–  AUGUST 2017 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA once again elected to leave the cash rate on hold at 1.50% following their August Board meeting.
  • In the statement the continued optimistic outlook was somewhat overshadowed by commentary around the recent rise of the AUD and its potential impacts.
  • The RBA then elaborated on this in their updated forecasts for growth and inflation in the quarterly Statement on Monetary Policy.
  • The key for the outlook for interest rates is how the risks to the outlook unfold over the second half of this year.

Rates Recap

  • The RBA left the cash rate on hold yet again in August with the cash rate remaining at 1.50%.
  • In the post meeting statement Governor Lowe maintained his optimistic outlook on growth and inflation over the medium term.
  • As was widely expected, he addressed the recent appreciation of the AUD and the potential implications it will have on the outlook should it continue to rise.
  • The subsequent quarterly Statement on Monetary Policy reinforced the optimistic outlook even after factoring in the higher AUD and outlook for the cash rate.
  • While the RBA remains confident in the outlook, ongoing weakness in some of the US data is undermining the outlook for the FOMC.
  • The market’s confidence in the FOMC’s ability to normalise rates continues to wane, with US bond yields and the USD coming under pressure.
  • However, the strength in the most recent payrolls data could be enough to swing momentum back in the FOMC’s favour.

RBA Maintains Optimistic Outlook

Over the past month the RBA remained focused on its own fight despite the ongoing monetary policy maelstrom that surrounds monetary policy settings in other jurisdictions. That is not to say that the RBA’s ongoing challenge to foster economic growth and price stability, while dealing with risks to financial stability, haven’t been impacted by what is happening offshore.

Over the past month the appreciation of the AUD has been the main focal point for monetary policy and how it may impact the outlook for economic growth and inflation. The RBA made mention of the potential impact of the AUD in the statement following their August meeting which cast some doubt over their current forecasts.

In their updated forecasts from the August quarterly Statement on Monetary Policy released last Friday, it was the growth forecasts that were most effected. The RBA has trimmed their growth forecasts slightly in the near term saying that “the recent appreciation of the exchange rate has been factored into the forecasts and has had a modest dampening effect on the forecast for growth.”

However they still see growth returning to above potential in the outer years of the forecasts. The continued optimism comes even with a shift in the assumptions that the forecasts are based on. The forecasts are based on the currency remaining at its current level for the forecast period, which is 5% higher on a trade weighted basis and 7% higher against the USD than it was for the forecasts made in the May statement.

More importantly, the forecasts are based on the cash rate moving “broadly in line with market pricing.” According to the statement “financial market prices suggest that it is expected to be unchanged over the remainder of the year, with some expectation of an increase by mid next year.” 

So even with a higher currency than three months ago and the market factoring some chance of an increase in the cash rate by the middle of next year, growth and inflation are still expected to increase over the medium term in line with previous forecasts.

How this outlook for the economy and inflation impacts the outlook for the cash rate largely depends on how you see the risks to the forecasts playing out over the months ahead.

Outlook for Interest Rates

The outlook for interest rates largely hinges on how the risks to the RBA’s forecasts play out over the forecast period. In the quarterly statement, the RBA outlined a number of risks to the outlook. These included the Chinese economy and commodity prices, consumer spending and the housing market, business investment, the Australian dollar exchange rate, and finally spare capacity and inflation.

Each of these on their own could pose both upside and downside risks to the outlook for growth and inflation, making the process of assessing the outlook for interest rates even more complicated. Of that exhaustive list of risks to the outlook, there are two that I see as the keys to the outlook for interest rates.

The first of those is the AUD. This is a tricky one for the RBA as they can only be reactive to its movements rather than proactive, unless it delves into a new toolkit of policy initiatives. On the risks the currency could pose on the outlook, the RBA said that:

“It is possible that the Australian dollar could appreciate further, which if sustained, would be expected to result in a slower pick-up in economic activity and inflation than currently forecast. Based on historical relationships, a 10 per cent appreciation of the trade-weighted exchange rate (that is not associated with higher commodity prices) would be expected to lower year-ended inflation by a little less than ½ percentage point over each of the following two years or so. Output would be expect to be lower by ½–1 per cent in around two years’ time.”

