DECEMBER 2016 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in December at 1.50% after cutting by 0.25% in May and August.
  • The Q3 GDP shocker will have an impact on the RBA’s forecasts and outlook for monetary policy.
  • Markets moves over the past month have been significant as the globe continues to reassess the outlook under a Trump led US economy.
  • Further monetary policy divergence is expected as the ECB extends its QE program ahead of a likely hike from the FOMC this week.

Rates Recap

  • The RBA left the cash rate on hold for the fourth straight month in December after lowering it at both the May and August meetings.
  • Governor Lowe was quite positive on the outlook but did flag that year end growth could dip before picking up.
  • The sharp decline in GDP will have an impact on the RBA’s growth forecasts and the outlook for the cash rate.
  • While most cash rates globally have remained steady, longer term rates are continued to rise over the past month.
  • There is a growing divergence amongst policy aspirations amongst the globes biggest central banks.
  • While the FOMC is likely to hike when they meet later this week, last week the ECB elected to extend its Quantitative Easing program.

What a Year

The best way to describe the year that have we seen is you really needed to “Expect the unexpected, expect the extreme!”

The year started off with panic across markets and the fear of deflation was tightening its grip. The FOMC had just raised interest rates for the first time in a decade and it sent the market into a tailspin. Add to that the abrupt decline in commodity prices and the market was starting to price in the worst. We had the most volatile start to the year in recent memory.

The market eventually calmed down and the focus on the economic outlook came to the fore. However, the more unexpected events and extreme responses were still ahead of us. The RBA was alert but not alarmed at the situation at the start of the year and openly stated that if needed, it had room to provide more accommodation to the setting of monetary policy if required. While the market wasn’t really expecting it at the start of the year, by April it was getting pretty clear the RBA would indeed act.

After a rate cut in May we got yet another unexpected event. The Brexit vote, which seemed more of a non-event the closer it got, turned out to be anything but. The decision by the British people to leave the EU sent another shockwave around markets with wild swings, especially for the British Pound. It also reaffirmed the risk of populist politics with the centre rising up after years of dismay and fed up with the lack of progress from incumbent governments. A similar tone was evident in Australia’s own election a week later.

Not long after the dust settled from the Brexit calamity for markets, the RBA stayed true to form, delivering a second rate cut taking the cash rate to a new low of 1.50%. The main driver behind the decision to cut rates to a new low was an unexpectedly low read on inflation and an outlook that saw little prospect for a significant pick up in the medium term.

Only a few month later we got the latest in the run of unexpected outcomes. Donald Trump pulled off what most deemed impossible and stormed home to win the race for the White House in the US Presidential Election. Rather than widespread chaos as many expected, if Trump won, the result was actually well received. Since his election, Trump has surrounded himself with a host of very capable people and if he can keep it together, he may just be what the US economy needs to shock it out of its decade long slumber.

The year ahead is poised to be equally unpredictable with no shortage of challenges. There will be plenty of political hurdles to jump, especially in Europe. The outlook for Italy, the 6th biggest issuer of sovereign debt in the world is clouded after its failed referendum. France heads to the polls in the first half of the year where there is a risk the far right could get up and follow through on putting forward a “Frexit” vote. Donald Trump will also take the reigns of  government on January 20 and the market will be expecting an immediate impact.

Economically there will be plenty of challenges. The Brexit process will get under way with the EU, while Europe will continue to be plagued by its debt problem. Japan continues to try to jolt its economy out of a 30 year slumber while our biggest trading parter, China attempts the biggest economic transition ever attempted.

Outlook for Interest Rates

The Reserve Bank can’t seem to take catch a break when it comes to the interest rate outlook. In our November Monthly Insights we highlighted the risk that the current employment market trend could have on the RBA’s forecasts. In this case it was the inflation forecasts that were most at risk.

