–  JULY 2019 INSIGHTS BY THE CURVE TEAM –

Highlights

  • As flagged in the aftermath of the June rate cut, the RBA lowered the cash rate again in July, taking it to a new low of 1.00%.
  • Governor Lowe once again highlighted that the decision was not driven by a deterioration in the outlook but rather a revision to their assessment of what constitutes full employment.
  • Lowe continued to stress that monetary policy cannot do it alone and repeated calls for other arms of policy to play their role.
  • Markets continue to price in another cut for early 2020 but the key to the outlook will come in next months Quarterly Statement on Monetary Policy.

Rates Recap

  • For the second month in a row the RBA lowered the cash rate by 25bps, taking it to a new low of 1.00%.
  • The post meeting statement indicated that once again the cut wasn’t due to any change in the outlook but rather aimed at expediting the return of inflation to the target band.
  • Governor Lowe stressed that they stand ready to act once more should they be required but stressed the need for action by government to stimulate the economy.
  • The move by the RBA has seen the yield curve continue to flatten, despite this some the inversion seen in previous months benchmark and government curves has dissipated.
  • While the RBA may cut rates further, we could have seen the long end of the curve reach its low point already.
  • The US curve also flattened this month with growing expectations of adjustments to monetary policy by the Fed in the coming weeks.

RBA Shows Its Hand, Now Where to From Here?

As was flagged in the aftermath of their June rate cut, the RBA followed it up with another 25bp reduction in the cash rate at their June Board meeting. In the accompanying statement to the July decision, the Governor said that “The Board will continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time,” leaving the door ajar for more easing’s if required.

In order to determine where monetary policy is headed over the months ahead, it is worth recapping how we got to where we are now.

The RBA gave very little away regarding the outlook for policy after the first rate cut in June. The accompanying statement referred to the reassessment of the level of spare capacity in the labour market. However, all the RBA said was that they would “continue to monitor developments in the labour market closely and adjust monetary policy to support sustainable growth in the economy and the achievement of the inflation target over time.”

Fast forward a few hours and the RBA Governor took the stage at the RBA dinner in Sydney which followed the meeting and flagged that there would be a follow up move to the 25bp cut in June. After outlining the driving factors behind the reassessment of the level of spare capacity in the labour force, the Governor said that

“Our latest set of forecasts were prepared on the assumption that the cash rate would follow the path implied by market pricing, which was for the cash rate to be around 1 per cent by the end of the year.”

From that point on, it was a matter of when, not if, the RBA would be taking the cash rate down to a new low of 1%. Two week later, the Governor delivered a speech titled “The Labour Market and Spare Capacity.” After going into the detailed analysis that drove their reassessment of the level of spare capacity in the labour market, the Governor then turned to the outlook for monetary policy. It was at this point, he said that:

“It would, however, be unrealistic to expect that lowering interest rates by ¼ of a percentage point will materially shift the path we look to be on. The most recent data – including the GDP and labour market data – do not suggest we are making any inroads into the economy’s spare capacity. Given this, the possibility of lower interest rates remains on the table. It is not unrealistic to expect a further reduction in the cash rate as the Board seeks to wind back spare capacity in the economy and deliver inflation outcomes in line with the medium-term target.”

When reading this statement through the lens of the assumptions that underpin the RBA’s forecasts, it became clear the cash rate was set to be cut again. The market subsequently moved to almost fully price in the move for the July Board meeting.

Throughout this change in policy setting over the past couple of months, the Governor has been at pains to point out that monetary policy can’t solve the issue of spare capacity in the labour force alone. On numerous occasions, he has pointed out that both fiscal policy and policy reform have a role to play. Fiscal spending on infrastructure to add to the country’s productive capacity and policy reform to support firms expanding, investing, innovating and employing people.”

In his speech at the RBA dinner following the July Board meeting in Darwin hammered home his point by saying:

“To repeat the point, it is important that we think about the task ahead holistically. Monetary policy does have a significant role to play and our decisions are helping support the Australian economy. But, we should not rely on monetary policy alone. We will achieve better outcomes for society as a whole if the various arms of public policy are all pointing in the same direction.”

So, the question now is:  what combination of policy will we see over the months ahead to address the level of spare capacity in the labour force, lift wages and return inflation back to the target band?

Outlook for Interest Rates

With the cash rate hitting a new low of 1%, monetary policy in Australia is entering unchartered territory. The last update on the outlook for monetary policy were the Governor’s remarks at the RBA Dinner in Darwin that followed the July Board meeting. The Governor closed his remarks by saying that:

“Given the circumstances, the Board is prepared to adjust interest rates again if needed to get us closer to full employment and achieve the inflation target in a way that supports the collective welfare of all Australians.”

