WEEKEND ECONOMIST: Hike then pause

Having abandoned the concept of 'gradualism', the RBA is likely to lift rates again in May before a prolonged pause that will allow the economy time to adjust.

We had not anticipated that move, choosing to take the Bank on its assertion that rates would be increased "gradually”. With the generally understood interpretation of 'gradualism' – avoiding moves at consecutive meetings – being ditched in April, and the Bank’s focus being on commodity prices and house prices, there has to be a decent chance of another move in May, and if not in May then certainly in June. Markets currently price the probability of a rate hike in May at 32 per cent and a move by June at 75 per cent.

We cannot claim much value add in picking the mindset of the Board at any particular meeting. Interestingly, the media commentators also seem to read short term nuances differently.

AFR: "But from the minute Governor Glenn Stevens stepped into the glare of a morning television studio last week to warn the audience against believing residential property would always be a sure bet, there was not much doubt the RBA would raise the official cash rate at its April meeting.”

News Limited: "What Stevens was doing last week in talking to Kochie about punting on property was giving fatherly advice, not monetary policy tips.”

What we can do is to apply our views on the fundamentals and predict that the interest-rate sensitive parts of the economy (consumer spending and confidence; residential investment; credit growth) will start to show a considerable reaction to the recent rate hikes. Note that retail sales, building approvals, and housing finance are already on a slowing trend while we expect Consumer Sentiment to start reacting to the rate hikes, probably starting next week.

The Bank is really committed to delivering a further rate hike but, after the next 25 basis point move we expect to see the RBA pausing for the remainder of 2010 as they buy time to assess the complicated interaction of the resources boom and a heavily-indebted household sector coming to terms with a rapid increase in interest rates.

We are not swayed by arguments that the Bank will want to "create room" for the mining boom by overtightening the interest rate sensitive sectors of the economy.

Markets are not in agreement with our view, expecting the overnight cash rate to reach 5–5.25 per cent by year's end.

In this note we focus on these and other issues relevant for our views on the Australian dollar.

Our forecast profile for the AUD had envisaged a negative reaction from the AUD to a re-emergence of global risk aversion by midyear. The settling of 'nerves' in Europe, optimism regarding the US jobs market and the recent surge in global commodity prices have combined to allay those concerns. As such it seems unhelpful to persist with this expectation of a return to global risk aversion over the coming months.

Our previous forecast envisaged a rapid recovery in the AUD through the second half of 2010 (from 85¢ to 95¢) as markets became more comfortable with risk and in particular, doubts about China successfully negotiating a 'soft landing' were settled. We are comfortable in retaining our end 2010 forecast that AUD will reach 95¢ and potentially beyond, but we now expect the path to be considerably smoother.

Our fair value model for the AUD has increased its central tendency valuation by around 3¢ to 93¢. That is in response to the general rise in commodity prices since December, in particular the 26 per cent increase in spot steaming coal prices and the 50 per cent increase in spot iron ore prices, and the more rapid than expected widening in Australia’s interest rate margin over US rates (previously we did not expect the RBA to reach 4.5 per cent until July/August). Over the last two months these fundamentals, along with a move back into risk assets, has seen the AUD/USD increase from 86.5¢ to just short of 93¢.

We do not expect to see a comparable rate of improvement in fundamentals or pace of increase in the appetite for risk assets over the rest of the year.

We continue to doubt the capacity of the US economy to maintain growth momentum in the second half of 2010 as the fiscal stimulus and inventory cycle reverse. The dimension of optimism partly encapsulated in the brief flirtation with a 4 per cent 10-year Treasury bond yield seems overdone.

We expect the US Federal Reserve to remain on hold through the course of 2010 and well into 2011 – first hike not before June 2011. Our RBA view is that it too will remain on hold after moving in May. That points to no further widening of the cash rate spread through the second half of 2010 – a key fundamental driver of the AUD.

We would also expect that the recent contract settlements for bulk commodities (highlighted by a 100 per cent increase in negotiated prices for iron ore, albeit on a quarterly interim basis) will not be exceeded at any subsequent negotiations over the course of 2010. In our view, the 'recovery' in the G3 will be very modest and maintaining the recent gains in the bulk contract prices will be a significant result despite current spot rates being significantly higher than the new contract prices.

We also expect the Chinese economy to slow back towards a trend pace in the second half as the maximum impetus to activity from 2009’s stimulus policies recedes. We do not expect to see the re-stocking in the G3 which would be required to provide a further boost to the commodity complex.

Our central view however, now precludes any major shift in sentiment regards risk and hence a repeat of the sharp 5¢ sell off in the AUD in January/February. However, we cannot rule such an event out completely. The US household sector is still deleveraging and the 'recovery' in the housing market is fading. Balance sheet concerns and resulting credit availability remain in the US and European financial systems. Sovereign risk remains a live issue. A shock from either of these quarters is still very possible. We maintain a watching brief for unexpectedly adverse developments in Europe, the US or China.

Bill Evans is chief economist at Westpac.

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