–  MAY 2017 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA once again elected to leave the cash rate on hold at 1.50% following their May Board meeting.
  • Recent data has given the RBA confidence in their core forecasts.
  • While key risks have abate, low wage growth and rising debt threaten to impact consumption and growth more broadly
  • The cash rate is unlikely to change in the near term as the RBA assess competing forces impacting the overall setting of monetary policy.

Rates Recap

  • The RBA left the cash rate on hold yet again in May with the cash rate remaining at 1.50%.
  • Governor Lowe in the post meeting statement gave subtle hints that the RBA was becoming more comfortable with its central forecasts in light of recent data.
  • This was confirmed in the subsequent quarterly Statement on Monetary Policy.
  • After holding at their May meeting, the FOMC resumed normalising interest rates by hiking again when they meet in June.
  • The big question is whether or not discussion over the normalisation of their balance sheet will develop further at the two day meeting.
  • Growing expectations of a June FOMC hike has seen short dated yields rise however longer dated yields have fallen over the past month leaving the curve flatter.
  • The growing divergence of monetary policy between Australia and the US could see the AUD come under pressure over the months ahead.

Abating Risks Give RBA Confidnce

The RBA’s confidence in their forecasts and the broader outlook has improved from three months ago. That was the underlying message from the latest quarterly Statement on Monetary Policy that was released last Friday. The improvement in confidence is a reflection of abating risks rather than a change in trajectory for the economic outlook and as such, forecasts have been largely unchanged from three months ago.

Inflation and the lingering threat of deflation has been the preeminent risk faced by the majority of central banks globally every since the GFC. The RBA is clearly more comfortable with inflation, emphasised by the opening two sentences from the May SoMP:

“The Bank has been expecting for some time that inflation will increase gradually over the period ahead, to be above 2 per cent. Recent data have been consistent with this expectation.”

As mentioned though, we shouldn’t confuse improved confidence with a change in trajectory. While headline inflation is back above 2% and at the lower end of the target band “the expected increase in underlying inflation over the next year or two is still quite gradual, because a number of forces are continuing to hold inflation down.”

The most noticeable force holding back the return of underlying inflation to the target band remains wages growth. The weakness in wage growth is a byproduct of slack in the labour force. However the situation is a little more complex than would usually be the case according to the SoMP

“wage outcomes have been weaker than would be suggested by a straightforward assessment of spare capacity based on the unemployment rate. The underemployment rate has been higher than its past relationship with the unemployment rate would imply, and might be exerting further downward pressure on wage growth.”

The weakness in wages is not only clouding the outlook for inflation. The lack of wage growth is impacting the outlook for consumption which in turn impact the outlook for growth more broadly. According to the SoMP:

“Given low wage growth, household income growth is likely to remain quite weak, though not as weak as the December quarter national accounts data would suggest. This makes it hard to be certain about the future pace of consumption growth, particularly in the context of ongoing high levels of household debt.”

The impact household debt on consumption and Australia’s ability to remain resilient in the face of an income shock was outlined in great detail by Governor Lowe in a speech last week. The linkage between low rates, rising debt and consumption is probably with key concerns for the RBA in regard to potential risks to the current forecasts for the economy.

Despite lingering risk around inflation and growth from the lack of wages outlined above, “the recent run of both domestic and international data has provided some assurance about the domestic outlook.”

On balance, the RBA is clearly more comfortable with is central forecasts than it was three months ago.

Outlook for Interest Rates

It is fair to say that with no material shift in the RBA’s forecasts, there is very little reason to expected a shift in expectations for the cash rate. As has become the norm in their quarterly forecasts, the RBA assumes that the cash rate will move in line with market pricing at the time the forecasts are complied. A quick look at the Curve futures pricing chart and the cash rate chart from the RBA’s Statement on Monetary Policy shows that no change to the current interest rate setting is expected for the foreseeable future.

