–  APRIL 2018 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold yet again in April but surprised with increased rhetoric on state of global economy.
  • Short term rates have continued to drift higher with BBSW-OIS spreads putting pressure on bank funding costs.
  • The FOMC, as widely expected lifted rates and dot plot indicated more hawkish sentiment amongst members.
  • There are a growing number of uncertainties taking shape with geopolitics casting doubt over the integrity of markets.

Rates Recap

  • The RBA left the cash rate on hold again in April with the cash rate remaining at 1.50% since August 2016.
  • Markets have pushed out expectations for the cash rate yet again with a 25bp increase now not fully priced in until July 2019, out from May 2019 a month ago.
  • Long term interest rates have remained relatively stable over the past month while short end rates have continued to rise.
  • We have seen increased levels of market volatility of late on the back of geopolitical factors.
  • The FOMC lifted the Fed Funds rate in mid March in the US, taking their overnight rate above our own cash rate for the first time since 2001.
  • Market volatility has seen US long term rates break through a key level indicating a more structural shift in market sentiment.

Uncertainty & Volatility Shroud Outlook

Uncertainty and volatility have become very prominent themes for the global economy over the course of the year so far and does not look to be letting up anytime soon. Ongoing geopolitical issues have been causing quite a stir in markets and this sets a pretty interesting backdrop for central banks who are looking to return to more normal monetary policy settings.

From where I stand, there are two key uncertainties that are shrouding the state of the global economy at the moment.

At the crux of one, US President Donald Trump. More particularly, the ways in which he is trying to fulfil some of his campaign promises.

With the US historically being a net importer of capital, something that was clear with last week’s trade balance figures, Trump is looking to implement protectionist trade policies to support local producers. The trade deficit widened to $57.6 billion in February, highest level in over 9 years.

It is not surprising that one of the key nations at risk is China being the largest contributor to the US’s current account woes. What has resulted has been a series of tit for tat behaviour whereby the US looks to tax Chinese imports and China retaliating.

You couple this with ongoing tech stock rout and a revolving door policy in the Trump administration and you get a whipsaw effect in markets. Since the start of February, we have seen the equity markets gyrate, with the S&P500 down over 7.50% while overall, safe havens have been on the bid.

Market sentiment was highlighted in a survey conducted earlier in March of 200 fund managers. The results indicated that around 70% were concerned that a 20% correction in the stock market could come over the next two-year period. The prospect of a trade war was

A more structural shift in sentiment was highlighted when US 10year Treasuries broke through the key level of 2.80% in late March. It is understood how the prospect of a trade war has got markets in a bit of a funk particularly with the FOMC issuing securities and China being the largest foreign holder.

While it is not all doom and gloom now, tit for tat protectionist policies by two of the world’s largest economies looks to dampen the global upswing in economic activity of late.

On the other end and something that is constantly overshadowed by the trade debacle, has been the dramatic rise in short term borrowing costs over the past couple of months. In particular, the widening of US Libor OIS spreads. The cause for concern here is that traditionally, the widening of such spreads is accompanied with times of financial stress.

The thing that has been on a lot of commentator’s minds, is what actually sparked the widening of such spreads? There are a couple of possible options however the path to which spreads are heading is still uncertain.

From my standpoint, there are a couple of reasons that could explain such moves. The first relates to the Fed and its path to normalised monetary policy settings. On one hand, we have increasingly hawkish rhetoric to near term rate moves and the other we have a surge in Treasury issuance. The latter has been driving up borrowing costs for all participants.

Back home and the spill over effects are starting to be felt and starting to raise a few eyebrows, particularly for the RBA. While there has been no real shift in policy expectations, heightened uncertainty and volatility is starting to undermine the RBA’s outlook.

Outlook for Interest Rates

The theme of steady as she goes from the RBA continues to be front and centre with another month done and dusted. As we saw last month there are ongoing concerns surrounding the path for growth of the economy, while recently we have seen developments offshore cast further doubt. These concerns continue to support the view that the cash rate will not be moving up anytime soon.

