitor how economic and financial conditions unfold, and how they impinge on prospects for a sustainable recovery in economic activity.

That means there’s so much oomph now in the economy that the RBA is hesitant to add any more by cutting rates further until it sees how the slumping economy handles the stimulus. That’s also why the flow of improving economic news from offshore is now impacting the RBA’s thinking.

Fed chairman, Ben Bernanke’s relative optimism in Washington overnight talking up the US economy’s slowing slump, and forecasting a very modest rebound later this year and into 2010, didn’t spark a further rebound on markets. They are now focusing on the release of the stress tests by the Fed on the 19 biggest US banks Thursday night, our time.

A month ago that was seen as being an enormous threat, but with the listed US banking and finance sector up more than 80% since early March and those big lows, suggestions Citigroup, Bank of America, Wells Fargo and possibly eight other banks might need to raise more capital, is no longer terrifying the market. In fact some investors reckon there won’t be too much trouble in finding the tens of billions of dollars in fresh capital because of the market’s big bounce.

And should that happen, then it would mean the chances of further rate cuts here from the 3% (49 year low) set in April by the RBA, will become remoter.

In a comment overnight, AMP Chief Economist Dr Shane Oliver said:

The reference to “assessing whether further reductions in the cash rate are required” in the Governor’s Statement indicates that the Bank still retains an easing bias. 0ur assessment remains that further cuts in the cash rate taking it down to around 2% are likely over the next six months as the unemployment rate continues to push higher.

Against this backdrop the RBA would probably like to drip out a bit of good news to help offset the pain of rising unemployment and its worth noting that in past cycles the RBA has continued easing until unemployment has peaked. However, with the global economic outlook starting to improve the risk that the RBA has finished easing or eases less than we are forecasting has increased.

And this morning Goldman Sachs JBWere told clients:

For now the RBA will be content to allow the equity rally to extend. In concert with improving real economy leading indicators, loose financial conditions, aggressive fiscal spending and tactical positioning suggest that being long rates and short equities will be a painful place for investors to be. Indeed, there is a very real risk that 3.0% will mark the bottom of the rate-cutting cycle and the cash rate will need to rise to a minimum of 4.0% by end-2010 and possibly as high as 5.5%.

Yes, the first mention of a rate rise, in 2010.

Peter Fray

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