Weekend Economist: Dollar dialect

The Reserve Bank board meets next week on May 6. The "myth" has been that the bank does not change rates in the week before the budget. However that does not accord with the "facts".

The bank has changed rates in May on seven occasions in the 14 years since 2000. That makes May the equal most "popular" month for the RBA with November (also 7 changes since 2000). However there is no chance that the Bank will opt to change rates next week.

As discussed, the governor has stated clearly that he plans a period of stability.

From my perspective, the most interesting aspect of the governor's statement which will be released following the board meeting is whether he will revert to describing the Australian dollar as "uncomfortably high". Recall that in December, when the Australian dollar was at $0.91, the Aussie was described as "uncomfortably high". Today it stands around $US0.9275, so it seems reasonable to expect a change in rhetoric.

Of course the bank moved away from the "uncomfortably high" language in the wake of the surprise 0.9 per cent print for underlying inflation for the December quarter. That result was clearly attributed to the fall in the Australian dollar through 2013 with "imported inflation" explaining most of the increase. The dropping of the easing bias and the "uncomfortably high" language subsequently coincided with the Australian dollar lifting back to $US0.93.

The Reserve Bank raised its forecast for core inflation in second half of 2014, fearing that the impact of the fall in the Australian dollar would persist for another two quarters. In the event, core inflation for the March quarter printed 0.52 per cent, indicating that the inflation "scare" around the weaker Australian dollar had passed.

Developments in the real economy over the course of 2014, especially around consumer spending; employment; and business confidence preclude a reintroduction of the easing bias, but it seems entirely reasonable that the bank will revert back to using strong language around the level of the Australian dollar – probably a return to the "uncomfortably high" line.

In the statement on monetary policy that will be released on May 9 next week, we will, as usual, be most interested in the inflation and growth forecasts.

The core inflation forecasts in 2014 are likely to be adjusted down substantially. Core inflation for the year to June 2014 was revised up from 2.5 per cent (in December) to 3 per cent in February.

With the first three quarters of the year to June 2014 totalling 2.1 per cent, the bank is likely to revise down the annual forecast to 2.75 per cent. Equally the year to December 2014 should be revised down to 2–3 per cent from 2.25–3.25 per cent. Other forecasts are likely to remain unchanged, although the "untidy" forecast of 2.25 per cent–3.25 per cent to June 2015 should be corrected to 2–3 per cent.

There will also be near term changes to the growth forecasts. Growth to December 2013 has printed 2.8 per cent rather than the bank's forecast of 2.5 per cent (that implies the bank was expecting 0.6 per cent growth in the December quarter compared to a print of 0.8 per cent). With 1.4 per cent already known for the first two quarters of the year to June 2014 and the partials (consumer spending and net exports) pointing to a near 1 per cent for the March quarter, it is reasonable that the bank could raise its forecast for the year to June 2014 from 2.75 per cent to 3 per cent.

That would only be done if it was prepared to raise its December 2014 forecast to 3 per cent. Although the Australian dollar has increased from $US0.89 (in February) to $US0.92 (in May), it would seem inconsistent with their assessment that growth is gradually improving to forecast a "slowdown" through the second half of 2014 (around a 3 per cent annual "pace" in first half and a 2.5 per cent "pace" in the second half).

Based on our assessment of the partials for the March quarter, we expect that the most accurate position to take would be to raise the forecast for June 2014 and December 2014 to 3 per cent given the "strong" December quarter and the positive signal from the partials for the March quarter. However at a time of budget uncertainty; evidence that the government's forecasts for the budget are likely to be more subdued; and the higher Australian dollar, the bank may choose to be more strategic with its forecasts.

Of course the decision to raise the forecasts would preclude the bank from using the "below trend" description of growth in 2014. That would be a significant development .

However it would not signal a change in our view that the bank is "on hold" until the second half of 2015. Lowering inflation forecasts and nudging growth forecasts to "just trend" do not constitute the need for a change in view.

While the outlook for the cash rate over the course of the next 15-18 months is benign, fixed interest rates are likely to be moving well ahead of those developments. The table highlights the fairly tight lead relationship which fixed rates have with the RBA's cash rate.

If we take, say, the 2009 tightening cycle as an example, the table shows that the three year swap rate started to move in February 2009, 8 months before the Reserve Bank actually initiated the tightening cycle. By the time the Reserve Bank tightened in October 2009, the swap rate had increased by 183bps. That lead relationship has been seen fairly consistently, with 1994 (7 months); 1999 (11 months); and 2003 (5 months). The "lead" increases in the swap rate are also comparable: 250 bps (1994);172 bps (1999); 162 bps (2003) and 183 bps (2009).

What does this imply from our expectation that rates will remain on hold until August/September 2015? It indicates that fixed rates are likely to remain fairly stable through the course of the rest of this year.

Currently the 3 year swap rate is in the 3.0 per cent–3.1 per cent range, with the 90 day bank bill rate at 2.65 per cent. That 35–40bp spread is likely to "hold" for most of this year. But based on that 7–10 month lead relationship, fixed rates are likely to be "stirring" from the first quarter of next year.

Given how quickly fixed rates have moved in anticipation of previous tightening cycles, it seems reasonable that, say, the 3 year swap rate could have lifted by 100–150bps before the RBA's first tightening in the September quarter.

From a risk management perspective, it makes good sense to consider "foregoing" the current yield advantage of around 40bps (for, say, 12 months) to avoid having to lock in a fixed rate next year 100bps higher for 3 years.

Our forecast for the first rate hike in the second half of 2014 is near the bottom of the rate forecast scale. Indeed 19 out of the 30 forecasters in a recent Bloomberg survey expect rates to be rising by the first quarter of 2015. In fact 13 expect rates to be rising in 2014. If those forecasters are correct, then fixed rates will begin to move around June. That would leave unhedged borrowers a very narrow window indeed to begin to cover borrowing costs.

Bill Evans is chief economist with Westpac.