Curve Monthly Insights, February 2016

Curve Monthly Insights.

  • The RBA left the cash rate on hold in February at 2.00% in line with market expectations.
  • In their quarterly Statement on Monetary Policy the RBA has maintained its current outlook but is cognisant of growing risks.
  • Divergent monetary policy settings in developed nations are threatening to derail the global economy.
  • Despite being comfortable with the outlook, the RBA stands at the ready should the fallout from market volatility spill over into the Australian economy.

Rates Recap

  • The RBA left the cash rate on hold at 2.00% in February as was widely expected.Key Market Moves - February 2016
  • With the Quarterly Statement on Monetary Policy due out on the Friday after the decision, the RBA made only a few subtle changes to their accompanying statement.
  • 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.
  • While the RBA’s outlook has yet to waiver, we have seen further easing from the ECB and BoJ as the global currency war continues.
  • The ongoing USD strength is weighing on the US economy and when combined with the ructions in global markets, many are doubting the FOMC’s ability to hike rates.
  • This has been reflected in the flattening of the yield curve over the past month.

Global Market Mayhem has Local Ramifications  

In has been a wild ride for markets to say the least so far in 2016. Volatility has festered on itself and driven wild swings across markets all around the globe. Adding to the growing uncertainty, there are concerns that consequences of the wild price action could spill over into the real economy and it has central banks worried. Economic uncertainty and the risk of deflation has seen the European Central Bank ease monetary policy while the Bank of Japan has followed them down the path of negative rates.

In their quarterly Statement on Monetary Policy, the RBA made particular mention of what they see as the drivers of the heightened volatility, saying:

“The diverging monetary policy trends among the major central banks, concerns about the challenges facing the Chinese authorities and large declines in oil prices have contributed to an increase in volatility in global financial markets of late.”

Oil Under pressureOil prices are a critical input to almost all facets of every economy and that is why the recent price volatility has many nervous. Rather than being a driver of volatility, oil prices are more of a byproduct. The divergent monetary policies and concerns over China, as highlighted by the RBA are just two of a multitude of drivers currently fuelling wild price movements. With the fortunes of our economy tied so closely to those of China in recent times, the RBA went into much more detail on our largest trading partner and they didn’t mince words [our emphasis]:

“While growth in China has been expected to slow gradually for some time, the recent bout of global financial market volatility has been characterised, in part, by concerns about the evolving balance of risks in China and the ability of the Chinese authorities to manage a challenging economic transition. The authorities still have scope to respond if the economy turns out to be much weaker than expected, but any sharp slowing in economic activity or increase in financial stresses in China could spill over to other economies in the region and adversely affect commodity prices, including those that are important for Australia.”

The RBA certainly appears comfortable that Chinese authorities are well equipped to deal with even a substantial slowdown but are cognisant of the ramifications if things get out of control. China certainly does pose a significant risk to Australia and our economic outlook. It, however, doesn’t represent the clear and present danger to the global and Australian economy.

The BoJ continues to purse Yen weaknessDivergent monetary policy from major central banks around the globe currently represents the biggest risk. If anything, self interest from central banks has a greater probability of being a  trigger for a further bout of volatility and potential economic weakness rather than a saviour. Central banks are waging a war against waning aggregate demand and the heightened risk of deflation. They are acutely aware of the incessant nature of deflation and the damage it can cause and want to avoid it at all costs. With debt levels globally at or around record highs, the latest moves to ease policy are not about encouraging more debt driven growth but are to gain a comparative advantage via a lower currency.

The falling AUD has been one of the big drivers of Australia’s economic transition away from mining investment led growth. The ECB has a greater reliance on the currency to stimulate growth as the Eurozone has no mechanism for fiscal transfers amongst members whereby Australia has the Federal The higher USD is effecting the US economyGovernment. Japan, who has been fighting deflation and deflationary pressures for over 30 years was the latest to throw a grenade in the currency war by moving to negative rates. As a result, the Yen weakened substantially and a plunge in bond yields took the curve out to 10 years on Government bonds into negative territory. In the days since however, the Yen has actually strengthened.

