–  AUGUST 2018 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in August and continues to see a gradual move towards achieving its forecasts over the medium term.
  • Markets are becoming less convinced with the RBA’s outlook which has seen market pricing for the next move up in the cash rate deteriorate further.
  • Growing domestic risks and falling confidence in the international outlook is undermining the RBA’s central forecast.
  • As a result the cash rate is likely to remain on hold for the foreseeable future.

Rates Recap

  • The RBA left the cash rate on hold again in August 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 hike continues to fall and a hike isn’t fully priced for 2018 or 2019.
  • There is more than just the RBA’s economic outlook impacting the expectations for the timing of a change in the cash rate.
  • Short end pressure in funding markets has abated further with 3 months BBSW falling over the past month; however, 6 month BBSW remains elevated.
  • The Australian Dollar has broken out of its recent trading range, falling in sync with most major currencies as concerns of emerging markets, in particular Turkey, reverberate around global financial markets.
  • After lifting the Fed Funds rate in June as expected, expectations for two more hikes have increased further after more strong data in the US.

The Market is Losing Confidence in the RBA’s Outlook

A busy week of RBA activity culminated on Friday with the release of the RBA’s quarterly Statement on Monetary Policy. As was flagged in the RBA’s post meeting statement on Tuesday and Governor Lowe’s speech on Wednesday, the RBA’s medium term forecasts were little changed.

The growth profile for next year was trimmed ever so slightly but still sees growth over the forecast period at or above 3%. This above trend growth, is expected to slowly eat into the spare capacity in the labour force over the forecast period.

This reduced capacity is then expected to gradually boost wages, eventually lifting underlying inflation into the target band to around 2.25% by the middle of 2020.

It all appears quite logical should things evolve as the RBA expects under it central outlook. The problem is the RBA has been singing from the same hymn sheet for some time and the lack of progress is starting to undermine their credibility.

In addition to their growth forecasts, the RBA updated their inflation forecasts. There was little change to their expectations for both headline and underlying inflation over the medium term; however, they downgraded their near term forecasts for 2018 due to one some off items expected in Q3 this year. If their forecasts prove correct, core inflation will have undershot the target band for the third straight calendar year by the end of 2018.

The extension of the RBA’s forecasts out to the end of 2020 also shows the unemployment rate is expected to fall from 5.25% in June 2020 to 5% by the end 2020. That level of unemployment has been the long held level perceived as the Non Accelerating Inflation Rate of Unemployment (NAIRU).

Recent evidence from other development nations, who have seen unemployment rates plunge below levels previously considered to be NAIRU and toward levels considereds to be full employment, are yet to see a material lift in wage growth.

The RBA itself even suggests there is a degree of uncertainty as to what level currently constitutes full employment in Australia. Their caution on when wage growth will actually start to lift is also warranted given their track record as the chart shows.

One reason for the RBA and Governor Lowe’s persistence with their central view is their reluctance to cut rates further from here.

During Lowe’s time at the Bank for International Settlements, he co-wrote a paper with BIS economist Claudio Borio. In the paper they argued that even when inflation was tame, central banks should be wary of allowing rates to fuel asset-price booms.

Lowe then reiterated the same sentiments at a central banking conference in Europe recently, citing the risks associated with lowering the cash rate further from here were greater than the potential benefits.

The problem the RBA faces is the longer it goes without meeting its forecasts, the greater the threat it faces to its credibility.

Outlook for Interest Rates

A cloud continues to hang over the outlook for interest rates in Australia despite the RBA’s best efforts to be a source of confidence and stability. Despite retaining their medium term forecasts in last Friday’s quarterly Statement on Monetary Policy, the market continues to question their outlook.

Rather than seeing expectations firm for the next move in the cash rate being up, market pricing has deteriorated further. At the timing of writing, the market has the probability at a rate hike in 2019 now below 50/50. Less than a week ago, the probability of a rate hike by the end of 2019 was sitting at more than 80%, much less than should be expected based on the RBA’s forecasts.

Markets have for some time been underpricing the probability or a rate hike from the RBA despite their constant reaffirmation of their medium term outlook.

The main reason for this has been the market sees a far greater risk to the outlook from the headwinds that are building than the RBA does. Subdued wage growth and high household debt levels already pose a credible risk to the RBA’s outlook. Add in the deteriorating housing market that has its own headwinds building and there is a large risk of a negative wealth effect if things get disorderly.

Confidence in the international outlook is also starting to deteriorate. The calls of synchronised global upswing only 6 months ago are now starting to look a bit premature with growth rates outside of the US starting to slip. Europe and Japan have seen their annual rates of growth slow while data out of China also suggests a slowdown.

That was before the latest bout of global market volatility, this time centred in Turkey and quickly spreading to other emerging markets, which flared up late last week. Rising interest rates and tapering of the Fed’s balance sheet is having a large impact on those who gorged themselves on cheap US debt during the days of quantitative easing.

This new wave of volatility has been centred in currency markets so far with a big rush towards the USD. The big problem is that this only exascerbates the problems for those already under pressure in the first place.

It is this growing concern over the international outlook with the continued steady build of domestic headwinds that is driving down the markets expectations for the cash rate.

So despite the RBA sticking to its medium term outlook, markets suggest that the RBA is going to have a hard time lifting interest rates for the foreseeable future and it is hard to disagree with them.

Australian Economic Highlights

  • Growth accelerated in Q1 with the economy growing 1% while the previous quarter was revised up to 0.5%. Net exports did the bulk of the heavy lifting while investment and government spending also helped. 
  • 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 bounced back strongly in June with total employment growth of 50,900, mostly full time. Despite the surge, the unemployment rate remained little changed at 5.4% thanks to a 0.2% increase in the participation rate. 
  • The ANZ job ads report has remained volatile in recent months, rising by 1.5% in July after a 1.7% fall the previous month.
  • 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.
  • Consumer confidence posted its first solid bounce in some time, jumping by 3.9% in July, taking the index to 106.1. Long term expectations around the economy were the big driver behind the improvement as family finances remain subdued.
  • Retail sales rounded out the quarter with another reasonable increase in the face of weak wage growth, high debt and falling house prices. 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. June also saw the outstanding balance of investor debt fall for only the third time in the past 30 years according to RBA data. The last two times it happened was during “the recession we had to have” and the GFC.  
  • Australia’s trade balance posted a huge surplus in June as prices continued to help boost trade revenues. Despite the large surplus for the quarter, steady volumes mean net exports will have minimal impact on GDP for the quarter.
  • After falling for two straight months, Building approvals bounced back, lifting 6.4%. While apartment approvals remain volatile, private housing approvals continue to rollover as house prices continue to fall. 
David Flanagan

David Flanagan

Director Interest Rate Markets