With the failing to rule out further policy easing, the market continues to price in the potential for policy support from the RBA. Currently the market has another 25bp interest rate cut priced in for February next year which would take the cash rate to a new low of 0.75%. There is the outside chance we could see even further action after that but for now the market has it as a low probability.

Market pricing is important as it feeds into the assumptions that underpin the RBA’s forecasts. The last time the RBA updated with forecasts in the May Quarterly Statement on Monetary Policy, they central outlook remained largely unchanged. What had changed was the assumptions that underpinned the RBA’s forecasts.

Looking even further back, the RBA’s long term forecasts have been largely unchanged for the last 12 months. The only real changes we have seen are small adjustments to the near-term forecasts as new data becomes available, changing the starting point. Other than that, the economy has been expected to get to a growth rate of 2.75-3% and inflation has been expected to move back into the lower end of the target band.

The assumptions under pinning the forecasts, especially the expected path of the cash rate, has changed materially. Given the RBA’s forecasts state that the “Technical assumptions include the cash rate moving in line with market pricing,” this is incredibly important.

At the time of the November 2018 forecasts, the market had a 25bp interest rate hike priced in for April 2020. Then at the time of the February Statement, where the long-term forecasts were largely unchanged, the market had swung the other way and had a 25bp rate cut priced in for April 2020.

So, while the RBA’s central outlook was unchanged, their forecasts implied a different path of monetary policy would be required to achieve the same outcome. They were essentially telling us that policy easing would be required to hit their forecasts. If it wasn’t, they would have upgraded their forecasts base on the assumption that a lower cash rate would have boosted growth compared to their forecasts three months ago.

When the RBA last updated their forecasts in May, the market was pricing in two 25bp rate cuts. At that point in time they were priced in for around August 2019 and April 2020. Obviously since then, the RBA has moved to deliver those two rate cuts quicker than the market had been expecting after reassessing the level of spare capacity in the labour force.

Given the relationship between the RBA’s forecasts and this key assumption underpinning them, the next update in the August Statement on Monetary Policy will be crucial to the outlook for monetary policy.

Should the RBA keep the same long term forecasts while the market still has a further rate cut priced in, it would be a pretty good indication that a rate cut is coming. Should the RBA lift their forecasts with the assumption that the cash rate it cut again, it would more likely be signalling an extended pause as they assess incoming data and how it impacts the outlook.

We now eagerly await the next update from the RBA to get a clearer indication on the outlook for monetary policy.

Australian Economic Highlights

  • Growth fell short of estimates again in Q1 with the economy only growing by 0.4% as the weakness from the second half of 2018 spilled into the start of 2019. The annual pace of growth slowed further from 2.4% to 1.8% and is likely to undershoot the RBA’s estimate this quarter.  
  • Inflation came in well below expectations in Q1 with headline CPI flat for the quarter which saw the annual rate fall from 1.8% to 1.3%. The RBA has moved to using the trimmed mean as their preferred measure of core inflation and it increased by 0.3% for the quarter with the annual rate slipping from 1.8% to 1.6%
  • The employment data managed to comfortably beat estimates again in June with a another solid increase in new jobs. Despite the 42,300 new jobs created, the unemployment rate remained unchanged thanks to yet another rise in the participation rate. 
  • The ANZ job ads partly reversed its 8.4% fall from June with a 4.5% increase in May. Despite the bounce, the series remains in a downtrend.
  • The boost in Business confidence following the election result was short lived with the index giving up 5 of the previous months 7 point gain to be sitting at 2, below the long run average. Business conditions posted a modest improvement with trading conditions increasing from 3 to 6 while profitability and forward orders remained at -2 and -4 respectively. One positive was an increase in the employment index from 2 to 5. 
  • Consumer confidence remained largely unchanged for the second consecutive month just above the key 100 level. The index was down 0.6 from a month earlier where it rose by the same about. This months will prove more interesting after another rate cut from the RBA.
  • After lacklustre first quarter, Retail sales have remained soft through the second quarter. After falling 0.1% in April, they failed to post a solid bounce in May, only rising by 0.1%. The one positive was that food retailing was the primary drag on the overall number during the month. 
  • Housing finance remains under pressure, with investors still leading the declines in new approvals. The value of investor finance was down a further 2.2% in April which was somewhat offset by a 1% rise in the value of owner occupier approvals. Interestingly, despite the rise in the value of loans, the number of owner occupier approvals was down 1.1%.
  • Australia’s trade surplus continued to hit new record highs. The surplus came in at $5.75bln in May as solid revenues from exports, particularly iron ore and LNG. 
  • After a volatile few months, Building approvals were largely unchanged in May.  Approvals are still down around 20% over the past 12 months and down almost 40% from their late 2017 peak.
David Flanagan

David Flanagan

Director Interest Rate Markets