Curve Monthly Insights, December 2015

Curve Monthly Insights.

  • The RBA left the cash rate on hold in December at 2.00% in line with market expectations.
  • Australia’s growth remains reliant on exports placing the economy at risk.
  • Another robust employment report in the US has a December hike by the FOMC widely expected.
  • But what does it mean for the cash rate in Australia?

Rates Recap

  • The RBA left the cash rate on hold at 2.00% in December as was widely expected.
  • The accompanying statement to the decision to leave ratesMonthly Market Moves December 2015 unchanged provided very little in the way of additional updates on the outlook for interest rates.  
  • The core message remains that prospects for growth appear to be improving; however, the outlook for inflation provides the scope to provide additional support for the economy if and when required.
  • Another robust non-farm payrolls employment report in the US in December has the market firmly expecting the FOMC to raise rates later this month.
  • The AUD has defied the weight of factors including a stronger USD and lower commodity prices working against it to rise back above 0.73 over the past month.

Economic Transition 

The latest growth figures from the Australian Bureau of Statistics for the third quarter confirmed Australia’s economic transition is still firmly in the embryonic stages. Australia’s growth continues to be predominantly driven by the final stage of the mining boom. Increased production capacity as a result of large scale investment is now pumping out additional supply which is translating into record export volumes. Even with commodity prices falling, the rise in volumes along with the 10% fall in the AUD over the quarter is means export Net Export still proping up growthvalues are still robust.

The big positive from the growth figures is that household consumption is trending in the right direction as low rates continue to put more money in mortgagees pockets. This pick up in consumption has taken some time to materialise which was frustrating the RBA. Recent economic and political stability has helped to boost confidence and consumption has steadily improved as a result. The most recent Westpac consumer sentiment survey saw optimists outweigh pessimists for only the third time in almost two years and should we see it consolidate from here, consumption should continue to support growth over the year ahead.

Where the transition is yet to materialise, which is also a risk to not only the immediate fortunes but long term prospects for the Australia economy, is in investment. The governments battle to get the budget deficit under control is limiting its ability not only to add to growth Contributions to GDPthrough consumption but it is limiting its ability to invest which can be seen in the break down of growth for the last quarter. This situation is not expected to turn around any time soon. This is why the RBA is at pains to entice businesses to unleash their animal spirits and invest.

As consumption can only help growth so much, the RBA and the economic future, hinges on business investment stepping up to fill the void that is being left by the end of the mining investment boom.  The latest Capital Expenditure Survey showed a small improvement in overall investment expectations; however, it was nowhere enough to offset the huge decline that is finally upon us. The chart on the right shows that over the past two years we have seen only a steady fall in capital expenditure with the big collapse currently under way in the 2015-16 financial year. This leaves the CAPEX Actual and Expectations Q4 2015Australian economy exposed should we see exports fall or consumption slow, leaving Australia’s approaching record for the longest run of uninterrupted growth by any country ever, in jeopardy.

The RBA is aware of this risk. It is why they continually reiterate that, despite improved prospects for economy, growth is likely to remain soft “with the economy likely to have a degree of spare capacity for some time yet”. It is the RBA’s base case that the transition away from mining led growth will eventually occur; however, as they have pointed out, it may not be without a few bumps along the way.

Outlook for Interest Rates

A central element of the RBA’s outlook for how the Australia economic picture will evolve and the implications for monetary policy is what the FOMC decides to do with their setting on monetary policy. Like Australia’s ongoing transition away from mining led growth, we have spoken at length over the FOMC’s desire to normalise interest rates and how that may impact Australia and the RBA’s setting of monetary policy. Recent data and stability on global financial markets has created the best opportunity yet for the FOMC to finally begin normalising interest rates when they meet this month.

What does this mean for Australia and our setting of monetary policy? While there is a multitude of moving parts at play into this equation, lets explore a couple of simplified scenarios based on the assumption the FOMC starts normalising interest rates before Christmas.

FOMC Futures Pricing - December 2015The first scenario is we see the FOMC lift the benchmark overnight rate and give strong guidance on the likelihood and timing of further hikes over the course of the year ahead. This would see the USD continue to trend higher and in effect push the AUD lower. Short end rates would see further support that has been evident in recent weeks while further out the curve in the 10 to 30 year maturities we would likely see yields ease back. This would on balance help the RBA by capping the recent rise in the AUD and keep, or even increase, the level of support that the current setting of monetary policy is exerting on the Australian economy.

