The Reserve Bank meets next Tuesday – decision at 2:30pm.
Up until this week we had been questioning market pricing that the Bank would ease by a full 50 basis points. However, this week financial markets have turned decidedly uglier. With the collapse of Washington Mutual and the bail out of Wachovia banks are questioning the financial credentials of most of their counterparts and restricting funding to overnight funds. US dollar funding is at a premium. Official three month LIBOR is now at 4.2 per cent compared 2.8 per cent at the beginning of September.
Banks are actually borrowing three-month US dollar funds at even higher rates than the "official” set. Even over the last week "official” LIBOR has increased by 50 basis points and by 100 basis points over the last two weeks.
These developments in credit markets now make it necessary for the RBA to cut by 50 basis points. Markets are fully pricing in the 50 basis points and whereas in normal circumstances we do not believe that the RBA would feel obliged to frank market pricing, current conditions in financial markets are so fragile that the Bank would see it necessary to avoid further market destabilisation.
Despite a fall of 60 basis points in the market’s outlook for the risk-free rate over the last month the 90 day bank bill rate has fallen by only 20 basis points. If the RBA was to only cut by 25 basis points next week then the 90 day bank bill rate would probably increase by 20 basis points. The major Australian banks fund their balance sheets about 50 per cent in retail deposits; 35 per cent in short term wholesale deposits and 15 per cent in wholesale term funds. Competition for retail funds has been intense and margins have contracted while the term fund market is effectively closed. That puts even more pressure on the short term wholesale market and making that bank bill rate even more important. A further rise in the bank bill rate would add more pressure to banks’ funding costs.
The margin between the bank bill rate and the market’s estimate of the RBA rate over the next three months is currently around 70 basis points. When the banks passed on the full 25 basis point cut by the RBA to mortgage rates that margin was around 30 basis points – with mortgages priced off the RBA rate the banks' expected spread on mortgages has effectively narrowed by 40 basis points. A cut of only 25 basis points by the RBA would see a further increase in the bank bill rate and therefore the banks’ effective funding costs.
We have consistently argued for a 25 basis point rate cut despite a general consensus earlier last month that rates would be on hold. That was driven by a steady stream of better than expected data (employment; retail sales; consumer sentiment; profits and business investment).
However, we argued that the credit crisis had taken centre stage in the thinking of the Bank and there was more work to be done as credit growth had sunk to 16-year lows. Even in the last week the domestic data flow has been acceptable. Business credit growth was somewhat stronger than expected; retail sales surprised on the upside for the second consecutive month and exports strengthened. These partials would make it very difficult for the RBA’s forecasters to squeeze growth in the third quarter to a level consistent with their view that growth needs to slow to 1.5 per cent through the year to the first quarter of 2009. That growth slowdown was seen to be needed to begin making inroads into inflation.
The Bank suddenly moved from discussing rate hikes at the May Board meeting to deciding to cut rates by mid-July, effectively delaying action to contain inflation pressures. We expect there has been a further downgrading in the urgency of the inflation task as financial conditions have tightened further. Certainly we support the general principle that a substantial widening of the output gap will contain inflation pressures.
Developments over the week in the global commodity markets would also be disturbing the Bank from the perspective of global growth and the spillover to the Australian economy. Base metal prices are now down by 13 per cent in the last five days. That of course is before we see any impact on the real economy from the recent financial market stress.
The urgency is now about the smooth functioning of the credit process – the containment of banks’ funding costs and the preservation of banks’ capital so that monetary policy can be effective and credit is available to finance growth. If the bank bill rate was to rise by 20 basis points next week then there is no guarantee that banks would be able to pass on any of a 25 basis point rate cut.
Stability of the bank bill rate would be delivered with a 50 basis point cut giving the banks flexibility to pass on some of the proposed rate cut. This stability is based on the assumption that the US Rescue Package is passed and we therefore do not get a repeat of the markets’ response to the failure to pass the Package earlier in the week when the bank bill rate increased to 95 basis points above the expected RBA rate.
The market is currently pricing in a quick move to neutral from the current 7 per cent to 5.5 per cent by March next year. That will certainly happen if the current financial stress persists for the next six months. While the US Rescue package will not have any immediate impact markets are accomplished at anticipating events well before actuality. It seems unlikely that the current gridlock could continue for the whole period.
Undoubtedly the US economy will start printing recession-style data. There will be further pressure on bank balance sheets but official efforts to force mergers; remove problem assets; encourage private capital into the banking system and subscribe government capital should see a gradual thawing of current conditions. At that point the RBA will be able to refocus on the inflation challenge in an economy which will be getting some support from the current easing process.
Unlike market pricing we still see a pause in the easing cycle from the first quarter of 2009 probably when rates have hit around 5.75-6.00 per cent. The unknown is how much of that expected additional 100- 125 basis point cut will find its way into the mortgage rate – a factor that is directly related to the time required to thaw the financial markets.
When this market thaw takes hold the RBA will once again be very confident to refocus on real data and the inflation challenge. The need to "frank” market pricing will have gone and the markets’ current forward pricing will prove to be a little ambitious.
While market pricing has now moved to anticipate a 50 basis point cut over the next few months we make no apologies in franking that pricing with our forecast. Readers will recall that we successfully resisted following market pricing in June when markets were pricing in up to four rate hikes during 2008.
The case for a 50 basis point cut from the Fed is very strong. The US is in recession. Lower rates will assist recovery by lowering floating borrowing costs for credit worthy corporates. However the real benefit of a lower Fed funds rate will be its role in indirectly assisting with the recapitalisation of the banking system The Rescue Plan will assist in that objective but is not the definitive solution to recapitalising the banking system. An adequately capitalised banking system is required to finance economic recovery by allowing banks to raise their lending to risk worthy borrowers.
The Plan is designed to eliminate uncertainty about banks’ balance sheet quality so they can resume lending to each other and so that mergers are attractive and private/sovereign wealth funds are encouraged to subscribe new capital. Alternatively, under the Plan, the government could purchase assets at above book value in
exchange for equity.
Another way to rebuild capital is to raise the profitability of the banking system. That can be enhanced with a steeper yield curve at the short end as the margin between borrowing and lending rates increases. That policy was used with some success during the Japanese banking crisis in the 1990’s.
While the US is in a classic liquidity trap, with the constraint on credit growth being supply rather than demand, a Fed rate cut will still help by assisting the rebuilding of bank profits. A 50 basis point cut in the near future (at the very least at the next FOMC meeting on October 28) with a possible further 50 basis point over subsequent months would assist banks to rebuild profits.
The Greenspan error of creating the property bubble with 1 per cent rates in 2003 can be avoided by tightening much more quickly as the economy starts to recover. Greenspan left rates at 1 per cent for almost 12 months between July 2003 and June 2004. The current crisis is much more severe but we would envisage the Fed taking back the stimulus in the first half of 2010.
The Fed is already operating in the market with an effective rate of 0.5 per cent to 1 per cent. With commodity prices falling and the inflation threat almost non existent the Fed can justify cuts in the official rate pointing partly to the current market rate and the implication behind the need to support liquidity by formalising current market rates.
Consistent with this Fed view, the ECB and Bank of England are also expected to follow suit with rate reductions in coming months (BoE on October 9 and ECB in Nov/Dec).
Bill Evans is the chief economist at Westpac.
WEEKEND ECONOMIST: Big cut coming
The turmoil of the last week leaves the Reserve Bank with no choice but to cut rates by 0.5% when it meets next week.
The Reserve Bank meets next Tuesday – decision at 2:30pm.
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