• The RBA left the cash rate on hold again in December, leaving the cash rate on hold for the second consecutive calendar year.
  • Data over the past month has disappointed with GDP growth slowing in the third quarter.
  • As the data slows, the tide is slowly turning against the RBA’s outlook, setting up for an interest RBA Board meeting in February.
  • What does that mean for the outlook for monetary policy in 2019?

Rates Recap

  • The RBA left the cash rate on hold again in December marking the second full calendar year the cash rate has remained at 1.50%.
  • Based on the RBA’s central outlook they still see the next move more likely to be up than down.
  • The market doesn’t share their confidence with long term yields falling sharply over the past month leaving the curve much flatter.
  • Futures pricing actually points to a small chance of a cut in rates early in 2019 before lifting back up above 1.50% out into 2020.
  • Short term rates have actually edged up over the month as funding markets remain tight.
  • Contributing to the pressure in funding markets is Quantitative Tightening by the US Federal Reserve as they continue to run down their balance sheet.
  • Despite a softening in the data recently, the FOMC is still widely expected to hike in December. Doubt over future hike though continue to grow.

Tide is Turning Against RBA’s Outlook

One short month ago, in the wake of their forecasts, the market was focused on the balance between the optimism of the RBA’s central outlook with the growing risks to that outlook. One month later, with the benefit of another month of data it is becoming increasingly evident that the tide is turning against the RBA’s central outlook.

The cornerstone of the RBA’s forecast has been that growth with remain strong enough to eat into the slack in the labour force and in turn will lift wages, which will then underpin consumption. More specifically, growth over the forecast is period is expected to remain between 3% and 3.5%.

After a solid start to the year, GDP fell short of estimates in the third quarter. The market had been expecting an increase in growth of 0.6% which would have kept the annual rate tracking closely to the RBA’s forecasts at 3.3%. The actual outcome saw the economy only grow 0.3% and after negative revisions to prior results, the annual rate slowed to 2.8%.

Unless we get a large turnaround and a bumper quarterly economic expansion of 1.3% for the quarter we are unlikely to see GDP for 2018 hit the midpoint of the RBA’s forecasts. The lower starting point to the RBA’s growth outlook isn’t the only point of concern.

The RBA has for some time pointed to consumption as the biggest risk to the outlook. That risk has been amplified by the deterioration in the housing market. To date at the national level, retail spending has softened somewhat but held up ok. Looking at it in more detail, a concerning trend is emerging.

In NSW, where Sydney house prices are now down more than 10%, retail spending is not slowing, but falling. Retail sales in NSW have been down 3 of the past 4 months, falling 1.2% in the past two months alone. This is the first sign that we have seen of material weakness in spending and it just happens to be where house prices have fallen the furthest.

There could be worse to come with house price declines accelerating. The private monthly house price index saw a marked acceleration in the declines in November. The data to date for December suggests the trend is continuing and we could be on track for record declines this month.

This is an area where the RBA is becoming more anxious. They continue to talk about house price moves in the context of the past few years rather than the most recent moves. They continually highlight markets that saw the largest growth in prices are now seeing the biggest declines. So rather than prices themselves, RBA angst stems from a shift in the biggest driver of house prices, credit growth.

The outlook for credit growth is quickly becoming one of the biggest risks to the outlook. In the wake of the royal commission, bank’s behaviours are changing, even before the final report is handed down. On the back of multiple rounds of macro prudential controls, the banks are now tightening lending standards which is reducing borrowing capacity for many borrowers.

While talking on leverage and credit growth last week, Deputy RBA Governor Guy Debelle said that “you need to keep the credit flowing to prevent the economy from seizing up.” It isn’t just credit to households, but businesses too. Credit is the life blood of the economy and greases the wheels of economic activity.

Adding to the pressure on the household sector is fading optimism in the business sector. The latest monthly business survey showed that business conditions are now running below their long run average. Forward orders are also slipping and overall business conditions are now well off their highs.

One salve from the survey in the near term was that the employment index remains well above its long run average. This suggests that employment growth over the near term should remain solid. Longer term the risk is growing of a slowdown. Profitability usually leads the employment index, and profitability has been falling for the past few months.

It sets up an interesting start to the new year. With no RBA meeting in January, the board will have another two months of data to digest before their February meeting and subsequent quarterly Statement on Monetary Policy.