On the flip side, should the FOMC raise rates but remain vague on the outlook for the likelihood or timing of any other follow up increases the market would be left disappointed. This scenario could result in the classic ‘buy the rumour, sell the fact’ price action pattern, with the USD actually softening, leaving the AUD to continue to drift higher unabated. Such an outcome would put the RBA in an uncomfortable position. With a number of financial institutions already raising mortgage rates out of cycle, this would further reduce the level of support that the current setting of monetary policy is exerting on the Australian economy.

RBA Futures Pricing - December 2015Ultimately however, given the loose precedent that the FOMC has set since Janet Yellen took over as head of the FOMC, we are likely to see something in between. The most likely outcome should the FOMC finally raise rates is that they  indicate that they will continue to look to normalise rates over the period ahead, with any move contingent on economic outcomes and financial market stability. While there would still be some initial volatility immediately following their decision, the current state of play would remain largely unchanged. Despite the FOMC’s desire to normalise rates, they have a stronger desire not to upset the apple cart, thus doing the least harm to the economy and financial markets in the process.

There is always the chance they don’t raise rates. This is becoming increasingly unlikely as the FOMC is already running out of credibility after taking an incredible amount of time since first announcing it wanted to raise rates and not following through until now.

Current market pricing for the cash rate is in line with the RBA’s outlook which is also consistent with a hike from the FOMC with a measured statement outlining a conditional plan to continue normalising interest rates. Whichever way the FOMC decides to go, it marks an important junction in the post GFC economic story.

Appendix: Australian Economic Highlights

  • Growth bounced back in Q3 with GDP rising by 0.9%, up from 0.2% in Q2 with the annual rate firming from a revised 1.9% to 2.5%. Domestic demand remains quite weak with net exports propping up growth once again, accounting for 1.5%, meaning the rest of the economy actually contracted 0.6%.
  • CPI increased by 0.7% in Q3, which was just below market expectations of a 0.7% rise. The increase saw the annual rate remain unchanged at 1.5% after it was expected to rise to 1.7%. The core rate was actually softer, rising by 0.3%, slightly below expectations with the annual rate easing to 2.15%.
  • The employment data provided a shock in October with a dramatic surge in employment. Total employment rose by 58,600, with full time jobs up 40,000. The unemployment rate fell back below 6% even after a small 0.1% rise in the participation rate to 65.0%. There are growing questions over the ongoing validity of the monthly employment series from the ABS.
  • Jobs ads continued to rise in November according to the ANZ job ads report. Job ads were up 1.3% for the month with September’s 0.4% rise revised down by 0.1%.
  • The NAB business conditions index continued to hover around a 6 year high in October, unchanged at +10 for the fourth straight month, above the long run average of +5. Business confidence index recovered after last months fall however remains rather subdued given the persistent improvement in conditions with the index at +5, marginally below the long run average.
  • Consumer confidence improved again in November with a 3.2% gain over the previous month leaving the index nicely up above the key 100 level at 101.7. It is only the third time in almost two years the index has moved above the 100 level with improved prospects for the economy over the short and medium term the big driver behind the improvement.
  • The pace of retail sales continued to chug along in October, posting  a rise of 0.5% on the back of consecutive monthly increases of 0.4%. Household consumption was one of the rare bright lights in the GDP numbers outside of the dominating contribution by net exports to the final growth figure.
  • The recent trend in housing finance accelerated in September. The number of owner-occupier loans was up 2.0% while the value of occupier loans rose 3.0%. Investor lending was significantly weaker once again with the value of investor loans down by 8.5% over the month as regulatory measures continue to impact investor lending.
  • Business credit was once again the main driver of growth in the RBA’s credit aggregates in October.  Total outstanding credit recorded growth of 0.7% in October with the annual rate of growth unchanged at 6.7%.
  • The pace of house price appreciation picked up in Q2, with total capital city prices up 4.7%, above the 2.3% increase that was expected. The annual pace jumped to 9.8% ahead of expectations of just 8%. Interestingly rents are now falling across all capital cities.
  • Australia’s trade deficit widened much more than expected again in October from a revised $2.4bln to $3.3bln after it was expected to print at $2.6bln. The decline does not bode well for growth in the fourth quarter after net exports did the heavy lifting for growth in Q3.
  • Building approvals posted their first back to back increase in some time, rising 3.9% in October after a revised rise of 2.3% in September. The annual growth rate eased significantly from 22% to 12.3%.
  • The improvement in motor vehicle sales was short lived as sales fell 3.6% in October. The result saw the annual pace of sales slip from 7.8% to 4.2% as a result.

David Flanagan – Director Interest Rate Markets