• The RBA left the cash rate on hold in June at 1.75% despite lingering uncertainty around the outlook for interest rates.
  • RBA Governor Stevens elected to leave the outlook open in his accompanying statement.
  • The FOMC still has the desire to lift rates despite data working against them.
  • Market pricing and the RBA’s forecasts suggest another rate cut is coming.

Rates Recap

  • After lowering the cash rate to 1.75% in May, the RBA left the cash rate on hold in June.
  • Governor Glenn Stevens accompanying statement outlined the ongoing challenges for monetary policy however without committing to an explicit easing bias.
  • The rate cut in May failed to have a lasting impact on the AUD thanks to renewed USD weakness.
  • Market pricing still suggests that another rate cut will eventually materialise.
  • A shocking nonfarm payrolls report has made it harder for the FOMC to hike rates next week.
  • As a result, yield curves globally continue to flatten with our own 10 year government bond hitting a record low.

The Real Growth Story

Australia reaffirmed its status of the miracle economy in the first quarter, extending its run of uninterrupted growth to 25 years. The Australian economy has successfully avoided a technical recession throughout the Asian Crisis, Dot Com Bubble and even the GFC. Remarkably, we are now only 4 quarters away from taking the world record from the Netherlands for the longest period of uninterrupted growth.

Growth for the first quarter was a rather robust 1.1% which has lifted the annual rate of growth to 3.1%, its fasted pace since September 2012. So if the economy is doing so well as the growth figures would suggest, then why do we have a cash rate at 1.75% with the market fulling pricing in the prospect of another one in the next 6 months or so?

In assessing that question, there is a number of elements at play. There is the current composition of growth and the outlook for future growth that go someway to explaining why the headline GDP figure above, doesn’t tell the true story.

The composition of growth in recent years has masked the underlying weakness in domestic demand. Growth obviously benefited in the huge surge in investment by the mining sector as companies aimed to cash in on the boom in demand for Australia’s raw materials from China. This large upswing in investment was significant from both a capital and labour perspective. The mining investment boom has since shifted into a new phase, where that new capacity that was created is being utilised, resulting in a significant increase the volume of exports.

Even with prices Australia’s miners receive for their exports falling as the increase in volume has coincided with a fall in demand, net exports is still making a huge contribution to the Australian economy. Net exports in the first quarter added a full percentage point to the final growth figure which accounts for over 90% of Q1 GDP. We saw a similar outcome in Q3 last year when next exports added 1.5% to growth while the final GDP figure was only 1%, indicating the rest of the economy actually contracted. In fact, if we strip out the contribution of net exports from growth for the past 3 1/2 years, the economy has only grown 1.4%. So if the economy feels like it is growth much less than the numbers suggest, it’s because it is.

The impact of falling commodity prices, the decline in the Terms of Trade and weak underlying demand in the economy is quite startling when you look deeper into the data. According to the ABS “A broader measure of change in national economic well-being is Real net national disposable income. This measure adjusts the volume measure of GDP for the Terms of trade effect, Real net incomes from overseas and Consumption of fixed capital.” The Productivity and Income chart from the RBA’s May Statement on Monetary policy (on right) speaks for itself.

The outlook for growth is also less that comforting. The annual growth rate of 3.1% is right in line with RBA forecast’s. From here, the RBA expects the pace of growth to remain at current levels until mid 2018 when it is expected to accelerate by a further 0.5%. The RBA’s forecasts rely on a far more significant rebalancing of the drivers of economy growth than we have experienced to date. There are also a number of headwinds that suggest that the current pace of growth may struggle to be maintained, let alone increase.

With consumption naturally constrained by low wage growth and a reluctance from consumers to materially run down savings, the RBA needs other growth drivers to do the heavy lifting. Construction is one area doing its best however the peak of the cycle appears near. Elevated debt levels and a potential oversupply of apartments in Sydney and Melbourne mean a further ramp up in these areas might not be desirable. The government is also reluctant to spend in order to stimulate growth as reducing the budget deficit is a bigger priority.

The RBA sorely needs non-mining investment to pick up and become a substantial driver of growth in the years ahead. The problems is that the lack of aggregate demand in the economy currently doesn’t justify the additional capacity new investment would bring. Outside of mining there hasn’t been a noticeable increase in investment in almost a decade. The latest Capex survey from the ABS suggest that this is unlikely to change any time soon.

