–  September 2018 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in September and continues to see a gradual move towards achieving its forecasts over the medium term.
  • While the cash rate is on hold, mortgage rates are on the rise and we are likely to see further funding pressures ahead.
  • Despite higher mortgage rates, the recent data has largely supported the RBA’s central outlook.
  • The key to the timing of any rate move will be how the risks to the outlook evolve.

Rates Recap

  • The RBA left the cash rate on hold again in September with the cash rate remaining at 1.50% since August 2016, a new record for stability.
  • The RBA continues to suggest the next move in the cash rate will be up; however, market pricing for a lift in the cash rate still points to no move until well into 2020 at the earliest.
  • Some commentators have gone as far as saying there is no chance of a move until at least 2021, especially after 3 of the 4 majors banks lifted mortgage rates out of cycle in the last month.
  • Short end pressure in funding markets has abated further with 3 and 6 months BBSW falling over the past month.
  • The Australian Dollar continues to fall, largely due to a stronger USD. The growing yield spread across the curve between the US and Australia isn’t helping the AUD either.
  • Recent data in the US supports the US Federal Reserve’s desire to normalise their setting of monetary policy with two more hikes widely expected by the end of the year.

Higher Funding Costs Are Expected to Keep Upward Pressure On Interest Rates

The outlook for the Australian economy is a contentious issue at the moment with plenty of debate on where the Australian economy is headed and what it means for interest rates. What is a little more clear is, that despite the cash rate being on hold for over 2 years, rates are rising and that in itself is impacting the RBA’s outlook.

Over the past month, three of the four major banks finally succumb to increased funding costs and lifted their mortgage interest rates out of cycle with the RBA for the first time in 18 months. Higher funding costs for Australia’s financial institutions have been prevalent for most of 2018 and it was only a matter of time until the major banks joined other smaller institutions in lifting their mortgage rates.

Out of cycle rates hikes have become far more common since the onset of the global financial crisis. After a long period where risk was underpriced, increased volatility in markets globally and locally has seen funding markets dislocate from the RBA’s cash rate target.

Since the onset of the GFC, we have seen more than 200 bpts of out of cycle rate increases as the cost of funding and capital have risen. In a way, it means the effective cash rate is much higher than the 1.50% reference rate that the RBA sets, actually suggests.

Assuming the demand for credit, and Australia’s financial institutions desire to meet that demand, remains constant, then it is unlikely we have seen the last out of cycle increase in mortgage rates.

One reason why overall funding costs are rising is because the cost of sourcing funding from overseas is rising. Interest rates in a number of developed nations, most notably the US, are rising. The higher cost of borrowing combined with a falling AUD is making it more difficult to raise what has traditionally been a cheap source of funding.

It isn’t expected to change any time soon. Recent data in the US has seen expectations of further interest rate increases from the Fed rise. Two more interest rate increases, one as soon as this month, are now expected by year end with at least two more next year.

Rising rates in the US is resulting in the negative spread between Australia’s interest rate curve and the US interest rate curve widening. This in turn is putting downward pressure on the AUD at a time when the USD is strengthening more broadly.

The cost of cheap offshore funding dissipating is putting an increasing onus on sourcing funding onshore. This has also proved a challenge given the size of the funding pie available hasn’t really grown since the end of 2017. As highlighted in previous Monthly Insights, broad money growth has stalled since October 2017.

Add to that the falling saving rate amongst Australian Households and the pressure on funding markets is likely to remain high for the forceable future. With rising mortgage rate comes implications for the economy and outlook for interest rates.

Outlook for Interest Rates

The RBA has maintained their cautiously optimistic outlook over the past month. They have had little reason to make any significant changes to their rhetoric with key data releases supporting their central outlook for the Australian economy.

Growth for the second quarter was in line with their expectations. Revisions to the previous three quarters now has the annual rate at 3.4% which is above where the RBA expected it to be in their latest forecast.

Their commentary on the employment market was, if anything, a little bit firmer than the previous month after the unemployment rate edged lower. The unemployment rate fell to 5.3%, its lowest level in some time, despite total employment also falling from a month earlier.

Furthermore, business conditions remain elevated, even if confidence is falling. The housing market, while still softening with demand for credit and prices both trending lower along with building approvals, the unwind of the boom from 2012 remains orderly. While the housing market softening remains orderly, the spill over effects to other areas of the economy are likely to remain limited.

The biggest impact on the outlook for interest rates has been the ‘out of cycle’ interest rate increases from three of the four major banks.

Those three major banks, along with the smaller lenders that have also lifted rates, account for around two thirds of the Australian mortgage market. That in effect means two third of Australian households with a mortgage have had the equivalent of  more than half a rate hike from the RBA added to their monthly repayments.

All other things being equal, it means there is even less need for the RBA to consider raising interest rates based on their central outlook.

The markets expectations for the cash rate compared to a month ago, reflect just that. The market doesn’t expect the RBA to be making an adjustment to the cash rate well into 2020. Some commentators have gone as far as calling no cash rate move until 2021.

The timing of any interest rate move will be determined by how the risks to the outlook evolve. Those risks suggest there is no urgency for the RBA to lift the cash rate any time in the foreseeable future.

Australian Economic Highlights

  • Growth remained strong for the second straight quarter with the economy growing 0.9%. Upward revisions to the prior three quarters helped lift the annual rate to 3.4%
  • CPI was as expected in Q2 with headline inflation up 0.4% while core inflation increased 0.5%. The annual rate of headline inflation edged back into the RBA’s target band at 2.1% while the core annual rate was unchanged at 1.9%.
  • The Employment data was a very interesting set of numbers in July. Total employment fell by 3,900 after the solid bounce in June. Despite the fall the unemployment rate was also lower over the month thanks to a 0.2% fall in the participation rate. 
  • While the ANZ job ads report remains volatile the trend growth in job ads has slowed and points to a slower pace of employment growth over the months ahead.
  • The Business confidence index continues to hover around the long run average, rising from 6 to 7 in July . The pull back in the Business Conditions Index has accelerated after spending 9 months at very strong levels. The index now sits at 12, well down on the 20 level 3 months ago.
  • July’s bounce in Consumer confidence was short lived with the index falling 2.3% in August. Expectations around the economy for the short and medium term provided the biggest drag on confidence. Family finances were also softer over the month.
  • After a solid Q2, Retail sales started the new quarter on a softer note and were unchanged in July. Ex-food sales were actually 0.25% lower over the month. The annual pace of sales continues to hover just above the pace of wage growth with little scope to accelerate from here.
  • Housing finance continues to slide, driven by a pull back in investor appetite. July saw investors lead the fall in total housing credit ex-refinancing while the value of owner occupier loans was also down for the month.
  • Australia’s trade balance posted another solid surplus in July at $1.55bln. Australia continues to benefit from elevated commodity prices, especially demand for coal. 
  • Building approvals resumed their decline in July after the unexpected 6.4% bounce in June. Both single and multi unit developments are now trending lower suggesting construction may come under pressure over the coming months. 
David Flanagan

David Flanagan

Director Interest Rate Markets