While the cash rate is expected to remain unchanged for some time, the overall setting of monetary policy continues to evolve. As noted on a number of occasions, the cash rate only forms part of what is known as monetary policy conditions. Some of the other influences of monetary policy conditions have been moving in different directions in recent times, which is not a bad thing.

The exchange rate is the one of the other most notable contributors to the overall setting of monetary policy. Over the past month we have seen a further decline in the currency against the USD. While the USD has also fallen over the past month against a basket of major currencies, the AUD has headed south at a faster rate. Previously the AUD had held up well against most other currencies. All other things being equal, this broad based weakness would leave the overall setting of monetary policy looser than it other wise would be.

At the same time, we have seen one of the other key determinate of the overall setting of monetary policy moving in the other direction. That is, the rates charged to borrowers has been rising despite the benchmark interest rate remaining unchanged since August last year.

Much of these increases in borrowers has been targeted at investors and interest only borrowers following announcements made by the Council of Financial regulators in March. However, as seen in the chart on the right, there has been varying increases for all borrowers in recent times.

How these other contributors evolve over the coming months are important as they not only influence overall monetary policy conditions, but can impact the setting of the cash rate.

Given the RBA’s growing comfort in their central forecasts, we are likely to see them sit pat over the coming months. This will give them time to assess a number of different influences of the overall setting of monetary policy.

It will give them time to asses the ongoing impact of the increase macro prudential oversight placed on banking institution to reduce risk emanating from the build up of debt in the household sectors. With the FOMC expected to hike rates next month, it will give them time to assess any impact that the narrowing interest rate differential will have on the currency.

Australian Economic Highlights

  • Growth bounced back in Q4 with GDP rising by 1.1% for the quarter. The pick up in growth saw the annual rate of growth rise to 2.4%, ahead of the RBA’s forecasts. The improvement in some sectors could prove unsustainable, casting a cloud over the outlook for growth.
  • CPI picked up inline with with market expectations in Q1. Headline inflation rose 06%, taking the annual rate up to 2.1% and back into the RBA’s target band. The RBA’s preferred measure, core inflation remained below the band at 1.8% after a quarterly increase of 0.45%.
  • The employment data was firmer in March with total employment rising by 60,900 after a solid gain was expected. Despite the large increase, the unemployment rate remained elevated at 5.9% thanks to a 0.2% jump in the participation rate.
  • ANZ job ads firmed a little in April, posting a gain of 1.4% after last months more moderate increase of 0.8%.
  • The NAB business conditions index continued to run well above the long run average of 5 with the index edging up from 12 to 14 in April. The ongoing buoyancy in conditions finally saw an increase Business confidence with the index jumping 7 points to 13.
  • Consumer confidence printed below the key 100 level for the fifth straight month in March as consumers remain cautious on their own finances, especially compared to a year ago even after two rate cuts last year.
  • Retail sales are continue to suffer as a result of consumers lack of confidence in their own finances. Retail sales were down again in March, falling 0.1% for their third fall in the past four months. A telling sign of consumers being under pressure is the fall in cafe and restaurant sales which are the last small luxury to be taken out of the household budget.
  • Housing finance collapsed in February driven by investors. The number of owner-occupier loans and the value of occupier loans were both down 0.5%. The value of investor lending was down 5.9%, more than offsetting the 4.6% increase the previous month.
  • Australia’s trade surplus remained elevated in March after bouncing back in February. The trade surplus came in just short of expectation at $3.1bln a half a billion fall on the previous months surplus. The decline was a result of import growth outpacing exports.
  • Building approvals collapsed in March, confirming that the peak of the construction boom is now behind us. The monthly fall led by apartments was 13.4% taking the annual decline to 19.9%.
  • After stalling in recent month, Motor vehicle sales were up in March. Total sales were up 1.9% for the month, failing to offset the previous months 2.7% decline Despite the rise, sales are still down 3% over the year.
David Flanagan

David Flanagan

Director: Interest Rate Markets