Growth figures for the Q3 that were released last week now cast serious doubt over the RBA’s growth forecasts. Growth came in at the very low end of expectations, falling by 0.5% for the quarter. What is a little worrying is that while the weakness in some sectors should prove temporary, other could remain softer than expected.

I have reprised one of my favourite charts to highlight not only how hard forecasting is but just how much impact the shock GDP outcome will have on the RBA’s forecast. You can see from the Actual GDP vs RBA Forecast chart that the 0.5% decline for the quarter saw the annual rate of growth fall sharply from 3.1% to 1.8%. Not only is that well below trend but it makes the RBA’s forecast for year end growth almost impossible to hit.

For growth to hit the RBA’s forecasts at the end of 2016, growth will need to be 1.8% in the fourth quarter. The last time we saw a result of that size it was the second quarter of 1997 when the RBA had lowered the cash rate 2.00% from 7.5% to 5.5% the previous 12 months. Since the GFC, Australia’s best quarter of growth was 1.3% in September of 2011, two quarters after the last time we saw growth go backward in first quarter of that year.

With the RBA not meeting until January we will need to wait until the early February to get the next official update from their post meeting statement as well as the next quarterly Statement on Monetary Policy. Even if growth bounced back in Q4 and matches the biggest post GFC increase, the annual rate will only reach 2.4%, below the 3% the RBA has forecast.

As a result we have seen the markets expectations adjust to the prospect of a lower trajectory of growth. It doesn’t necessarily mean that the RBA will be back cutting rates in the new year. It does mean that the prospect of a higher cash rate in the near term is much lower, especially when the banks recently lifting mortgage rates outside of the RBA cycle.

Australian Economic Highlights

  • Growth disappointed across the board in Q3 with GDP falling by 0.5% for the quarter. The sharp fall which saw most components of growth fall, saw the annual rate decline significantly from 3.1% to 1.8%, well below the RBA’s forecasts.
  • CPI was a little mixed in Q3. Headline inflation was up 0.7% ahead of expectations of 0.5% which saw the annual rate lift from 1.0% to 1.3%. The RBA’s preferred measure, core inflation, just missed expectations, rising by 0.35% which saw the annual rate edge lower by 0.1% to 1.5%.
  • The employment data still soft in October but managed to break the trend of declining jobs growth. Full time employment rose by 41,500 whilst part time employment fell by 31,700 for a net gain of 9,800. The unemployment rate remained unchanged at 5.6% as did the participation rate at a revised 64.4%.
  • ANZ job ads were positive again in November, positing a gain of 1.7%, adding to the gain of 1.0% in October.
  • NAB business conditions continued to slide in November with the index dropping a further 2 points to 5 which is its long run average. Business confidence continues to largely trend sideway, printing at 5 as well in November. The downtrend in conditions and the subdued outlook has NAB calling for 2 more rate cuts next year.
  • Consumer confidence continued to print above the key 100 level in November despite slipping 1.1%. The broad based decline which saw all but one sub index fall saw the index ease to 101.3 with optimists still marginally outweighing pessimists.
  • The rebound in Retail sales continued for a third month in October with total sales growing by 0.5%. The improvement over the past few months will be needed to continue to help growth rebound from the disappointing result in Q3.
  • Housing finance was softer in again in October. The number of owner-occupier loans were down 0.8% with the value of occupier loans also falling 0.8% while investor lending managed a small gain, up 0.7%.
  • Australia’s trade deficit reversed its recent trend and widened in October. The deficit printed at $1.541 billion which was much wider than the expected $610 million deficit expected.
  • The huge slide in Building approvals continued in October with the 12.5% fall adding to the 8.7% decline in September. The October reading has resulted in the annual rate of building approvals falling 25% from a year ago suggesting construction growth going forward will be limited.
  • Motor vehicle sales struggled to maintain momentum in October, falling 2.4% after rising the same amount the previous month. Despite the fall, the annual rate of growth lifted 0.4% to 1.2%.
David Flanagan

David Flanagan

Director: Interest Rate Markets