Weekend Economist: Down, then Up!

Weakness domestically early in 2015, strength internationally in 2016; when it comes to rates, the market is underestimating these two themes.

In early December we revised our interest rate outlook. We still expect rates to be on the rise in 2016 as the world economy gathers considerable momentum but we now expect the RBA to cut rates further in the early months of 2015 in an effort to bolster domestic demand and lower the Australian dollar before evidence around the world economy becomes clearer around the middle of the year.

We expect a 25 basis points rate cut at the February board meeting and another one to follow in March.

We think that the weakness in the September quarter national accounts – including falling inflation; contracting national incomes; and a loss in growth momentum – coupled with further sharp falls in commodity prices and continued weakness in consumer sentiment (down to 3 year lows) will be enough to prompt the RBA to use some of their remaining policy ‘scope’ and lower rates further.

Our Coast to Coast report, which was released on December 17 and contains a detailed analysis of the performance and outlook for all of the states, emphasises the weakness in the Australian economy, specifically outside New South Wales. New South Wales was the only state to record an increase in final demand in the September quarter, up a sharp 1.3 per cent. Tasmania and South Australia experienced flat demand while sizeable falls were recorded for Victoria, Western Australia and Queensland.

We have lowered our GDP forecast for 2015 from 3.2 per cent to 2.7 per cent (below trend). Within that year we see growth momentum in the first half at around 2.5 per cent lifting to around 3 per cent in the second half of 2015. However, we have been surprised to see that the hurdle for RBA Governor Glenn Stevens to cut rates is higher than we expected due to his belief that the 2014 policy of steady rates has assisted confidence. On face value that seems to be a difficult argument to support given that consumer sentiment is down by around 15 per cent over the year and business confidence has also fallen.

The RBA has made a clear shift in rhetoric in recent months, returning to the more strident language on the currency used late last year and softening concerns around housing. The pronounced and sustained weakness in the terms of trade over the second half of this year obviously lowers the fair value of the Australian dollar; the RBA’s recent commentaries clearly imply that in their minds the currency is far from reflecting this in full, despite recent losses. In addition, ongoing QE in Japan and Europe is indicative of both global disinflation pressures and a valuation ‘premium’ for exchange rates with conventional policies.

The RBA governor has recently opined that an Australian dollar of around $US0.75 is desirable. However, he is unlikely to achieve that objective unless he indicates to the market that he is prepared to cut rates. That change in mood has been hinted at in his recent interview with the media where he nominated lower inflation as a confidence boosting justification for cutting rates. We expect to see that “door” open with the release of the December quarter inflation report in late January.

It was also alluded to in the minutes of the December RBA board meeting where it was noted that the board was reported to have discussed the case for cutting rates – not an easing bias but nevertheless evidence of a subtle change in mindset. We were also interested to see a new observation in the minutes – recognition that ongoing concerns around job security and employment prospects were weighing on consumer spending. The various state detail in our Coast to Coast report demonstrate a clear relationship between spending and the labour market.

On housing, the RBA has noted a marked moderation in price appreciation in recent months. The bank also has some scope to use macro prudential tools to contain any further sharp upswing in investor housing activity, if it were to occur. We remain positive for the housing market if the RBA cuts rates further, although we do not expect to see any marked excesses in the market while overall confidence remains challenged.

Of course the next board meeting is not until February 3 and much could change over that period. In particular, commodity prices – which have shown sharp swings in the past – could post a strong recovery from recent sharp falls. However, while we expect commodity prices to be lifting over the course of 2015, the picture on prices is likely to still be unclear in the March quarter. In fact we expect commodity prices to fall further in the March quarter prior to lifting through the second half of 2015. In this regard our (controversial) view on China is important as a supplement to our (uncontroversial) upbeat view on the US.

For example, in the government’s Mid-Year Economic and Fiscal Outlook (released on December 15) the treasury downgraded its forecasts for Chinese growth and now expect it to decelerate to 6.75 per cent in 2015 and 6.5 per cent in 2016, from 7.25 per cent this year. That compares with its Budget forecasts of 7.25 per cent and 7.0 per cent respectively.

We have a different view – growth will be around 7.5 per cent in both years. Our interpretation of the government’s forecast is that they are placing greater emphasis on the structural challenges facing China’s growth model, whereas we are overlaying cyclical views on policy (easing) and external demand (improving). Indeed we think that the same internal inconsistency that is presently dominating the global consensus is reflected in the Treasury’s thinking. An acceleration in US growth (and advanced country growth in general, particularly underpinned by low oil prices) will not be enough to boost Chinese growth, despite the latter being the world’s biggest exporter of manufactured goods. 17 per cent of China's gross value added comes from its export sector.

Our critique of this consensus is not that we dispute the structural challenges confronting China. It is that China’s structural impediments will lower the multiplier effects from easier policy and rising global growth, but they do not reduce them to zero. Relating that to commodity prices, here too structural issues are weighing on prices, but that does not mean that they are a) completely resistant to an improving demand environment, or b) that unprofitable producers can stay in business for ever. Those forces are likely to see a substantial rebalancing of the demand/supply forces, particularly in iron ore as we traverse the second half of 2015 and 2016.

Fixed Rates

Markets are already pricing in more than a full cut of 25 basis points by mid 2015. Certainly any move to bring the cut forward by the RBA will lead to markets pricing in another cut.

However, swap rates are unlikely to fall too much further (the 3 year swap rate is currently around 2.5 per cent) since markets will be focussing on the expected first hike by the US Federal Reserve, which we anticipate is timed for September. (Federal Open Market Committee events on December 17 have brought forward the risks around this timing.) Anticipation of that event is almost certain to trigger a rise in fixed rates in the US. That is likely to contain any further falls in fixed rates when the RBA moves.

We are also at odds with the market around rates in 2016. We anticipate rate hikes from the June quarter of 2016 as the Australian economy derives a considerable boost from a strengthening world economy and the Fed’s tightening cycle is in full flow.

The Australian Dollar

The low point in the Australian dollar is likely to be around the September quarter, in the aftermath of the RBA’s rate cuts and amid both a strengthening US dollar (as markets focus on the first Fed tightening) and ongoing weakness in the Euro and the Yen (as the European Central Bank and Bank of Japan embrace aggressive quantitative easing).

As indicated above, the RBA views the currency as overvalued and would like to see it fall further. At a minimum, it would like to hold on to the losses already recorded. Westpac puts current AUD/USD fair value in the 79-81¢ range – an estimate that incorporates both the cuts introduced into our forecasts and a lower trajectory for commodity prices out to mid 2015.

In that scenario we see the low point of the Australian dollar as around $US0.80 by June 2015 with near term downside risks. A strengthening world economy; rising commodity prices; the RBA on hold with the next move up; and Australian interest rates still comfortably above US rates are likely to see Australian dollar strengthen through the second half of 2015 and into 2016.

As we have seen in previous episodes of Fed hikes the highly preemptive foreign exchange markets are likely to have moved largely before the first ‘well-signalled’ move.

In those circumstances we expect the Australian dollar will finish 2015 at around $US0.85 and continue to benefit from strong world growth; rising commodity prices; and rising Australian dollar rates from the June quarter.

Bill Evans is chief economist with Westpac.

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