WEEKEND ECONOMIST: Finely tuned rates

Despite an avalanche of data and RBA communication, markets have been relatively stable over the last week. They are flirting with only one rate cut in the final quarter and continue to price in 100-125 bps' of rate hikes in 2010. In response to our reading of the Governor's latest statement we pushed back our timing of the next rate cut to September from August but expect that cumulative cuts (probably including at least one 50bps) will total around 100bps before rates reach their low. This 'fine tuning' of the rate cycle will be important although our much more significant observation is that rates will be on hold in 2010 in direct contrast to market pricing.

The details of the Governor's statement on June 2 gave us some encouragement that our expectation of further rate cuts may have some legs despite market pricing: "The prospect of inflation declining over the medium term suggests that scope remains for some further easing of monetary policy" is a much more direct remark than we saw in the May statement: "In assessing whether further reductions in the cash rate are required over the period ahead". It is possible that this wording could be in place to dissuade markets from pricing in even more rate hikes next year or even late this year. Recall that when the RBNZ indicated that rates may have bottomed, curves steepened further and the bank had to then issue a statement indicating that rates were unlikely to rise until late 2010 at the earliest. The RBA would not like to be pushed into that corner and we expect would never give such explicit guidance. Better to maintain an easing bias even if it is not expected to be acted upon.

We also saw a repeat of the critical remark: "Continued progress in restoring balance sheets is essential for a durable recovery”. Emphasis on the risks from balance sheet deterioration should not be ignored. The current surge in financial markets appears to have masked the potential problems with balance sheets that are likely to be emerging in response to the collapse in global activity and associated spillover to employment and profits in the last two quarters.

Recall that the IMF increased their estimates of write-downs associated with exposures to US borrowers from $1.5 trillion in October 2008 to $2.7 trillion in April 2009. In addition the IMF provided a first estimate of potential losses of those entities lending to European counter-parties of $1.2 trillion. In discussions I have had over the last two weeks in Europe with those folks close to bank balance sheets in both Europe and the US there is ongoing concern that further balance sheet problems are likely to emerge once the growth boosts from the fiscal stimulus and the one off recovery of production levels (as inventory overhangs are cleared) have passed.

With momentum in the 'euphoria' trade likely to have more time to run, particularly as those original doubters now feel the need not to miss out, the type of balance sheet evidence that would disturb the RBA is probably some months away.

Australia's national accounts for the March quarter emphasise how difficult it has become for the authorities to assess Australia's current economic performance. There are three large distortive forces – the collapse in AUD and commodity prices in the second half of 2008 which has made it difficult for the statistician to calculate trade volumes from nominal data (note the 3.9ppt's contribution to GDP growth from net exports over the last two quarters). Imports are estimated to have collapsed by nearly 15 per cent while final demand slowed by only around 1 per cent – very suspicious indeed! Another distortive force is the impact on consumer spending of the huge one off payments from the government in the December quarter ($8.7 billion); March ($5 billion) and the funds expected in the June quarter ($4.5 billion). Finally, the effect the first home owners grant may be having on the current signals of a strong housing recovery need to be taken into account.

What we did see was a 1.1 per cent contraction in employees' compensation (the sharpest fall since Q2 1983); a 6.3 per cent fall in business investment; a 5.6 per cent fall in dwelling investment; and a 1.3 per cent contraction in private final demand. Clearly these private spending signals are disturbing and consistent with a fairly dismal outlook for growth through 2009.
Net exports are now likely to subtract from growth through the rest of 2009 (rising AUD; statistical revision of import collapse; export contraction as impact of resources capacity and rural surge fades); we also expect ongoing weakness in business investment and labour incomes. Further, the strength of the housing recovery will be tested by credit availability for multi–unit developments and the phasing out of the first home owners grant. We expect negative growth for the next three quarters of GDP averaging around 0.5 per cent while growth in 2010 will be restricted to 1 per cent – hardly an environment for the RBA to be tightening in 2010 or seeing any substantial risk of over easing in the second half of 2009.

Our figuring behind our expectation of further rate cuts hinges on the signals from contracting demand and our leading indicators correctly pointing to a sharp rise in the unemployment rate. That domestic scenario will be in the context of ongoing global weakness. That profile still appears to be on track although the convincing evidence is likely to be delayed for some months. In the mean time the RBA will remain on hold; and maintain an easing bias, if only to dissuade markets from pricing in more rate hikes in 2010, but will eventually respond to rising unemployment and disappointing global growth.

We are a little concerned that the bank may be putting too much emphasis on China. Speeches and statements depict an increasing optimism about China. We are concerned about the durability of China's surge without clear evidence that the fiscal infrastructure/bank lending package is spreading to the private sector. Lack of reliable data for the private sector is also a concern.

If we are wrong and the RBA is in fact on hold we still would argue strongly that the growth signals for 2010 will keep rates on hold in 2010.

Bill Evans is chief economist at Westpac Banking Corporation.