Curve Monthly Insights, November 2015

Curve Monthly Insights

  • The RBA left the cash rate on hold in November at 2.00% despite the market placing the probability of a cut at a 50:50 chance.
  • A robust employment report in the US has cleared the final hurdle for the FOMC to hike rates when they meet in December.
  • Chinese trade data is sounding warning bells not only for the Australian but the global economy as well.
  • The market has a cut fully priced for the next year but is this the most likely outcome?

Rates Recap

  • The RBA left the cash rate on hold at 2.00% in November despite the market being 50:50 on the prospects of a cut at the meeting.
  • The RBA said that low rates were working as expected, adding that “while the recent changes to some lending rates for housing will reduce this support slightly, Monthy Market Moves - November 2015overall conditions are still quite accommodative“.
  • The statement also said that “members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand”; however, at this stage it wasn’t deemed appropriate.
  • A robust non-farm payrolls report in the US last month has the market firmly expecting the FOMC to raise rates in December which resulted in sharp steepening of the yield curve.
  • The expectations of the first hike from the FOMC also saw the USD appreciate substantially, placing downward pressure on the AUD which is once again hovering just above 0.70c.

FOMC Now Has All Clear to Start Normalising Interest Rates

The US Federal Reserve’s Federal Open Market Committee’s (FOMC) long held desire to normalise interest rates could finally materialise at its next meeting in December. Many thought the FOMC would have made their first move by now; however, they have repeatedly baulked at making the jump despite standing at the precipice so many times before. It was widely expected they would go at their meeting in October, only to once again back pedal and leave rates on hold yet again.

Volatlity Has Declined Significantly Since AugustConfidence in the incoming data and outlook for inflation and employment has long held the FOMC back; however, it was a spike in global financial market volatility that appeared to spook them at their most opportunity to take the leap to higher rates. Since their October meeting, we have seen  global financial markets stabilise significantly. The wild gyrations in the Chinese share market have dissipated which has seen a sense of calm and normality return to broader markets in developed economies. According to the Chicago Board Options Exchange Volatility Index (See Chart left, Source: Bloomberg), volatility has eased right back to levels seen in the months preceding the August surge.

With volatility now much less of a concern, the focus is squarely back on the outlook for employment and inflation. Confidence in the outlook for employment inflation have long been cited at the final hurdle to the FOMC finally normalising US Core Inflation Hovering Around Targetinterest rates. These final hurdles are no longer standing in the way of a rate hike when the FOMC meet in December if the most recent data is anything to go by. The most recent reading of underlying inflation in the US has the inflation rate hovering just under the desired 2.00% level (See Chart right). There had been concerns in recent months that a renewed weakness in price pressure had re-emerged. The most recent result, suggests the risk of deflation has eased, albeit slightly.

Bumper Non-Farm payrolls removed last hurdle to FOMC HikeEven with an element of doubt over the inflation outlook, the most recent employment number suggests the current setting of monetary policy in the US is not consistent with the employment situation. The latest non-farm payrolls report saw the number of people employed jump by 269,000, the biggest jump this year (See Chart left, Source: Bloomberg). The average gain in employment since early 2010 is now sitting just under 200,000. Add to that the fact that the unemployment rate fell to 5%, the long held perceived level of full employment, and it is easy to see how a 0% benchmark overnight interest rate is no longer appropriate for the current economic situation in the US.

With volatility no longer a pressing concern, the risk of deflation dissipating and the economy running with full employment, the FOMC hasn’t had a better time to normalise interest rates.

Outlook for Interest Rates

Another month has passed and overall the outlook for interest rates remains largely unchanged from where it was a month ago. That’s not to say we haven’t seen a number of significant developments over the past month that could shape the outlook moving forward.

Over the month we saw the major banks and a number of regional institutions announce out of cycle increases to variable mortgage rates for owner occupiers. Many thought that this would draw a reaction from the RBA when they met in November. The RBA however simply acknowledged the move from the banks would reduce the degree of support the current setting of monetary policy would provide, stressing that overall monetary conditions remain very accommodative.

The RBA then expanded a little on their reasoning in their quarterly Statement on Monetary Policy, highlighting that “overall, growth appears to have picked up in the September quarter, as resource exports and dwelling investment returned to growth following temporary weakness in the June quarter”. The assessment that growth had improved over the last quarter gave the RBA some latitude to leave the cash rate unchanged following the out of cycle moves by the banks. This type Chines Trade 12m MAof moves from the banks are likely to become more common as regulators push banking institutions to become more self-reliant in a crisis.

