Share market bulls who have been getting excited by the thought of interest rate cuts will be salivating at JP Morgan's prediction that rates will go lower than what most are expecting.
The market has priced in a 25-basis point cut to the official cash rate at the Reserve Bank of Australia's (RBA) meeting next week and two in the following months.
This expectation is one reason why the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index has been running hot in recent weeks and has broken above the psychologically important 6,400 level.
Stock valuations typically improve as interest rates drop and that's why some might be particularly enamoured by JP Morgan's call for a fourth rate cut before mid-2020, which would bring the interest rate to a fresh record low of 0.5%!
Be careful what you wish for
But it could be a case of being careful for what you wish for. While lower interest rates are stimulatory, it could come at a high cost. Such a dramatic move by the RBA would be a signal for investors to panic.
The reason behind JP Morgan's non-consensus call is a case in point. The economists at the investment bank is basing their forecasts on the worsening global economic downturn, according to the Australian Financial Review.
If global growth takes a bigger than expected hit from macroeconomic factors like the US-China trade war or a hard Brexit, ASX stocks will sink regardless of the lower interest rate.
RBA could cut rates below 0.5%
Speaking of lower rates, JP Morgan's economist Sally Auld thinks the RBA may not stop at 0.5%. There are a few reasons for this.
Firstly, she doesn't think core inflation in Australia will reach the RBA's target, not when global growth is weakening, even in the US where the economy is performing better than most developed nations.
This could force the US Federal Reserve to cut rates, which would in turn mean the RBA has to lower the cash rate to below 0.5%.
It's not only the absolute level of the interest rate that is important. How it compares to other economies is also fundamental when it comes to stimulating the domestic economy.
The other concern is that real interest rates have been going up. While the RBA has held the cash rate at 1.5% since mid-2016, falling inflation has pushed up the real rate to its highest level in three years. The real rate is the difference between the cash rate and inflation.
The thing that could throw off JP Morgan's forecast is how the newly re-elected federal government will move to shore up the local economy beyond the income tax cuts they have already announced.
Foolish takeaway
I don't think the RBA will cut rates to 0.5%. This isn't because I have a more bullish view on the Australian economy but because of the "diminishing rate of return" theory where the impact of an action becomes more muted the more you do it.
From that perspective, I think lowered the rate from 0.75% to 0.5% won't have the desired impact and the RBA would be better off using "unconventional" measures, such as quantitative easing.
Regardless of whether the RBA cuts three or more times, investors should better appreciate the risks facing our economy. Right now, there's too much optimism factored into our share market, in my view.
