–  MAY 2019 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in May making 33 straight months the cash rate has been at 1.50%.
  • Ongoing deterioration in the data, in particular the latest growth and inflation data, has seen the RBA downgrade their outlook.
  • One of the key technical assumptions underpinning the RBA’s forecasts suggests a change in monetary policy is coming.
  • As a result, the RBA has signalled lower rates are coming and it is now a matter of when, not if, it cuts the cash rate.

Rates Recap

  • The RBA left the cash rate on hold again in May, marking 33 months the cash rate has remained at 1.50%.
  • Following the decision to hold in May, the post meeting statement flagged downgrades to the outlook for growth and inflation.
  • The RBA’s Quarterly Statement on Monetary Policy then confirmed the downgraded outlook.
  • Assumptions underpinning the forecasts were that the cash rate moves in line with market pricing which suggests two rate cuts are coming.
  • As a result the Australian yield curve has continued to flatten. BBSW has continued to fall, also driven by falling demand for funds while longer term rates have fallen even further driven by the downgraded outlook.
  • The key for market rates will be whether or not rate cuts will be passed on when the RBA does eventually lower the cash rate over the months ahead.

RBA Signals Rate Cuts Are Coming

As the data has evolved over the first half of the 2019, so has the messaging from the RBA. The economy had been slowing over the back half of 2018 and it was becoming increasingly clear that this trend was continuing in the first half of 2019.

While the monthly data has been flagging the slowdown in activity for some time, the release of the fourth quarter growth figures crystallised just how much the economy had stalled. The economy grew at an annualised pace of nearly 4% in the first half of 2018 before slowing to an annualised pace of 0.5% in the second half of the year.

We don’t get an update on growth until the day after the RBA’s June board meeting when data for the first quarter is released. However, the data so far hasn’t exactly suggested growth has bounced back. Retail sales volumes for the first quarter actually fell 0.1% which doesn’t bode well for the consumption component. Net exports are unlikely to add too much either, despite the trade surplus as it is mainly being driven by increased commodity prices.

The biggest indicator of a lack of domestic demand was the inflation read for the first quarter. Headline inflation for Q1 was unchanged from a previous quarter. As a result the annual rate fell from 1.8% to 1.3%. The trimmed mean, which is now the RBA’s preferred measure of core inflation, rose by 0.3% over the quarter with the annual rate dropping to 1.6%.

As the data has continued to deteriorate, there has been a noticeable shift in the RBA’s narrative around their outlook for the economy and monetary policy. You can see in the sequence below how the final sentence/paragraph of their monthly post meeting monetary policy statement’s have evolved:

March:

“Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.”

April:

“The Board will continue to monitor developments and set monetary policy to support sustainable growth in the economy and achieve the inflation target over time.”

May:

The Board judged that it was appropriate to hold the stance of policy unchanged at this meeting. In doing so, it recognised that there was still spare capacity in the economy and that a further improvement in the labour market was likely to be needed for inflation to be consistent with the target. Given this assessment, the Board will be paying close attention to developments in the labour market at its upcoming meetings.”

Also contained in the May statement was a clear indication the RBA had lowered their forecasts for both growth and inflation.  These forecasts were then laid out in full in their subsequent Quarterly Statement on Monetary policy which was released last Friday.

As a result of the recent weak reads on growth and inflation, the RBA lowered their near term forecasts for both growth and inflation.

Growth is now expected to increase to 2.75% by the end of 2019 and remain there throughout the forecast period mid 2021. Meanwhile both headline and core inflation are expected to return to the bottom end of the target band by year end and will also remain there for the duration of the forecast period.

As a result of the downgraded growth outlook, they pushed out their expectations for the fall in the unemployment rate. The unemployment rate is now expected to remain around 5% this year and next year before drifting down to 4.75% by mid 2021.

The most interesting component of their forecasts and the one that gives the biggest insight into the outlook for monetary policy, was one of the technical assumptions the forecasts were based on. The Statement said that:

“The domestic forecasts are conditioned on the technical assumption that the cash rate moves in line with market pricing, which implies two 25 basis point cuts to the cash rate.”