Outlook for Interest Rates

The outlook for monetary policy is noticeably shifting as the tide turns against the RBA’s central outlook. Market pricing for the cash rate has moved significantly in the wake of the soft Q3 GDP outcome. The futures curve actually falls below the current cash rate level of 1.5% before drifting back above it into 2020.

With the latest data and market pricing pointing to a vastly different outlook for monetary policy than that of the RBA, the question is how will that resolve itself over the year ahead?

If the flow of data over the months ahead continue to flow against the RBA’s expectations then we can expect that they will continue to slowly walk back from their central forecast. At the least we will see revisions to the outlook for growth when the February Quarterly Statement of Monetary Policy is released to factor in the lower starting point.

We have already seen some subtle shifts in the RBA’s rhetoric in recent communiqués with an increasing focus on the risks to the outlook. These have been adding more balance to the outlook despite their repeated mantra that they still see the next move in the cash rate more likely to be up than down.

It suggests that if the recent slippage in the data continues we are likely to see the RBA shift towards a more neutral tone during 2019.

The other key question is will the RBA cut interest rates?

RBA Deputy Governor Guy Debelle, when speaking on lessons from the GFC, pointed out that the RBA does have room to move should the situation warrant it. They also have other tools at their disposal such as quantitative easing if it is required.

Even with that in mind, the hurdle rate for a rate cut or a loosening of monetary policy by the RBA remains high. The RBA Governor Philip Lowe has stressed on more than one occasion that the benefits of loosening monetary policy from its current setting doesn’t outweigh the risks that it would bring.

However, the RBA is pragmatic when it comes to setting monetary policy so I expect that there will be a tipping point somewhere that could lead to a rate cut.

One obvious trigger would be an economic shock or event either here or offshore that represents a clear and present danger to the immediate outlook. As we saw during the GFC, the RBA wasn’t afraid to act. They cut early and they cut hard when it was obvious they needed to with moves as big as 100bp.

The second trigger would be unemployment. This will be the key metric for the RBA when it comes to their shift in the outlook. Falling house prices can be contained. A pull back in consumption can even be offset by growth in other areas of the economy. However, rising unemployment would be a clear sign of a slowdown in the broader economy that will need to be addressed.

Absent an economic shock or a material rise in unemployment, 2019 is likely to be yet another calendar year where the cash rate remains unchanged.

Australian Economic Highlights

  • Growth disappointed in the third quarter with the 0.3% increase only half what was expected. The annual rate slipped to 2.8% while the previous quarters 3.4% rate was revised down to 3.1%. The RBA’s forecasts for 2018 are now unlikely to materialise.
  • CPI was a little softer than expected in Q3 with headline inflation rising 0.4% while core inflation rose 0.35%. The annual rate of headline inflation fell back below the RBA’s target band at 1.9%, while the core annual rate slid to 1.75%.
  • The Employment data continues to post interesting outcomes. Jobs growth bounced back in October with jobs growth of 32,800. It had limited impact on the unemployment rate which remained at 5% as the participation rose once again.  
  • The ANZ job ads continues to suggest that jobs growth will moderate over the months ahead as growth in new ads remains softer. 
  • Business confidence and Business conditions  both continue to drift lower. Business confidence and forward orders are below their long run averages. The employment index remains solid but if its continues its relationship with profitability then it can be expected to fall over the months ahead. 
  • Consumer confidence built on the uptick in October with a improvement across the board in November. The headline index was up 2.8% with the long run expectations for the economy positing the biggest gain over the month. That may change this month.  
  • Retail sales rose 0.3% inline with expectations in October.  However in NSW, where Sydney house prices are leading the declines, has seen retail sales fall three of the past four months which could be a sign of things to come as house price declines spread.  
  • After capitulating over the past two months, Housing finance had a better month in October. Owner occupier finance managed to bounce back a little while investor finance was little changed over the month. 
  • Australia continues to produce a solid trade surplus. It was a little lower at $2.3bln in October after September’s near $3bln surplus as import growth outpaced export growth for the month. 
  • The recovery in Building approvals was short lived with total building approvals slipping 1.5% in October. The decline was offset somewhat by an upward revision to the previous month but what is clear is that the peak in construction is now behind us. 
David Flanagan

David Flanagan

Director Interest Rate Markets