• The RBA left the cash rate on hold yet again in March but surprised with a change in language around the outlook for growth.
  • While long term rates were on the move last month, it is now short term rates on the move and it has many scratching their heads as to why.
  • The FOMC is widely expected to raise the Fed Funds Rate next week which will lift it above the RBA Cash Rate.
  • Clouds are brewing on the horizon if the RBA’s subtle shift in language in their March Statement is anything to go by and it could squeeze them between a rock and a hard place.

Rates Recap

  • The RBA left the cash rate on hold again in March with the cash rate remaining at 1.50% since August 2016.
  • Markets have pushed out expectations for the cash rate with a 25bp increase now not fully priced in until May of 2019, out from February 2019 a month ago.
  • Long term interest rates have remained relatively stable over the past month while short end rates have started to rise.
  • It is still unclear what the core driver is behind the recent rise in BBSW but it could have something to do with rising short end rates in the US.
  • The FOMC is expected to lift the Fed Funds rate next week in the US which will take their overnight rate above our own cash rate for the first time since 2001.
  • US long bond rates have remained stable over the past month and for now, additional issuance from the US Treasuries has been easily absorbed by the market.

Rock and a Hard Place Looming for RBA

The RBA has a maintained a positive undertone to its rhetoric around the outlook for some time and rightly so. It wants business and consumers to feel comfortable with the outlook so that they invest and spend. However, following last weeks RBA Board meeting, where they left the cash rate on hold for the 19th straight month, we saw a subtle shift in the language used around growth.

Since the RBA last cut the cash rate in August of 2016, the RBA’s forecasts have been suggesting growth will pick up to above 3% during 2018 and beyond. However since then we have seen growth underperform those forecasts and there is now a risk that we see this continue over the forecast period.

The most recent growth figures, released the day after the RBA’s March meeting, was a little softer than both the market and RBA were expecting. The economy grew by 0.4% with the annual rate slowing from 2.9% to 2.4%. The biggest drag on growth came from net exports while consumption surprised on the upside. Both these elements will prove crucial to the RBA’s outlook.

A rebound in exports is one of the core underpinnings of the RBA’s expectation that growth will pick up over the forecast period. After an unexpectedly weak finish to the year, Australia’s exports are expected to pick up through 2018. The early data from January supports this with the trade balance rebounding from a deficit in excess of $1bln to a surplus of more than $1bln.

Consumption on the other hand poses the biggest risk to the RBA’s forecasts. The RBA has pointed to this risk for some time and absent an uplift in wage growth over the months ahead, there is little scope for consumption to materially and sustainably increase and drive growth.

In order for consumers to increase their rate of consumption above the pace of wage growth, they either have to borrow or run down savings.

The RBA, through the Council of Financial Regulators, has already put in place measures to address Australia’s huge increase in household debt and is unlikely to want consumers to go out and borrow to consume.

Meanwhile the savings rate since the GFC has fallen from a high of 10.3% to the mid 2% region where it has stayed for the last three quarters of 2017. There is little room for consumers to run down their savings any further from here. Equally both a run down in savings or increase in debt to finance consumption isn’t sustainable over the long run.

So without wage growth picking up over 2018, growth could undershoot again, putting the RBA firmly between a rock and a hard place. The RBA’s seemingly endless panglossian view on growth is already shifting following their March statement.

In the Statement, Governor Lowe updated the commentary around growth that said the RBA’s forecast was “for GDP growth to pick up, to average a bit above 3 per cent over the next couple of years” and replaced it with “the Bank’s central forecast is for the Australian economy to grow faster in 2018 than it did in 2017”.

I have long pointed to the fact that the RBA has little choice to be endlessly panglossian because they fear being otherwise, would startle the horses. They will be walking a fine line over the months ahead. If the market sniffs a negative shift in the outlook, expectations for monetary policy, along with business and consumer behaviour, could shift quickly.

Outlook for Interest Rates

The core message from the RBA has changed little over the past month. Their base premise is the cash rate is unlikely to be going anywhere anytime soon. Following the shift in the RBA’s rhetoric around their forecasts for growth and a softer than expected GDP print, expectations for a cash rate increase have been pushed further out.

