–  MARCH 2019 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in March making 31 straight months that the cash rate has been at 1.50%.
  • Domestic data continues to disappoint with the latest national accounts confirming economic growth stalled in the second half of 2019.
  • The risk are now firmly to the downside with pressure building on the RBA to act.
  • Labour market outcomes remain the key to the monetary policy outlook and forward looking indicators are heading in the wrong direction.

Rates Recap

  • The RBA left the cash rate on hold again in March, marking 31 months the cash rate has remained at 1.50%.
  • According to the latest from the RBA, they now see the risks to the outlook as being more balanced, with the next move in the cash rate just as likely to be up or down.
  • However, the market pricing suggests there are greater downside risks, with long term yields falling sharply again over the past month leaving the curve even flatter.
  • A cut by year end is now priced with a follow up cut in 2020 60% priced in.
  • The other big move this past month has been in short end rates with BBSW falling sharply out to six months.

Stalling Growth Puts Pressure on RBA

The latest national accounts for the fourth quarter confirmed that the Australian economy stalled in the second half of 2018. After recording the strongest six months of growth since 2011, when the economy was bouncing back from the GFC, the economy has just experienced its slowest 6 months of growth since the GFC.

According to the RBA’s latest forecasts contained in the February Quarterly Statement on Monetary Policy, growth was expected to be 2.8%. With the economy only growing 0.2% for the quarter, the annual rate actually slowed to 2.3%, missing the RBA’s forecasts by a full 0.5% for the 2018 calendar year.

The annual rate of growth is also likely to fall further in the first quarter. In the first quarter of 2018, economic growth surged by 1.1% which was followed up by a increase of 0.8% in the second quarter. So unless growth picks up substantially in the first two quarters of this year, then the annual rate of growth will continue to fall towards mid 2019. The RBA was expecting mid year growth to slow to 2.4%. However it will be lucky to stay above 2% even if the economy grows at an annualised rate of 3%.

So far the data for the first quarter of 2019 has hardly painted the picture of an economy growing above the RBA’s current estimates of potential of 2.75%.

According to Purchasing Manager Indices from the Australian Industry Group, Australia’s largest engine of growth, the services industry, is contracting at the fastest pace since late 2014. The PMI’s also show that after booming in recent years, the construction industry is also under pressure, something that was expected after building approvals fell more than 37% over the past 14 months.

More broadly, the business sector is also under pressure according to the monthly business survey. Both business confidence and conditions have fallen from their mid 2018 highs to now being below trend. As far as conditions go, both trading conditions and profitability have been hit hard. Not surprisingly, retail conditions are the lowest with construction slowly catching up.

The news on the housing market hasn’t improved either. House prices in Australia’s two largest cities continue to fall with the declines now spreading to other capital cities and major regional areas. The RBA’s continues to suggest that supply and demand factors are the main driving force behind the declines. However the collapse in credit growth is surely a massive influence over the direction of house prices.

A falling demand for credit, especially from investors, is being flagged as the main demand side indicator of house price declines. However the RBA is becoming increasingly concerned with the availability, or supply of credit and that banks have tightened up lending too much in the wake of the Royal Commission into Financial Services.

Either way you want to cut it, credit is the life blood of the economy and slowing credit growth has ramifications for the broader level of economy growth. On the demand side, it is hard to see a pick up in the appetite for debt given the current outlook for the economy and house prices. On the supply side, regulatory oversight and the lack of broad money growth is likely to keep the availability of credit constrained for some time as well.

With credit growth unlikely to roar back in the month ahead, it is likely that house prices will continue to slide. The longer that house prices continue to decline, the greater threat that the negative wealth effect of falling asset prices will impact household behaviour and in turn household consumption.

Prior to the latest growth figures, the RBA was expecting growth by the middle of 2019 to slow to 2.4% from 2.8% at the end of 2018 before climbing back up to 3% by the end of 2019. For the growth to hit the RBA’s forecasts from here, growth would need to average 0.95%, or an annualised rate of 3.5%. for the first two quarters of this year. Short of a a major turnaround, this seems incredibly unlikely.

With Governor Lowe’s most recent speech occurring just before the growth figures were released, we have yet to get an update on how much they have impacted the RBA’s outlook. While there is plenty of speeches from RBA staff over the remainder of the month, we are unlikely to find out how much impact the figures have had on the RBA’s confidence in their outlook.

Outlook for Interest Rates

With growth missing the RBA’s forecasts at the end of 2018 and a rebound in growth currently looking unlikely, it casts a great deal of doubt in the RBA’s expectations around the outlook for monetary policy.

Prior to the growth figures being released, the RBA’s narrative had already shifted from “the next move in the cash rate is likely to be up” to the outlook to the cash rate being “evenly balanced.” 

