JULY 2016 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold in July at 1.75% as expected.
  • RBA Governor Stevens suggested August is live with upcoming information to sway the outlook.
  • The British referendum and Australian Election have added further uncertainty to the outlook.
  • The RBA decision in August hinges on inflation which suggests another cut is coming.

Rates Recap

  • The RBA left the cash rate on hold again in July but left the door open for August.
  • Governor Glenn Stevens accompanying statement indicated that ‘further information’ ahead would help refine the outlook for monetary policy.
  • A rally in global bond markets on growing uncertainty helped drive longer Government bond yields to record lows.
  • The amount of government bonds globally with negative yields continues to grow.
  • We are yet to get an update from the FOMC since the UK referendum driven volatility and uncertainty hit markets.

Uncertainty or Opportunity?

Over the past month we have witnessed a number of events which, while not outside the realm of possibility, have thrust greater uncertainty over an already uncertain outlook. Uncertainty, which ever way you cut it, is not good for financial markets, the economy or confidence, and it can create negative feedback loops that can be hard to circuit break. However, sometimes uncertainty can also open the door for opportunity.  

One of the major events over the past month was the unexpected vote by the British people to support their country in leaving the European Union. Those campaigning for the UK to remain in the EU used fear of the unknown to persuade voters to opt for the status quo. Alternatively, those while campaigning to leave played on the desire for the UK to regain control that had been lost through the UK’s EU membership. This heightened level of fear reverberated through financial markets in the aftermath of the decision with many expecting a ‘Lehman’ style event. The quick realisation that this is first and foremost a political crisis, compared to an economic or financial one, has seen a sense of normality quickly resume.

While the leave campaign was the eventual winner, we are unlikely to see the fears of political isolation and economic suicide materialise. Nor are we likely to see the UK able to flex its independence muscle once it rids itself of intervention by the EU Commission in Brussels. Overnight the UK appointed Theresa May as their new Prime Minister. She immediately voiced her commitment to Brexit. She will commence the negotiations of enacting Article 50 of the Lisbon Treaty. We foresee two years of negotiations which will require the UK and EU to nut out a mutually beneficial coexistence. The reality is the UK still needs Europe, and Europe – especially its largest economy – still needs the UK, so commonsense will prevail. 

The UK’s decision has also vexed the question of who is next to want to leave the EU. There are a number of nations where residents are becoming restless and the UK’s decision might just give them the confidence to speak up. One of the most significant developments in the aftermath of the UK’s vote was the swift, unusual,  joint statement from the EU’s founding six which you can read here. After acknowledging the UK’s decision to leave, they conceded the decision created “a new situation”. They vowed to continue working towards a united Europe which was followed by a huge shift in thinking on the European Union experiment:  

“It is to that end that we shall also recognise different levels of ambition amongst Member States when it comes to the project of European integration. While not stepping back from what we have achieved, we have to find better ways of dealing with these different levels of ambition so as to ensure that Europe delivers better on the expectations of all European citizens.”

This statement was designed to directly address the reason behind the UK’s decision to leave. It was also aimed squarely at other nations pondering following in the UK’s footsteps that prepared a position to drop their hardline approach and look for compromise.

Another more recent event was our own Federal Election. The swing away from the incumbents to the opposition and the prospect of another term with a hung parliament got most of the headlines. However, it was the shift towards populist candidates in the Senate and the nationalistic rhetoric which is more significant. It is a theme not too dissimilar to the movements we have seen across Europe and the US as voters become disenfranchised with the established political parties. 

The inherent uncertainty around the UK’s exit from the EU, Australia’s political landscape and even the upcoming US election, have the potential to cause a great deal of unease which threatens confidence, decision making and ultimately economic performance. While there are a number of significant headwinds to growth already present in all of these regional and broader global economies, these recent agitators of uncertainty also present opportunity. 

It presents an opportunity for the UK and EU to build a better relationship with mutually beneficial outcomes. It presents an opportunity for the EU to become more consultative with its member countries and compromise on those issues that are creating tension, bringing the EU closer together as a result. It presents an opportunity for the Australian political system to embrace a broader consultative process in formulating new policies and legislation that will improve our nation.

It will take progressive and forward-looking leaders to capitalise on these opportunities. The outlook for both the domestic and global economy hinges on it so lets hope they are up to the challenge.   

Outlook for Interest Rates

There was a fair degree of anticipation around the RBA’s July meeting – and not because the market was expecting a rate cut, with only a 5% chance priced in prior to the meeting. The anticipation was due to the fact there has been an increase in the level of uncertainty over the past month, leaving the market yearning for some direction.

