Australia hikes interest rates

Overnight, the Royal Bank of Australia hiked its money market rate from 3% to 3.25%. This action is being hailed worldwide as a first sign we are moving out of the deep global recession. Some economists even profess to be surprised that the move came now and not in 4 weeks. Apart from the fact that Israel hiked rates already on 24 August, the question is whether RBA's move signals the turning point for anything at all.

We all know that interest rates eventually will go back up. Central banks do not continue rescue missions forever, particularly not as it becomes increasingly clear that the patient, i.e. the global economy, did in fact survive. Recently, there has been a lot of writing about the coming wave of monetary policy tightening and many pundits have concluded that given the interest rates will increase, the stock markets are overvalued, and the only reasonable thing to do is to SELL.

Well, maybe not quite. Yet, at least. It is true that the past weeks have seen some volatility in the stock markets that might give a first indication that the uptrend that began in March is running its course. But in all probability it is too early to panic.

There is no shortage of analyses pointing out that the economic recovery may well be a rather anaemic one, as several of the large economies are saddled with consumer debt that will block the way for a strong recovery. Instead we appear to be headed for a longer period of sub-par growth, as consumers are working to rebuild their balance sheets. This outlook appears to be close to a consensus by now.

Then there is what happened in the stock market. Far from being subject to a U-shaped or L-shaped recovery, the markets have seen a profit recovery that by some measure has been surprising. Obviously, there has been no help from the demand, so virtually all of the good news for the stock markets have come from the massive cost reductions that have taken place – and which were at the heart of the very steep fall in economic activity in Q4 of last year and Q1 of 2009.

As if on cue, companies worldwide cut orders, stocks and production capacity. And thereby they made the first moves to rebuild profitability and profitability did indeed come back almost with a vengeance. Stock markets reacted correctly and we have seen a 50%+ recovery.

And then to the 64 bn question: why would it continue? A 50% recovery after a 50% loss sums up to a 25% loss. Aren't the markets priced fairly for the slower economic growth ahead? Should we prepare for a setback? Probably not. Or maybe just not yet. There are two reasons for that.

One is that the Australian interest rate hike is obviously a signal, but it is no signal that the interest rates worldwide will now be pushed up in and the brakes put on. All indications from G20 and down are that central banks are in absolutely no hurry. And a finer point: the arsenal of weapons put in place by the central banks is so much wider than just interest rates. The term "Quantitative Easing" that was so in fashion long time ago – like last Monday – covers a number of initiatives to create liquidity and to bolster bank's balances. The QE will be phased out slowly before short term interest rates are hiked. It will be a relatively slow process and most market participants will not really notice until the monetary tightening is a reality. And only then the interest rates will begin to hike.

This scenario has not been lost on the bond markets, where the yield curves have steepened in anticipation of the policy changes.

The second reason is that as long as the liquidity boost is intact, investors will remain willing to take on more risk. In the time-honoured way of the financial markets, this implies that arguments will be sought and found that the markets can go higher. It is not that difficult: while cost reductions can restore profitability at a given activity level, they cannot provide for profit growth. Profit growth will in the medium term have to come from top-line growth. There is a possibility that the improved profitability from the cost reductions can carry the better results all the way until demand begins to show some life, probably sometime next year.

So yes, at some point in time this strong rally in the stock markets will end and for all the right reasons. The profit recovery will peter out, monetary policy will tighten, and the risk appetite will drop. It is probably just not now and the Australian rate hike has preciously little to do with it.