The situation in China continues to look more concerning as fresh data showed over the past month. The latest trade data showed both imports and exports continue to slow, experiencing their biggest slowdown since the GFC. The decline in imports that moved into its 8th month has obvious ramifications for Australia and our raw material exports. It is the decline in exports, which recorded 12 straight months of decline, which has wide reaching implications for global growth. The chart on the right shows just how big the current slowdown in trade is. This has prompted the OECD to downgrade their forecasts for global growth yet again.

Business Conditions remain elevatedFortunately, the offshore weakness is somewhat offset by improving prospects for domestic demand. The latest monthly business survey from the NAB showed Business Conditions continue to hover around post GFC highs. In their release the NAB wrote “Business conditions were unchanged at an above average +9 index points in October, again consistent with the theme of recovery in non-mining sectors of the economy”. This is something that is desperately needed to fill the looming gap that is going to be left by CAPEX over the next 12 months and the headwinds coming from offshore, most noticeably China. Capacity utilisation, another key index within the NAB’s monthly survey, was also a bright spot with the NAB saying “capacity utilisation increased further this month, which bodes well for business investment and the labour market”.

Despite these developments, the main influence on the outlook for interest rates over the past month remains the FOMC and the expectations around the timing of their first rate hike. After pricing in at least one cut with the 50:50 chance of a follow up only a month ago, the market now only just has one cut priced in over the next 12 months. This accurately reflects the balance of risks facing theMarket Pricing for Interest Rates - November 2015 economy at present, especially in light of Governor Stevens recent comments. Stevens said that if there were a move in rates over the near term it would most certainly be down not up. That is not to say the RBA is considering a rate cut, it is simply a reflection of where the risks to the Australian economy currently are.

Given the RBA’s preference to do least harm to the economy, we are likely to see the RBA hold rates for the foreseeable future. This will give them time to assess the impact previous moves are having on the incoming data as well as give FOMC more time to begin normalising rates which should assist the RBA achieve its monetary policy objectives. Absent any substantial deviation from the current path of economic outcomes, rates are likely to be on hold for at least the next 12 months.

Appendix: Australian Economic Highlights

  • GDP grew by 0.2% in Q2, down from 0.9% in Q1. The annual pace was slower at 2.0% against expectations of 2.2%. Growth in the economy was particularly weak in Q1 with domestic demand only 0.5% for the quarter.
  • 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 recent trend seen from the employment data remained unchanged in September despite the unexpected fall in employment. Total employment fell by 5,100, full time jobs down 13,900. The unemployment remained unchanged at 6.2% while the participation rate also eased 0.1% to 64.9%.
  • Jobs ads continued to rise in October according to the ANZ job ads report. Job ads were up 0.4% for the month with Septembers 3.9% surge revised down by 0.1%.
  • The NAB business conditions index continues to hover around a 6 year high in September, unchanged at +9. The fading of the initial positive effect from change in the political narrative saw business confidence index ease back from 5 points to 2.
  • After being hit hard in September consumer confidence retracted some of the decline in October. In October the index rose 4.2% to 97.8. Another result below 100 points continues to indicate pessimists still outnumber optimists.
  • The pace of retail sales continued in September, posting the second consecutive monthly rise of 0.4% which was right in line with estimates. Sales for the quarter, adjusted for inflation, were up 0.6%, slightly lower than the previous quarter.
  • 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.
  • A solid rise in business credit of 1.2% for the month saw the RBA’s credit aggregates jump in September.  Total outstanding credit recorded growth of 0.8% in September with the annual rate of growth rising to 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 narrowed again in September from a revised $2.7bln to $2.3bln after it was expected to print at $2.9bln. Despite another large quarter of deficits, net exports will still add to growth as this quarters deficit is smaller than the previous quarter.
  • Building approvals continue to be plagued by volatility, rising 2.2% in September after a revised fall of 9.5% in July (Previously -6.9%). The annual growth rate rose sharply from a revised 4.7% to 21.4%.
  • The weakness in motor vehicle sales reversed in September with sales surging by 5.5%. The result saw the annual pace of sales jump from 2.9% to be 7.7% higher than a year ago.

David Flanagan – Director Interest Rate Markets