The British referendum and the Australian election were expected to be two key talking points, given the potential impact they could have on the outlook for growth and inflation in Australia. As it turns out, and it shouldn’t have been entirely unexpected, talk of both of these drew little attention at all.

Addressing the British referendum in his accompanying statement, Governor Stevens said: “Any effects of the referendum outcome on global economic activity remains to be seen and, outside the effects on the UK economy itself, may be hard to discern.”

That is the RBA’s way of saying ‘move along, nothing to see here’ –  for the time being that is. The election result, or lack there of, at the time of the RBA’s Tuesday meeting, did not even get mentioned. This could of course change if over time, a situation of political gridlock threatens the outlook for the economy in a material way.

The majority of the rest of the statement contained little in the way of changes from what we had seen over the previous month. That is until the final paragraph, which is traditionally where the real gems, if any, are always positioned. In June, the RBA gave little away in terms of the outlook for monetary policy after lowering the cash rate the previous month. The final paragraph of the June statement read:

“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.”

While there has been little to change the outlook in the month since, the July statement saw some subtle changes:

“Taking account of the available information, the Board judged that holding monetary policy steady would be prudent at this meeting. Over the period ahead, further information should allow the Board to refine its assessment of the outlook for growth and inflation and to make any adjustment to the stance of policy that may be appropriate.”

The ‘further information’ that the RBA is referring to is the second quarter inflation print which is due out on the last Wednesday in July. Despite the RBA seemingly comfortable with the economic outlook, the inflation outlook is a different beast.

Since the first quarter fall in inflation was released in the last week of April, we have seen some mixed readings from the monthly inflation gauge compiled by TD securities and the Melbourne Institute. Headline inflation according to the monthly gauge rose 0.1% in April before falling 0.1% in May, only to jump 0.6% in June on the back of the resurgent oil price. This data would suggest that a second consecutive negative reading on headline inflation is unlikely in Q2.

While the negative headline inflation got all the attention in Q1, it is core inflation and its outlook that really worries the RBA. Core inflation printed at 1.55% in the first quarter, and the monthly readings suggest we could be in line for a similar result come the end of the month. So far this quarter, the monthly core reading on inflation rose 0.2% in April, fell 0.2% in May and then rose 0.2% again in June. With a 0.5% increase from Q2 last year set to drop out of the annual equation, a result of 0.2% would see the annual core rate of inflation fall even further below the RBA’s target band from the 1.55% print in Q1.

So we now sit and wait for 11:30am on July 27th when the Q2 inflation numbers are due. It will either tip the scales towards another rate cut, taking the cash rate to a record low of 1.50%, or if it will be strong enough for the RBA to sit back and wait for the next update at the end of October.

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 structural shift in the employment data continued in May. Total employment rose by 17,900 jobs with all of the growth coming in the form of part-time employment. Both the unemployment rate and participation rate remained unchanged at 5.7% and 64.8% respectively.
  • The recent volatility in the ANZ job ads report subsided in June with jobs arise rising by 0.5% for the month after last month’s 2.4% jump.
  • NAB business conditions index jumped higher in June even with the survey undertaken at the peak of recent market volatility. The employment index also increased. Business confidence rose higher as well, from 3 to 6 points.
  • Consumer confidence eased slightly in June with the index dropping 1% to 102.2. This is a good result following the rate cut inspired jump of 8.5% in May. It could be short lived given the narrow victory of the Coalition in the federal election.
  • The lull in retail sales continued in May with a 0.2% increase falling short of expectations while the previous months result was revised down to 0.1%. There has been a noticeable downshift in the pace of retail sales growth so far in 2016.
  • Housing finance was mixed in May with the data continuing to show little direction. The number of owner-occupier loans were down 1%, slightly better than the expected -2%.
  • Growth in outstanding credit according to the RBA’s credit aggregates eased a touch in May thanks to a slowing in the pace of business lending. Housing lending continued to chug along while personal lending continued to decline.
  • Australia’s trade deficit improvement was short lived with the deficit blowing back out in May. The trade deficit widened to $2.2bn ahead of expectations of $1.7bn while the previous months $1.6bn was revised up to show a $1.8bn deficit.
  • After solid increases in March and April, building approvals fell heavily in May, down 5.2% from the previous month. The annual pace of building approvals slumped to be 9.1% lower that 12 months ago as a result.
  • Motor vehicle sales continued to decline in May with total sales down 1.1% from the previous month. Passenger vehicles led the decline in sales while SUV sales rose for the first time in four months.
David Flanagan

David Flanagan

Director: Interest Rate Markets