So the RBA expects growth to only return to trend at 2.75% not above trend, the inflation rate to only get back to 2% at the bottom of the target band and for it to take to 2021 to get the unemployment rate down to 4.75% based on them cutting the cash rate twice.

Based on the updated forecasts and the assumptions which underpin it, it is now not a case of if, but when the RBA lowers the cash rate.

Outlook for Interest Rates

With the RBA signalling that two rate cuts are on the horizon, it becomes a question of when they will eventually decide to lower the cash rate. As is always the case, the data will be the main catalyst behind any decision to adjust monetary policy. The RBA has made no secret of what data it sees as the key to the outlook for both the economy and monetary policy.

As they outlined in their May post meeting statement, the RBA Board: “recognised that there was still spare capacity in the economy and that a further improvement in the labour market was likely to be needed for inflation to be consistent with the target.”

However, the RBA doesn’t believe the reduction in spare capacity in the economy will be addressed too quickly. In their Quarterly statement on Monetary Policy, the RBA said that “Employment is now expected to grow at around the same rate as the working-age population over the next six months, but then to pick up a little as GDP growth increases.”

That suggests that employment growth is expected to run at around 20,000 new jobs a month over the next few months before increasing above that level. Over the past 12 months, the economy has been adding around 25,000 jobs per month.

If employment growth were to fall short of that 20,000 average, then it will likely bring forward the chance of a rate cut. Equally, if employment growth were to continue to grow at rate in excess of 20,000 per month, then the RBA may hold fire a little longer.

The latest update on employment is due this week and given the RBA doesn’t likely reacting to month to month data movements, it is likely to wait to see how the trend growth in employment evolves. This essentially takes a move at the June meeting out of the equation. July is a possibility but it would take two pretty poor employment results in a row to trigger a lowering of the cash rate.

However, August shapes as the next critical meeting for the RBA. By August, not only will they have a number of updates on the employment data, they will also have growth figures and inflation data for the second quarter. A move in August also sits consistent with market pricing at the time that the forecasts were updated.

History suggests that rate cuts rarely come in isolation and are generally followed by a second move, usually a quarter later. That means that the second cut that is currently slated for early 2020, could be brought forward to November this year. That will also give the RBA plenty more information on how employment in evolving as well as another read on growth and inflation.

There are a number of other things that could also impact the outlook such as how the international backdrop evolves as the trade war between the US and China escalates again. There is also a question over how much of any movement down in the cash rate is actually passed on to borrowers.

For now though, we wait and watch employment outcomes for further clues as to when the first move from the RBA will come.

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.  
  • 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 saw total employment growth bounce back in March with a 25,700 increase with a skew towards full time employment growth. The unemployment rate edged back up to 5% after another uptick in the participation rate. 
  • The ANZ job ads continue to point to a slowdown in employment growth after edging lower again in April. The next update in the ABS’s job vacancies series will give us a better indication of where employment growth is heading.  
  • Business confidence remained soft in April with the index still hovering around while business conditions softened once again. However the employment index was the big concern, collapsing from 6 to -1 and is a warning sign for the RBA and their reliance on the employment market. 
  • Consumer confidence continues to gyrate around the inflection point that separates pessimists and optimists. After a big fall in March, consumer sentiment edged back up in April with the index now sitting at 100.7.
  • After recovering in February, Retail sales finished the quarter ok with a 0.3% increase in March. The quarterly sales data ex-inflation were a little troubling, posting a 0.1% fall, pointing to lower sales volumes over the first quarter of the year. This doesn’t bode well for the consumption component of GDP. 
  • Growth in housing finance continues to slow across the board. In March, the slowdown in owner occupied lending actually outpaced the decline in investor lending, falling 3.4% over the month, while investor lending was down 2.7%.
  • Australia’s trade surplus remained near its all time high in March as rising commodity prices continue to support export receipts. While the bumper trade balance is great for national income and the budget bottom line, it doesn’t add to GDP which focuses on volumes. 
  • The surge in Building approvals in February was subsequently unwound in March as was widely expected. Total approvals were down 15.5% in March after rising 19.1% the prior month. The volatility continued to be driven by units rather than detached housing approvals.
David Flanagan

David Flanagan

Director Interest Rate Markets