“Record low interest rates”. This seems to be the headline of the year, having been used so many times it is hard to remember any other kind of interest rate. Each time we see this, expectations for another rate cut decrease momentarily, only to return to the same, pre-cut probability-levels after a few weeks.
Figure 1 paints a clear picture of a similar short-term outlook, yet weakening long-term expectations. While this graph does not include data since the rate cut (yields on 10 year treasuries have lifted a whopping 0.03% since the July levels shown in Figure 2), we can see almost identical movements at each maturity date from May to June and from June to July.
Yields on 3 year bonds are down 0.05%, 5 year bonds are down 0.1% and 10 year bonds are down 0.2%. This is almost a textbook example of yield curve inversion. In fact, yields on 90 day treasury bills in June were identical to those on 10 year bonds at 1.93%. Other than perhaps transaction costs, there is no reason for an investor to take on the extra risk of longer term securities without any increase in expected return. The RBA had little choice but to cut rates again. Figure 2 shows a similar picture, with greater inversion in the short and medium-term (up until about 2022) and lower yields on long-term maturities. This is a dangerous combination.
An interest rate cut effectively lowers the short-term cash rate (i.e. 90 day yield), which normalises (steepens) the yield curve. In theory, this stimulates the economy by making borrowing cheaper and incentivising banks to borrow at the short-term rate and lend out at the higher long-term rate. If the curve continues to flatten out (as it did since the last rate cut in May) then this impact is almost entirely negated. Like a see-saw, rates will continue to decrease until long-term expectations increase or at least stabilise.