The RBA's double act

A likely rate cut from the RBA next week would cool the Australian dollar, yet cash rates should remain high.

PORTFOLIO POINT: The circus in politics is but a macabre sideshow; what matters is what the Reserve Bank will do next week. But even if interest rates fall, the good news for income investors is that the banks will continue to pay well for your deposits.

You wouldn’t know it considering this week’s political maelstrom, but the most important thing happening in government is next week’s RBA rates decision. Luckily, however, as I’ll explain, even if the Reserve Bank does drop the cash rate, fixed income is the place to be (hybrids, however, may not be).

Let me reveal how I came to this conclusion: Over recent days, fiscal – or government – policy has been firmly in the spotlight. Here in Australia we had a former prime minister invoke a crusade against caucus-room electioneering by doing exactly that, while internationally, European governments gave a €130 billion fiscal bailout to Greece in exchange for further austerity measures.

Yet beyond these headlines, the markets didn’t care. Australian stocks remained largely unchanged (up about 0.5% after Gillard’s 71-31 vote win midday Monday). Traders clearly see neither a Rudd nor Gillard victory as making any difference. Meanwhile in Europe, traders were muted on the bailout: a sign if any that the world either no longer cares if Greece defaults, or never really thought it would be allowed to in the first place (see Europe faces recession, not regression).

"Give me control of a nation's money and I care not who makes her laws," Mayer Amschel Rothschild is alleged to have once said. The quote is popular among conspiracy theorists and those who advocate for a return to a gold standard (which was ironically the case in Rothschild’s time), but it nevertheless illustrates that money, not politics, is after all what really matters.

This week's G20 summit in Mexico City seemed in agreement, with leaders of the world's largest economies refusing to back additional IMF funding for Europe unless Europe shows "the colour of their money", in the words of Britain's Chancellor of the Exchequer, George Osborne. As has been increasingly voiced elsewhere, political solutions are no longer enough to stimulate economies and just as the Federal Reserve, the Bank of Japan and the Old Lady of Threadneedle have discovered, the European Central Bank will eventually need to print its way out of recession.

It is in this context where we find Australia’s present challenges, which have indeed contributed to an environment where Rudd could have realistically taken back the prime ministership. Since central banks across the world embarked on the present course of 'competitive devaluation’, Australia’s dollar has found itself moving from a value of 64 US cents at the market nadir of March 2009, to $1.069. As a result, Australian tourists have been doing very well overseas, but manufacturing and non-mining export industries have been shattered.

Source: Stock Doctor

The strength of our terms of trade with China has been responsible for much of our dollar’s appreciation since the financial crisis – a phenomenon that has also kept our employment rate and house prices where they are – but equally to blame has been the carry trade (mischaracterised as a flight to safety) and our central bank’s own unwillingness to drop interest rates to current OECD norms, which is reflected in our government’s high 10-year bond rate.

The highest rates for the highest rating...

3-mo
10-yr*
$USD
S&P rating
Australia
4.69
4.19
0.935
AAA
Brazil
10.40
11.00
1.7095
BBB
Britain
1.10
2.21
0.63
AAA
Canada
0.94
2.15
0.9992
AAA
China
5.28
3.66
6.2988' 
AA-
Euro area
1.05
1.92
0.7435
N/A
France
1.05
2.97
0.7435
AA
Germany
1.05
1.92
0.7435
AAA
Greece
1.05
37.10
0.7435
CC
India
9.02
8.35
49.015
BBB-
Italy
1.05
5.49
0.7435
BBB
Japan
0.15
0.98
81.19
AA-
New Zealand
3.00
4.10
1.1963
AA
Russia
6.53
4.73
29.12
BBB
Switzerland
0.08
0.71
0.8962
AAA
United States
0.12
1.97
N/A
AA
Source: Bloomberg, The Economist, Standard & Poor’s; * domestic CNY

And it is this carry trade, as I see it, in particular that has so exacerbated what was already a two-speed economy in Australia where, if we were a looser union like in Europe, there would be calls for Western Australia and the Northern Territory to bailout 'peripheral' Victoria and Tasmania.

As layoffs at Toyota, OneSteel, Qantas and the banks have shown, businesses can no longer justify the relative costs of Australian exports and workers without either a marked increase in productivity or marked decrease in the Australian dollar. And while Rudd, Gillard and Abbott may stoush over these issues, assuming that our decades-long quest for Australian productivity growth fails to yield some miraculous result in the near future, the only solution lies in monetary policy; i.e. with the Reserve Bank.

Next week the RBA has the opportunity to do just that, and help ease the strength of the dollar. There are suggestions of this happening, with the RBA's policy minutes saying "that if demand conditions were to weaken materially, the inflation outlook would provide scope for a further easing in monetary policy." And although demand conditions, notably the ABS unemployment rate, look stable, alternative measurements such as Roy Morgan's jobs poll and secondary indicators such as March's PMI could spook RBA governor Glenn Stevens and his board into action.

Either way however, as expressed by the multiple out-of-cycle rate rises by the banks this month, monetary policy transmission ain’t what it used to be and commercial lenders are once again largely determining credit supply instead of the RBA (or rather, having money supply determined for them by the international markets). Whether the Reserve Bank lowers rates or not, it is unlikely that this will be passed on in full by the banks.

As discussed earlier this month (see Banks: Duck and cover), Australia’s lenders have found themselves squeezed between higher borrowing costs offshore and lower lending margins domestically, as demand for housing and personal credit dries up against a background of unreasonably high property prices and a deleveraging consumer sector (for more thoughts on housing, see Property pales before bond rivals).

Per the experience of other central banks overseas, money markets are being determined by interbank fear, not central bank policy. And although I do not predict a second credit crunch arising from this milieu of uncertainty – I'm still confident of the ECB making the right move in Europe (eventually) – I do think that offshore markets are acting sensibly in rationing credit to Aussie banks due to the undeniable risks of China's contribution to our terms of trade coming unstuck (see China's false dawn).

What this means in the short to medium-term term for Australian fixed income investors is that the banks will welcome your deposits with generous rates regardless of what the RBA does or doesn’t do. While there is undoubtedly the motivation to lower the cost paid out to term deposit holders, these lenders (i.e. people like me and you) are still cheaper and easier to tap than the usurious institutions demanding as much as 6.8% for covered bonds. Indeed, if banks did lower term deposit rates in the event of an RBA cut, they’d kill off a large source of funding; funding that would otherwise rush back into the sharemarket as it usually does in the event of a rate cut (for more on investing for income, see The Ten Commandments of Income Investing).

Personally I’m forecasting a 25 basis point rate cut by the RBA next Tuesday, although I suspect that the consensus of mainstream economists will move to a 'hold’ forecast in the meantime, against the near-unanimous cut forecast of February. It is with hope that this will lower the dollar, but that doesn’t mean it will lower rates. Good news for income investors, bad news for mortgagees.

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