As we saw in the minutes from last month’s RBA meeting, the central bank’s usual optimistic tone to growth took a slightly more pessimistic turn. In particular, the outlook on growth is looking less certain with the minutes stating “over 2018, GDP growth was expected to exceed potential growth.” With potential growth widely regarded as 2.75%, this is a clear shift in language to what we have heard since the February SoMP, where the RBA repeatedly forecasted that growth would pick up over 3%.

Market expectations of a rate hike have been pushed out to July 2019 on the back of softer GDP and as I mentioned earlier, adding to the RBA’s concerns is the looming presence of volatility. While the spike in market volatility is consequential of activities offshore, the spill over effects are being felt here.

In the statement that followed their April meeting where rates were left unchanged yet again, the RBA voiced concerns surrounding the equity market and the rising short term borrowing costs. On the latter, 3 month BBSW has risen nearly 30bps since the start of February with Lowe indicating the rising borrowing rates in the US are,

increasing for reasons other than the increase in the federal funds rate. This has flowed through to higher short-term interest rates in a few other countries, including Australia.

The interesting case here is that there is no indication the cash rate will not be moving up any time soon and the effects are starting to hit home for banks. The spread between BBSW and the Overnight Index Swap has risen considerably to levels not seen since the Eurozone debt crisis. The rising cost of debt is putting pressure on the banks’ profit margins and the interesting thing to watch is whether this will be passed on to the consumer through higher mortgage rates.

As we saw last week with the employment numbers, despite another 17,500 increase in employment, we are still yet to see this number eat into the unemployment rate and drive up wage pressures. As such, the prospect of increased pressure on highly indebted households despite any immediate forecast lift in incomes will be something the RBA will be monitoring carefully.

Despite the bearish commentary above, the Australian economy looks to be tracking along nicely and hence the RBA can continue to be cautiously optimistic given the strength in business conditions and the labour market. As such it is likely the RBA will continue to sit on their hands throughout the near term with no change in policy on the horizon.

Australian Economic Highlights

  • Growth for Q4 came in at 0.4%, short of both the market and RBA’s expectations. The economy grew just 0.4% in Q4 which saw the annual rate slow to 2.4% from an upwardly revised 2.9% last quarter. The most recent RBA statement reflected a less optimistic view on growth for the rest of 2018.
  • CPI continued to disappoint, the headline figure only lifting 0.6% for the second straight quarter in Q4. The RBA’s preferred measure, core inflation also remained below the band at 1.9% after a quarterly increase of only 0.4%.
  • Employment data continues to be a pillar of strength in the Australian economy with another 17,500 jobs added in February. The unemployment rate increased 0.1% to 5.6% that looks to be attributed to a small uplift in the participation rate. 
  • Following the negative result last month, ANZ job ads were flat at 0.0%. The previous month was revised from -0.3% to -0.4%.
  • The NAB business conditions came off recent highs declining 6pts, however still remain strong at +14. The Business confidence also declined 2pts and now just sit above the historical average, this could be attributed to heightened volatility in financial markets. 
  • Consumer confidence remained steady in March following the volatility-driven fall in February. The index remains above the key 100 level, sitting at 102.7.
  • Following on from a steady January result, Retail sales posted a significant gain of 0.6% for February, well above expectations.
  • Housing finance looks to be stabilising as the value of approvals to both owner occupiers and investors were up in January.
  • Australia’s trade balance rebounded after the previous deficit to record a surplus of $1.055bn in Q4. Non-monetary gold was one of the larger contributors, up 54% whilst imports on consumption goods was down 7%.   
  • Large swings in Building approvals continue to be seen as high density approvals rise and fall each month. Total approvals were down 6.2% following a sharp increase in the previous month.
  • Motor vehicle sales woke from their slumber with a solid 4.5% to end the year in December. The increase saw the annual pace of sales rise from 2.1% to 6.7%. 
Oliver Parsons

Oliver Parsons

Client Relationship Manager