Markets take centre stage

The bomb in yesterday's speech by RBA governor Glenn Stevens is that market-generated tightening may take care of the inflation problem.

He said that "financial conditions were shifting in the right direction for containing inflation, even without a further adjustment in the cash rate…hence the Board decided to leave the cash rate unchanged, for the time being (in December)". Stevens also noted that "the outlook for the world economy looked a little weaker".

Stevens used the December RBA meeting as an example of why the communiqus were a good idea. He said that it was "a good example of one [meeting] where no change in the cash rate needed an explanation".

This suggests to me that the call to leave rates unchanged would have otherwise been a close run thing. It seems that the instability on the global scene has both directly and indirectly held the RBA back. First, it had led to an increase in wholesale funding costs, and raised the probability that retail banks would do the RBA's work for them, by lifting rates ahead of any action from the RBA. Second, it has increased the risks to the Australian Macro story.

I think it's wrong to infer that the RBA's inaction is only as durable as the wide spread between the overnight index swap (OIS) and the bank bill swap rate (BBSW) for two reasons. First the effect of the wide spread may be more durable than the phenomenon itself, as retail banks are likely to widen the spread between their standard rate and the cash rate. Second, the global growth outlook is souring and is unlikely to be sweetened in short order – and as a prime beneficiary of the recent boom (via commodity prices) Australia is particularly exposed to the slowdown (or the potential for a bust).

From the Q4 MPS onwards, the RBA has been smoothing the way for the retail banks to lift the key variable mortgage rate. It seems that they have formed the strong expectation that there will be a retail rate hike, and that this has been factored into their decision making. There is nothing untoward about this unofficial campaign – the fact is that BBSW is setting wider over cash, and floating rate notes are pricing at wider spreads over BBSW, so the retail banks are facing higher funding costs in the wholesale market for a given cash rate. In that sense at least, ‘market borrowing rates' are already higher – as foreshadowed by Stevens – it's just that they have just not yet been fully passed onto retail customers.

These higher costs have, however, been passed onto credit cards and business customers, and some of the mortgage clients of the smaller and non-bank lenders. Only the major bank variable rate customers remain (though they are the largest group). The banks are being forced to choose between lower profitability and higher retail mortgage rates. I'm sure that the RBA's liaison programme has told them the retail banks are disinclined to indefinitely accept margin compression – and hence will not indefinitely choose lower profitability. With the election out of the way, I suspect that the Big Four are presently daring each other to jump first.

When the standard variable mortgage rate rises, disposable incomes will be slightly lower. This will achieve much the same as an increase in the cash rate – though it will be a finer tuned policy as it will have an incremental impact only on variable housing borrowers.

My ongoing view of RBA policy is that they would be raising rates if financial markets were calm. The language in the Q4 MPS, and especially the December communiqu, was cautious – and I think designed to reflect the uncertainties surrounding the global outlook – however the economic forecasts in the Q4 MPS were inconsistent with a central bank that is ‘on hold'.

Stevens has said in the past that doing the Bank's job means aiming for the middle of the target, and inflation was not forecast to fall to 2.5 per cent within the entire forecast horizon (it was forecast to be 2.75 per cent to 3 per cent in H1'08). Alongside that, non farm GDP for 07/08 was forecast to be 3.75 per cent and 08/09 was forecast to be 3.5 per cent - both on the high side of the 3.25 per cent to 3.5 per cent that is probably the potential or non-inflationary growth rate. Thus, the point forecasts said ‘hike' while the linguistic posturing said ‘patience'.

To tie down the RBA's next move, we must answer the questions 'when will these markets calm down?' and 'will the damage have been done by the time that they do calm down?'

My guess is that money market conditions will ease across January, and flare up again in February (as notes extended for 6 months in August mature). The RBA snuck in a rate hike in November, just ahead of the 3 month anniversary's flare up, and it may be able to do so once again in February – but the souring global growth outlook makes it less likely they will want to. An increase in retail variable mortgage rates will probably take care of the RBA's desire to lift rates in Q1, unless Q4 core CPI is 0.9 per cent q/q or worse (I'd say there is a one third chance of this).

Thus, the next possible date for a rate hike would be in May 2008, following the publication of the Q1 CPI report. A necessary condition for a rate increase in May 2008 will also be that global growth and commodity prices are holding up. If the terms of trade continue their recent slide, I think that the RBA will really need to be pushed into the next rate hike. How hard? Well, that depends on how commodity prices are doing and how poor the global growth outlook becomes – say GDP above 4 per cent y/y in Q4'07, and CPI around 3.4 per cent q/q in Q1'08 (this would require core CPI to average 0.8 per cent q/q in both Q4'07 and Q1'08).

If I'm right about this, there's value left in the February IBs – they are presently 93.145 bid, and a one third chance of a rate hike should have them at 93.185. If the IBs rally they should pull the bill futures and the 3s up with them. This should allow the March 3/10 curve to steepen up to the low -30s (it's presently -33bps). The bills may offer the best value as there are assumed premiums built into the pricing, and an easing of these premiums would see prices rally further.

In other news, Stevens announced that all the unreleased minutes from the RBA board meetings that he's chaired (Oct 2006 to Oct 2007) will be released with the December meeting's minutes on Dec 18. At least I'll have some holiday reading…