Curve Monthly Insights, October 2015

Curve Monthly Insights

  • The RBA left the cash rate on hold once again in October at 2.00%.
  • Dwindling expectations of a FOMC rate hike this year could see the RBA have to play the waiting game a little longer.
  • Downside risks to the Australia economy continue to evolve as highlighted by the IMF.
  • The market still has a cut fully priced for the second quarter of next year, however the materialisation of a move by the RBA is the less likely scenario at this stage.

Rates Recap

  • The RBA left the cash rate on hold at 2.00% once again in October as was widely expected.
  • The RBA’s accompanying statement was as close to a carbon copy of the previous month’sScreen Shot 2015-10-12 at 12.55.01 pm statement that we have seen in a long time.
  • The RBA walked a well trodden path by closing the statement saying “Further information on economic and financial conditions to be received over the period ahead will inform the Board’s ongoing assessment of the outlook and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.”
  • The RBA and the market still expect the FOMC to start normalising interest rates in the coming months; however, there is a growing expectation that the first move will now be delayed until 2016.
  • As a result we have seen the USD trend lower, driving up the AUD while equity markets have also been boosted by the expectations that low rates will remain in place a little longer.

The IMF Weighs In On Australia’s Biggest Challenge

For a number of months we have been suggesting that the window the Australian economy has to make to transition away from mining led growth to traditional drivers is slowly closing. The downside risks to the economy are building and these more traditional drivers of growth are going to be required sooner rather than later to take the baton from mining led growth. The decline in mining investments contribution to growth will be increasingly evident over the remainder of this year and 2016.

This challenge has not gone unnoticed with the IMF, this month releasing their report card on the Australian economy and it wasn’t one you would want to run home and show your parents. The IMF’s report card on the Australian economy delivered a rather blunt message with the key takeaway being that the glory years are coming to an end and its going to be a tough slog over the years ahead.

The table on the right gives a great summary for the IMF’s report and looks at the upside and downside risks to IMF Report Cardthe economy, the likelihood and the impact that they would have. As it shows, the list of downside risks is longer and more likely to occur according to the IMF which would have a significant impact on the Australian economy.

The IMF highlighted that while the economy has enjoyed a 25 year run without a technical recession, Australia Terms of Trade“waning resource investment boom and sharp fall in the terms of trade have brought this to a halt”. The IMF pointed out that while Australia’s overall vulnerabilities are low, “several distinct downside risks could interact and exacerbate the impact on the economy”. The key risks to the Australia economy are centred around the housing market and China.

The IMF noted that APRA and the RBA have be warning and are actively seeking to restrain the current housing boom which had driven house prices into over-valuation territory and warns there is a risk of a housing hard landing. The IMF said on that topic that:

A sharp correction in house prices, possibly driven by Sydney, could be triggered by external conditions (e.g., a sharper slowdown in China or a rise in global risk premia) or a domestic shock to employment. This might have wider ramifications if it affects confidence. The house price cycle could be amplified by leveraged investors looking to exit the market and a turning commercial property cycle.

Australia isn’t the only economy likely to be impacted by a slowdown in China. The latest data in Germany showed that exports posted their biggest fall since the GFC in August. The 5.2% could be a sign of things to come for Europe’s biggest economyGerman Exports. A chart that I put together back in 2009 as the global economy was picking itself up off the floor following the GFC was featured in Business Insider earlier this month. It shows an interesting relationship between the Chinese and German economy. One which is known as a low cost producer of goods and one which has built its economic might on the back of value added manufacturing. The chart maps the relationship
between the Chinese leading indicator, which has been advanced 6 months, and German exports. The chart Chinese Leading Index Vs German Exportshammers home why central banks are worried about China and more importantly, global growth. Should German exports remain under pressure, it won’t be too long before we see concerns over growth in Europe and the rest of the globe gather pace.

With this backdrop and the deflation risks already present, there is a risk the FOMC holding back their interest rate normalisation intentions will continue to build. As we have highlighted on a number of occasions, a prolonged delay from the FOMC will have ramifications for our own economy and more importantly monetary policy settings.

