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Sunday, October 30, 2011

Financial markets' pricing of RBA rate changes: are they right (charts)?

You read a lot in the media about the financial markets' "pricing" of RBA cash rate changes, or "probabilities" of a rate change in any given month.

There are a number of ways to work these numbers out, but probably only one exact method. The ASX/SFE has listed a specific "interbank futures contract" that settles on the basis of the average RBA cash rate in the month in question (eg, March 2012). Thus the pricing of this futures contract reflects the weighted-average expectation of the RBA's cash rate in the relevant settlement month.

So take the November 2011 contract. The contract's price fluctuates daily. The price is the financial market's best guess at what the RBA's cash rate will be in November 2011. Working out the actual expectation is easy: it is simply 100 less the current futures price. So if the SFE's November 2011 interbank futures contract is, say, 95.25, then 100 less 95.25 equals 4.75. That means the market thinks the RBA's average cash rate over the month of November will be 4.75% (ie, no change).

On Friday this particular contract closed at 95.455. Accordingly, the market was telling us that it felt the RBA's cash rate in November would be 4.545% (to be precise!), or lower than the current cash rate. More specifically, the market was pricing in 82% of one full 0.25 percentage point reduction in the RBA's cash rate from its current 4.75% level.

With this background in mind, we can make sense of some interesting analysis. My first chart below shows the daily changes in the price of the November 2011 SFE interbank futures contract since the start of 2011 (ie, the SFE contract that tries to predict the RBA's cash rate in November).

The black dotted line is the current 4.75% cash rate, which relates to the left-hand-side axis. The red line is the market's prediction of the RBA's cash rate in November 2011. You can see that this has been as high as 5.10% in February 2011 (ie, 0.35 percentage points, or 35 basis points, above the current 4.75% level).

More usefully, look how far the red line has plummeted below the black line at various times. Every time the red line goes below the black line, the financial markets are saying that the RBA is going to cut rates by November. They did this in March 2011, and have been doing so consistently since June 2011. The magnitudes of the cuts are striking. On different days the financial markets' best guess of the November 2011 cash rate has been as low as 3.57%, or nearly five standard RBA rate cuts of 0.25 percentage points, or 25 basis points, a pop.

The green bars denote the implied RBA cash rate change by November 2011 relative to the current 4.75% cash rate. This is measured in basis points (or fractions of a percentage point), and pertains to the right-hand-side axis. So currently the financial markets reckon we will get about 0.20 percentage points worth of cuts by November 2011, or, as noted before, 82% of a normal 0.25 percentage point cut.

To make this pricing clearer, my next chart shows the probability of one normal 0.25 percentage point RBA rate cut. If the probability of a cut is 200%, the market is telling us that it expects two 25 basis point cuts, or 50 basis points in total. The big spike in the red line corresponds to the US and Euro crises when the financial markets somehow convinced themselves that the cash rate would be more than 1.2 percentage points lower than its current level. Of course, they were proven wrong, and by a rather wide margin!

My final chart expresses the financial markets' pricing in terms of a normal RBA cash rate move. In the first couple of months of 2011 we had more than one RBA hike priced by November. Then in March there were no hikes, and, in fact, a small chance of a cut. By May the probability of hikes had surged again. Then in August the market dived from pricing in hikes to a series of--nearly five--RBA cash rate reductions. This coincided with the US debt ceiling and European sovereign debt crises. Since that time the probability of cuts has consistently fallen to less than one today.

As the RBA has recently noted, and I have previously explained, financial market pricing for rate changes can get "technically" distorted by other influences. For example, if the global central banking community decides to diversify their holdings of US, UK and Euro sovereign debt by allocating higher weights to very safe, AAA-rated Australian government bonds, there will be a tremendous increase in the demand for our debt. Central banks can hold this debt to maturity, and so don't, therefore, necessarily care about its price: they are much more focused on the high yields offered by Aussie bonds. This can have the effect of driving up all bond prices, and thus driving down market yields. Since the yield curve gives us the market's expectation of the future price of money, these estimates may be biased downward by an increase in the demand for the otherwise small stock of Australian government debt.