The equal and opposite risk is that if the data continues to improve in the US, allowing the FOMC to continue normalising policy and the Trump Administration can finally get some momentum, the AUD could fall against a rising USD. That would mean that the opposite of the above scenario could be a possibility.

The second risk is how the household consumption and housing market unfolds. The RBA has clearly stated on numerous occasions that it sees risks to financial stability stemming from the ongoing rise of Australia’s debt to disposable income ratio. While they outline upside and downside risks of consumption, wages and the housing market at length in the Statement on Monetary Policy, it is the overall debt and wages dynamic that is the concern.

The RBA through the Council of Financial Regulators is attempting to address the debt side of that equation via increased lending oversight and restrictions led by APRA. At the same time, low rates designed to stimulate growth and reduce unemployment is hoped to eventually lift wage growth. While the later is taking longer than expected, it should be known in the next couple of months if the former is evolving as expected.

If the APRA measures, which have resulted in a shift in market pricing for mortgages, has the desired effect then it should simultaneously slow the growth of lending and take some heat out of the housing market. This would then leave the RBA to focus more closely on the wages side of the ratio.

If the measures fail to have the desired effect, then by the end of the year we could see even further measures from the regulators in order to address the debt side of the ratio. If that still fails to garner the desired outcome then the RBA would likely need to step in.

How these two risks evolve over the second half of this year will shape the outlook for interest rates going into 2018. In the meantime, the RBA is still likely to do least harm by leaving the current setting of monetary policy in place for some time.

Australian Economic Highlights

  • After bouncing back in Q4, Growth slowed considerably in Q1 with the economy expanding by 0.3%. The Australian economy has now equaled the record for the longest run of growth without a recession at 103 quarters.
  • CPI was weaker than expected in Q2 with the headline reading of 0.2% short of the 0.4% expected. The result saw the annual rate fall below the RBA’s target band. The RBA’s preferred measure, core inflation also remained below the band at 1.8% after a quarterly increase of 0.5%.
  • The employment data was firmer again for the fourth straight month in June with total employment rising by 14,000 after the revised 38,000 last month. Despite the monthly increase, the unemployment rate edged higher by 0.1% to 5.6% in line with expectations. The participation rate was also up 0.1%.
  • ANZ job ads strengthened again in July, posting a gain of 1.5% after June’s stronger increase of 2.7%.
  • After a 1 point downward revision in June, the NAB business conditions index continued it’s strong performance in July with the index hitting 15, remaining well above the long run average of 5. Business confidence strengthened above market expectations with the index firming to 12 from the previous months revision of 8.
  • Consumer confidence once again printed below the 100 level for July, with the weakness in confidence becoming more broad based, rather than just centred around family finances.
  • After the weak start to the year, Retail sales were again a little firmer in June with total sales rising 0.3%. The June result helped lift the quarterly inflation adjusted increase in sales to 1.5% which should help growth in Q2.
  • Housing finance was mixed in May. The number of owner-occupier loans and the value of occupier loans were both up, rising 1.0% and 2.9% respectively while the value of investor lending continued to fall, dropping down 1.4%.
  • Following the strong surplus in May, Australia’s trade surplus decreased significantly, falling to $856m from the previous revised $2.02bn. The main drivers were the drop in bulk commodity exports including coal and iron ore while imports were lifted by a one off increase in Civil Aircraft and telecommunication equipment imports.
  • Building approvals came in well above expectations in June with an increase of 10.9%. This was driven by multi unit approvals which goes against the recent trend.
  • The uptick in Motor vehicle sales resumed in June with sales posting a 1.2% increase in comparison to the upwardly revised May figure of 3.1%. This pushes the year on year figure to 3.6%
David Flanagan

David Flanagan

Director: Interest Rate Markets