SCOREBOARD: Runaway rate cuts

A manufacturing spike pushed Wall Street higher, while the big question after the RBA's cut is: where will they stop?

The US manufacturing ISM index came in stronger than expected and led to a pretty decent bid on Wall Street. The index itself rose to 54.8 (from 53.4) which was stronger than the consensus forecast for a fall to 53.0. Moreover, if you check out all the major components there were rises across production, new orders, employment and exports. Prices were flat. So this is a great result – the best result in a year – and follows a lift in China’s manufacturing index yesterday.

A lot of the commentary from US business leaders is all about how business is stronger and about how good the outlook is at this stage, notwithstanding some European concerns. It’s all very positive stuff and is very similar in tone to what German business leaders are saying. The world isn’t so bad after all. Unless you’re Australian that is – with our oppressively high interest rates (lending rates are historically low), massive unemployment problem (the unemployment rate is also historically low) and weak sub-trend growth (demand is at a 4-year high and well above average).

US equities shot higher on the data, with the S&P putting on 16 points in the ensuing two hours of trade, to hit a high of 1415. Into the close, some of these gains were given away. But the index still managed to close about 0.6 per cent higher (1405). Energy, basic materials and financials were the key outperformers although outside of crude, commodity price gains seemed lacking. WTI was up 1.1 per cent (4105.9) and Brent rose 0.2 per cent ($119.7), but then gold did little (down smalls to $1662) and copper was flat. The Dow for its part was 0.5 per cent higher (13279) and the Nasdaq rose 0.1 per cent (3050).

Over in the fixed income space, US treasuries sold off but not by too much, and indeed compared to 1630 AEST yesterday afternoon, the 10-year yield is only 3 basis points higher at 1.94 per cent. The 5-year for its part is 1 basis point higher at 0.83 per cent, while the 2-year yield was just under one basis point higher to 0.26 per cent. Aussie futures in contrast managed to put on another 6-7 ticks – with the 3s at 97.13 and the 10s at 96.45.

Finally for the price action, and following an 85 pip move after the Reserve Bank's decision, the Australian dollar didn’t change much and sits at $US1.0332. Similarly, the euro, having hit a high of $US1.3284 just prior to the ISM data and a low of $US1.3204 just after, settled at $US1.3239 or 20 pips lower than 1630 AEST. Sterling and yen were little changed at $US1.6220 and $US80.08.

Bits and pieces otherwise. US construction spending rose 0.1 per cent in March and there was a whole bunch of Fed speak. Doves wanting more stimulus and ignoring strong data (John Williams and Charles Evans), with Evans suggesting an unemployment rate over 7.5 per cent warranted more stimulus. Hawks in contrast noted the reality that the data had picked up.

Looking at the day ahead there is nothing much out today. Tonight, check out German employment, the US ADP employment report and factory orders. The HSBC China manufacturing PMI is also out today at 1230 AEST.

As to the Reserve Bank's meeting yesterday I think the biggest question that lingers is, where do they stop? That they were going to cut by more than 25 basis points over the next two meetings was pretty clear following the RBA’s minutes, so in my mind, that 50 basis point cut yesterday wasn’t the shock that some people thought. I think it was a very bad decision, but I didn’t bat an eyelid, this is where we are at. The only question was how they were going to distribute the cuts and this was ultimately arbitrary. Following the CPI data I suggested – guessed – they would deliver 75 basis points worth of cuts over the next few months. So we’ve got 50 basis points of that so far. Reading the statement and noting they gave no guidance, I think we’ll at least get another 25 basis points almost regardless of the data – and you only need to look at the modest reaction of the Australian dollar to the RBA’s 50 basis point cut to see why.

It’s only about 85 pips lower and at $US1.0336 isn’t low enough to stop people complaining about how high the unit is – it’s a small move overall. Note that the board left the future direction of policy open. Unfortunately we have few guiding metrics to look at to try and determine the path of rates and it has become very much a guessing game. Unemployment? Well it’s already historically low and the pace of job growth has accelerated sharply in 2012 so far – yet we saw a 50 basis point cut. We get the GDP numbers in June, they should be important, but if they’re strong they’ll just be ignored. Like they were last year. So we can’t look at that – unless they’re weak.

The other complicating factor is that we just don’t know the answer to some questions – the real issues that are ultimately dictating where the cash rate goes. How much of a lift in net interest margins do the banks want? What level of the Australian dollar will satisfy? How low does it need to go to stop people complaining? How much does the All Ords need to go up? How much money needs to come out of cash and back into equities? And lastly, when will Swan and Gillard realise that no matter how low rates go, they will lose the next election?

So all the data is there, already, if people want to change their tune and become more optimistic on the economy all of a sudden. And they will, make no mistake – nobody makes money talking about how weak the economy is, especially when it is strong. But they want rates to come down first. That they are coming down means the rhetoric on the economy will change very soon, even without much of a change in the underlying data – so watch out for that. As dumb as I think the decision is I can’t help but be excited by the opportunities it provides. Think about it, demand was already running at its strongest in four years and now rates are 100 basis points lower! You are kidding – this is great. It's bad overall but great for now; money is very cheap already and the Reserve Bank will keep cutting! Growth will only get stronger. Let the good times roll baby.

Adam Carr is a leading market economist. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.

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