Since the start of the month, the market has pushed out expectations of a cash rate increase a further three months, from February out to May, 2019. Should we see the RBA wait until then to lift the cash rate, it would mark a record for the modern era for cash rate stability. Currently the record stands at 22 months which would blow out to 35 months at 1.50% by May of next year.

As outlined above, from a purely domestic standpoint, there is a real risk that growth and inflation continue to undershoot the RBA’s expectations. Barring a significant deterioration in economic activity, prolonged underperformance is unlikely to result in a fall in the cash rate but it could see the cash rate remain on hold much longer than expected.

The challenge for the RBA is Australia’s monetary policy isn’t solely driven by domestic factors. Factors stemming from offshore can have just as much impact on local developments in shaping the outlook for monetary policy.

After briefly going negative a month ago, yields spreads between Australia and the US have moved into negative territory across the curve with the cash rate the only point between overnight and 10 years that remains positive. That is also likely to be temporary with the FOMC widely expected to lift the Fed Funds Rate band up to 1.50-1.75% next week.

To date, the yield spread going negative has had minimal impact on the AUD as it continues to hold up in the high 0.70 region and trade well against other major currencies. However it could go some way to explaining why we are seeing short end rates climbing over the past couple of weeks.

While the RBA has said for some time that a higher currency would dampen the outlook for growth and inflation, a substantial fall in the currency would also have its own problems. With the currency one of the important elements that contributes to overall monetary conditions this will be something that needs to be watched closely.

The yield spread could become more of an issue throughout the year, especially if the FOMC tightens as much as they have indicated they expect to. Whether they end up lifting the Fed Funds Rate 3 or 4 times, there will be a significant negative interest rate differential between Australia’s cash rate and the Fed Funds rate.

For now though, the RBA is firmly on hold but there are a number of moving parts that could reshape the outlook over the months ahead.

Australian Economic Highlights

  • Growth for Q4 came in at 0.4%, short of both the market and RBA’s expectations. The economy grew just 0.4% in Q4 which saw the annual rate slow to 2.4% from an upwardly revised 2.9% last quarter. The most recent RBA statement reflected a less optimistic view on growth for the rest of 2018.
  • CPI continued to disappoint, the headline figure only lifting 0.6% for the second straight quarter in Q4. The RBA’s preferred measure, core inflation also remained below the band at 1.9% after a quarterly increase of only 0.4%.
  • Employment data continues to be a pillar of strength in the Australian economy with another 16,000 jobs added in January. It is still evident that a degree of slack still remains despite the lift in jobs, as the unemployment rate decreased to 5.5% that looks to be attributed to the drop in the participation rate. 
  • Following the strong result last month, ANZ job ads turned negative with a decline of 0.3%. 
  • The NAB business conditions continues to perform strongly with the index jumping to 21 in February, a new record. The Business confidence on the other hand declined to 9, this could be attributed to heightened volatility in financial markets. 
  • After improving the prior two months, Consumer confidence pulled back in February as was expected following the pick up in volatility in global markets. Despite the 2.3% fall, the index remains above the key 100 level.
  • Following on from the soft December result, Retail sales posted a small gain of 0.1% for January, falling short of expectations. Consumer spending continues to be a weak point in the economy as retail turnover lifted only 0.3%, compared to 2.3% in January last year.
  • Housing finance looks to be stabilising as the value of approvals to both owner occupiers and investors were up in January.
  • Australia’s trade balance rebounded after the previous deficit to record a surplus of $1.055bn in Q4. Non-monetary gold was one of the larger contributors, up 54% whilst imports on consumption goods was down 7%.   
  • Large swings in Building approvals continue to be seen as high density approvals rise and fall each month. Total approvals rebounded strongly following a sharp fall in the previous month.
  • Motor vehicle sales woke from their slumber with a solid 4.5% to end the year in December. The increase saw the annual pace of sales rise from 2.1% to 6.7%. 
David Flanagan

David Flanagan

Director Interest Rate Markets