Outlook for Interest Rates

Following May’s interest rate cut and the subsequent update’s to their inflation and growth forecasts, there were high expectations around the June RBA Board meeting. Expectations of a follow up rate cut at the June meeting were low with the market rather eagerly awaiting to carefully dissect the wording used by Governor Glenn Stevens in the accompanying statement. Those looking for some clarity on the outlook for interest rates were sorely disappointed with Stevens electing to refrain from committing to an explicit easing bias in concluding the statement.

Instead Steven’s preferred to go down the well trodden path of: “Taking account of the available information, and having eased monetary policy at its May meeting, the Board judged that holding the stance of policy unchanged at this meeting would be consistent with sustainable growth in the economy and inflation returning to target over time.”

The fact that he opted against a clear easing bias doesn’t necessarily mean that the outlook for interest rates is as balanced as the statement suggests. Given the recent knee jerk reactions to their Statement on Monetary Policy which saw a number of calls suggesting the cash rate could fall to 1.00%, he may have just wanted to put some perspective back into the debate over the outlook for the cash rate.

Rather than second guess the outlook from Steven’s most recent statement, lets take a look at the facts as we know it through the lens of the current economic situation as outlined above.

The RBA’s latest forecasts tell us a lot about the outlook for monetary policy. Even if the current level of growth is maintained over the forecast period out to mid 2018, core inflation is still expected to take the entire forecast period to get back up to the bottom of the RBA’s target band. While this is important, it is the assumptions behind these forecasts that are far more pertinent.

There are a number of assumptions that form the basis of the RBA’s forecasts. From a monetary conditions perspective, the level of the currency is very important. In the forecasts, the RBA assumes that the level of the currency would remain unchanged at 0.75 where is was trading at the time of the forecasts. The assumptions for the cash rate have evolved over the years. According to the RBA, in more recent times “The forecasts are conditioned on the assumption that the cash rate moves broadly in line with market pricing as at the time of writing”.

At the time of writing, the market was pricing in another full cut in the cash rate to 1.50%. It is very important to note that that the RBA explicitly says “This assumption does not represent a commitment by the Reserve Bank Board to any particular path for policy”.

What is does indicate is that for the current level of growth and AUD, the RBA will need to cut the cash rate again to get inflation back into the target band by the end of the forecast period. Should the AUD fall materially over the months ahead then a cut could be avoided. However the forecasts suggests another cut is coming.

Australian Economic Highlights

  • Growth managed to beat expectations in Q1 with GDP rising by 1.1%, up from 0.7% in Q4 with the annual rate firming from a revised 2.9% to 3.1%. Domestic demand was subdued with net exports accounting for over 90% of growth in the quarter.
  • CPI posted an unexpected fall of 0.2% in Q1 against expectations of a 0.2% rise. The fall saw the annual rate slip to 1.3%. The core rate was weak, rising by 0.15%, well short of the 0.5% that was expected. As a result, the annual rate of core inflation fell below the RBA’s target band to 1.55%.
  • The softer tone to the employment data re-emerged in April with total employment growth of 10,800 jobs with another big swing towards part-time employment. The weaker growth saw the unemployment rate drift up to 5.8% even with a 0.1% fall in the participation rate.
  • ANZ job ads remained volatile once again in May with a rise of 2.4% more than offsetting the revised 0.6% fall the previous month.
  • NAB business conditions index was unchanged in May with a further firming of profitability and trading conditions providing a boost. The employment index was weaker.  Business confidence continued to drift lower, slipping from 5 to 3 to be running below the long run average.
  • Consumer confidence responded well to the RBA’s May rate cut, posting a solid rise of 8.5% to take the index back above the key 100 level.
  • Retail sales continued to struggle in April with the 0.2% increase falling short of expectations. Spending on discretionary items remains very inconsistent from month to month.
  • Housing finance was mixed in April with improved a large divergence between owner occupier and investor lending. The number of owner-occupier loans were up 1.7% with the value of occupier loans rising 0.1% while investor lending slumped 5.0%.
  • Growth in outstanding credit according to the RBA’s credit aggregates was steady in April, rising. Business lending was surprisingly the biggest driver with a 0.8% increase while personal lending continued to fall.
  • Australia’s trade deficit finally showed further signs of improvement in April. The deficit printed at $1.6bn which was much better than the previous months $2.0bn and better than the $2.1bn expected.
  • Building approvals posted their third consecutive gain in April. Total approvals were up by 3.0% for the month and are now 0.7% higher than 12 months ago.
  • Volatility in motor vehicle sales continued in April with total sales down 2.2% from the previous month. Despite the fall in sales in April, total sales remain 2.4% higher than a year ago.
David Flanagan

David Flanagan

Director: Interest Rate Markets