In his more recent speech, which occurred the morning of the day that the latest national accounts were released, Governor Lowe went as far as saying that:

“There are plausible scenarios under which the next move in interest rates is up. There are also plausible scenarios under which it is down. At the moment, the probabilities appear reasonably evenly balanced. Given these various cross currents, the Board’s judgement remains that the most appropriate course is to maintain the cash rate at its current level.”

Given the margin by which growth missed the RBA’s forecasts in the fourth quarter and the growing downside risks to growth, the probability that the next move is down rather than up has increased.

The market certainly thinks that is the case. Not only is the market pricing in a 25bp reduction in the cash rate by the end of this year, it has a 60% chance of a follow up move priced by the middle of next year.

The more likely scenario is that if the RBA were forced to cut they cash rate, they would deliver two cash rate reductions a quarter apart. Recent history suggests they would cut in a month coinciding with the quarterly Statement on Monetary policy which is released in February, May, August and November.

The key to if or when the RBA will adjust the cash rate still revolves around the labour market. In his recent speech, Governor Lowe outlined in detail why this is the case, saying:

“Looking forward, a key issue is the labour market. Achieving full employment is an important objective in its own right. But, in addition, a strong labour market is the central ingredient in the expected pick-up in inflation. We are expecting that as the labour market tightens, wages growth will increase further. In turn, this should boost household income and spending and provide a counterweight to the fall in housing prices. The pick-up in spending is, in turn, expected to put upward pressure on inflation. Of course, it is possible that inflation could move higher for other reasons, although the likelihood of this at the moment seems low. This means that a lot depends upon the labour market.”

The RBA currently expects the labour market to remain strong with further jobs growth pushing the unemployment rate down from 5% currently to 4.75% over their forecasts period. However the two key forward looking indicators of employment growth suggest that labour market strength is expected to ease over the months ahead.

The employment index from the NAB survey remains a little above its long term average but is well down from its recent peak. It is also hard to see businesses continuing to hire new employees if business conditions continue to slide.

The ANZ job ads report has also reversed course over the best part of the last year. Total job ads have been in decline and have a good track record flagging future moves in the unemployment rate. Currently the jobs ads report suggest that the unemployment rate will actually rise over the months ahead, rather than fall as the RBA is currently anticipating.

Based on the RBA’s mandate, it seems unlikely that there is yet enough evidence to trigger an imminent change in the cash rate. The RBA is tasked with keeping inflation low and stable, achieving full employment and promoting the economic prosperity and welfare of the Australian people.

As such, it could be argued that house prices falling to more sustainable levels in debt to income terms, stable and low inflation, even if under the RBA’s target band and an unemployment rate at 5% is consistent with their mandate.

However there is already risks present that could put downward pressure on inflation and compromise the welfare and economic prosperity of the Australian people should current trends continue.  Thus the key to the outlook is the labour market and should it become clear that the unemployment rate is reversing trend and heading higher, the RBA will need to act. So all eyes will be on the monthly labour data over the next few months.

Australian Economic Highlights

  • Growth disappointed again in the fourth quarter with the economy only expanding by 0.2%. Annualised growth over the second half of 2018 was 1% compared to almost 4% in the first half of the year.  
  • CPI slightly exceeded expectations in Q4 with headline inflation rising 0.5% while core inflation rose 0.4%, in line with expectations. The annual rate of headline inflation inched further below the RBA’s target band to 1.8%, while the core annual rate stayed at 1.75%.
  • The employment data continues to be the one bright spot in an economy that is otherwise struggling. Employment growth remains strong enough to keep the unemployment rate hovering around 5% despite the uptrend in the participation rate. Forward looking indicators are starting to point to a slowdown in employment growth ahead.
  • The ANZ job ads suggests that jobs growth will slow down over the months ahead with a clear downtrend now in place. If the relationship between the ANZ jobs report and the unemployment rate holds, the unemployment rate will drift higher by the middle of the year. 
  • Business confidence eased again in February, falling from 4 to 2 and remains below its long run average while business conditions was also weaker, giving up last months gains as profitability and trading deteriorated. The employment index remains solid at 5, staying above long run averages. 
  • Consumer confidence rebounded in February, lifted by the prospect of rate cuts after the RBA shifted to a move balanced outlook. The index now sits at 103.8 meaning optimists slightly outweigh pessimists. 
  • Retail sales failed to bounce back from their 0.4% decline in December, registering a small 0.1% increase in January. Discretionary spending remains weak and the uptick in the savings rate from the GDP report suggest the wealth effect of falling house prices is impacting overall consumption. 
  • The downward trend in housing finance remains firmly in place. Both owner occupier and investor loans fell heavily in January. Further house price declines suggests new credit generation remains weak so far in 2019.
  • Australia recorded its second largest trade surplus on record in January driven by a surge in exports values. Exports rose 5% over the month while imports also bounced back after falling heavily in December. 
  • After sharp falls in recent months, Building approvals posted a moderate increase in January. Building approvals are now down over 37% from their November 2017 peak and are around their long run average going back to the 1970’s.
David Flanagan

David Flanagan

Director Interest Rate Markets