Outlook for Interest Rates

Despite the downside risks mentioned above, we are unlikely to see any action from the RBA just yet. The current setting of monetary policy is already very accommodative with the cash rate at 2.00% and the AUD hovering around its post GFC low of 0.70. Governor Stevens and the RBA board will be reluctant to ease monetary policy further using the cash rate given it is already at 2.00%. The RBA’s preference is that the AUD does the heavy lifting from here and at 0.70, the currency is starting to provide some significant benefits to the Australian economy. The latest NAB Business serve is testament to that with business conditions remaining strong for two straight months however it is still early days.

It is for this reason that the RBA is now playing a waiting game. The current data suggests that the Australian economy continues to muddle along. The RBA knows the risks are there; however, they expect other drivers of growth to pick up to fill the gap left by mining. Their outlook is based on the cash rate and the currency to continue to support growth. The latter is largely dependant on the FOMC and the timing of their intentions to normalise interest rates.

Over the past week we have seen the AUD drift higher, from just below 0.70 to be trading above 0.73. The shift in expectations around the timing of the FOMC’s move Austrlaian Interest Rate Futures - October 15has been one of the key drivers behind this move higher. We would expect, without an economic or market shock, that the RBA will give the FOMC ample time to announce its first rate hike, before it would consider any actions itself to keep downward pressure on the AUD. The market is now split on whether the FOMC will actually raise rates before the end of the year or whether it will be delayed until early next year.

It is for this reason that the market still has at least one cut from the RBA priced in for Q2 next year. The most likely scenario is that the FOMC will commence normalising interest rates over  the next quarter or so which will help keep the AUD low and along with the cash rate at 2.00%, provide ample support for the Australian economy. The longer the FOMC hold off increasing rates, the more likely it will be that the RBA has to act.

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 Q2, which was just below market expectations of a 0.8% rise. The increase saw the annual rate rise from 1.3% to 1.5% after it was expected to rise to 1.7%. The core rate once again remained more stable, rising by 0.6%, slightly above expectations with the annual rate easing to 2.3%.
  • The recent trend seen from the employment data remained unchanged in August. Total employment rose by 17,400, split across both full time and part time jobs. The unemployment eased a touch from 6.3% to 6.2% while the participation rate also eased 0.1% to 65.0%.
  • Jobs added to their August rebound with a solid rise in September according to the ANZ Job Ads report. Job ads were up 3.9% for the month with Augusts 1.3% rise revised down to 1%.
  • The NAB Business Conditions index eased back from a 6 year in September, easing 2 points to 9 however remains above its post GFC average of 0.3. Stable conditions and a change in the political narrative saw Business Confidence index rebound, rising 4 points to 5.
  • As was expected Consumer confidence was hit hard by market volatility in September with the index giving up most of its 7.8% gain from the previous month. In September the index fell 5.6% to 93.9.  The outlook for the economy both here and abroad continues to weigh on confidence with a result below 100 points indicating pessimists still outnumber optimists.
  • After July’s lull, the pace of retail sales picked back up in August, posting a rise of 0.4% which was right in line with estimates.
  • Housing finance was a bit softer than expected in August with owner occupiers once again dominating the growth. The number of owner-occupier loans was up 2.9% while the value of occupier loans rose 6.1%. Investor lending was weaker once again with the value of investor loans down by 0.4% over the month as regulatory measures continue to impact investor lending.
  • Growth in the RBA’s credit aggregates continued on trend again in August Total outstanding credit recorded growth of 0.6% in August even with investor lending slowing. The monthly rise saw the annual rate of growth rise back above 6%.
  • 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.
  • After narrowing in July Australia’s trade deficit headed wider again in August, rising to $3.1bln from $2.5bln after it was expected to fall to $2.4bln. July’s $2.4bln was also revised up to a deficit of $2.8bln.
  • Building approvals continue to be plagued by volatility, this time falling by 6.9% in August after a revised rise of 7.9% in July (Previously 4.2%). The annual growth rate slowed sharply from a revised 17.9% to 5.1%.
  • The weakness in Motor vehicle sales continued in August, falling by 1.6% for the second consecutive month which saw the annual pace of sales ease further but remained 2.1% higher than a year ago.

David Flanagan – Director Interest Rate Markets