On the other side of the coin, the US FOMC has

made no secret of its desire to normalise interest rates, hiking them for the first time in a decade last December. This desire to raise rates and wean their economy off extremely accommodative monetary policy has driven the USD higher. That hasn’t come without consequence with a number of areas of the US economy now struggling under the weight of the higher USD, much like a number of area’s in Australia’s economy did during the mining boom. In short, this growing divergence in monetary policy in developed economies is unsustainable. As long as central banks race to the bottom in pursuit of a comparative advantage, volatility and uncertainty will continue.

Outlook for Interest Rates

How the current environment of divergent monetary policy settings amongst the worlds developed economies evolves with have impact on how the RBA calibrates Australia’s setting of monetary policy. Getting back to the quarterly SoMP, the RBA remained comfortable with the outlook that they have been communicating for same time. There recent addition of a quantifier remained and has become more relevant than ever. They summed up their opening remarks in the statement by saying:

“The Board will continue to assess the outlook over the period ahead. New information should allow the Board to judge whether the recent improvement in labour market conditions is continuing and whether the recent financial turbulence portends weaker global and local demand.”

US Current Market PricingImportantly, as opposed to many other central bank’s the RBA still has a greater degree of latitude with their setting of monetary policy, adding that “continued low inflation may provide scope for easier policy, should that be appropriate to lend support to demand.”

It is pretty clear from the SoMP, that the RBA currently doesn’t think that it will be required to provide more stimulus by lowering the cash rate further, should the Australian economic outlook evolve as expected. They are however, fully aware of the ructions offshore and the impact that could have on our economy and setting of monetary policy. Current market pricing for the cash rate is reflective of the downside risks and has at least one interest rate cut fully priced in by the second half of 2016. If the market actually thought a cut was a distinct possibility, it would be fully priced in much earlier.Australian Current Market Pricing

The risk is that the currency war results in the FOMC abandoning it’s plans to normalise interest rates. This would put  upward pressure on the AUD as the USD reverses tack and eases back from its recent highs. At its December meeting where the overnight rate was lifted 25bp, the FOMC’s median expectations from the members suggested that there would be four further increases in the overnight rate. The market was far less optimistic and has two hikes priced in at best. Since then, expectations of rate hikes have only diminished as can be seen in the chart. The market has walked right away and only has roughly a 50/50 probability of an additional hike this year.

Ultimately the RBA will sit pat as long as it can but if required, Glenn Stevens and the RBA Board will not be afraid to act if required.

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 0.4% in Q4, which was just above expectations of a 0.3% rise. The increase saw the annual rate edge higher to 1.7%. The core rate was a little firmer, rising by 0.5%, right on expectations with the annual rate easing to 2.00%.
  • The employment data was softer in December after a run of very strong results. Total employment fell by 1,000 jobs. There was a swing towards full time jobs which were up 17,600. The unemployment rate remained unchanged at 5.8% despite the 0.2% fall in the participation rate to 65.1%. Questions remain over the ongoing validity of the monthly employment series from the ABS.
  • After a fall in December, jobs ads grew once again in January according to the ANZ job ads report. Job ads were up 1.0% for the month.
  • 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.
  • After finishing the year above 100, Consumer confidence fell sharply in January to be back under 100. Confidence fell 3.5% taking the index down to 97.3 and the ongoing volatility in global financial markets and concerns over the economic outlook both here and abroad weighed on sentiment.
  • The pace of retail sales stalled in December. The flat outcome comes on the back of a run of solid sales growth in the lead up to December. With expectations of a big spending splurge for Christmas failing to materialise retailers will be hoping that sales return to trend in the new year.
  • The recent trend in housing finance resumed in December after stalling in November. The number of owner-occupier loans was up 1.8% while the value of occupier loans rose 2.4%. Investor lending posted a small increase of 0.7% after falling by 5.8% the previous month.
  • Growth in the RBA’s credit aggregates continued to slow a touch in December.  Total outstanding credit recorded growth of 0.5% with the annual rate of growth unchanged at 6.6% with business credit and housing credit both rising 0.5%.
  • Australia’s trade deficit printed in excess of $3 bln for the 5th time in 2015 in December. The trade balance blew out to $3.5bln in December thanks to a sharp drop in exports with iron ore down 26% for the month alone.
  • Building approvals returned to their volatile ways in November and December, first falling 12.4% before bouncing back by 9.2% as medium density and apartment approvals bounce around.
  • The slowdown in motor vehicle sales continued in December with total sales down 0.5% which saw the annual pace slow from 6.0% to 2.2%.

David Flanagan – Director Interest Rate Markets