WEEKEND ECONOMIST: Iron board
The correlation between interest rates and the iron ore price suggests there is little scope for near-term easing but domestic considerations, particularly investment intentions, should pave the way for a March cut.
We certainly do not believe that the rate cut cycle has ended and, to date, expect there will be a rate cut of 25 basis points at the following meeting on March 5.
Between next week and the March meeting, the board will have the opportunity to: assess another jobs report; receive further evidence from the quarterly Wage Price Index; and a further report on the outlook for business investment.
In particular, the next Capex Survey will include the first estimate for investment intentions for fiscal year 2013-14. Recall that a key objective of monetary policy has been to support a rebalancing of spending towards non mining investment as mining investment begins to fall. The Capex Survey will cast considerable light on prospects for an improved non mining investment outlook, while also giving an insight into the timing and level of the peak in mining investment.
Last week we provided a range of evidence that the rate cuts to date have not had the comparable impact on activity and confidence which we have seen in the 2 previous easing cycles. Both business and consumer confidence have failed to respond. The negative response from business confidence (despite the strong bounce back in December – up 12 points having fallen by eight points in November) is likely indicating soft investment intentions. That is likely to be confirmed in the capex results.
The other key reason for a rates pause is the sharp improvement in global conditions since the December meeting. Financial prices are booming, and global confidence in financial and important commodity markets has been boosted. This is exemplified by: the 75 per cent rebound in iron ore prices since September; the fall in credit default swap spreads for most euro area countries to their lowest level since January 2010; and the 15 per cent increase in global equity prices over the last year.
The chart shows how, on occasions, RBA decisions appear to have been linked to the iron ore price in this recent cycle.
The first rate cut in November 2011 was preceded by a 30 per cent tumble in iron ore prices over the previous few months. The follow up cut in December 2011 was preceded by a 15 per cent rise in the price, although a sharp deterioration in European financial markets over November-December contributed to the decision to cut again in December. Despite markets' expectations of a follow up move in February, the bank remained on hold. Global conditions improved with Europe's LTRO, and the bank was expressing reasonable comfort around the domestic economy (growth at trend; inflation mid band; and full employment). The decision to cut by 50 basis points in May and a further 25 basis points in June was largely driven by domestic concerns as growth faltered; the labour market weakened and inflation slowed. The global backdrop was largely neutral, with iron ore prices having stabilised.
The collapse in iron ore prices in August-September was the key catalyst to the October rate cut. The iron ore price had fallen 36 per cent since the July meeting. Signals in the Governor's Statement following the September meeting indicated deep concern around the Chinese economy's sudden slowdown, and the associated collapse in the iron ore price. Despite a partial recovery by the October meeting, the price was still down 24 per cent since July, and the rate cut was duly delivered. By November, prices had rallied around 40 per cent since the September low; the Board paused, but cut again in December – prices were now down by "only" 13 per cent since July, but concerns around the end of the mining boom and underwhelming evidence on the impact of the rate cut cycle on spending prompted another move.
Since December, the iron ore price has increased by 26 per cent to now be back at to the level that prevailed in the first half of 2012, when the bank remained on hold for four months.
Any decision to cut in February would have to be driven by domestic considerations. We believe there is a case on domestic grounds for lower rates but, as discussed, we expect the bank will wait another month before acting.
The perplexing issue will then be around subsequent moves. Our current forecast is that March will be the date of the final rate cut in the cycle. That low point of 2.75 per cent has been our view since May last year.
Our forecasts for the iron ore price (set out in the chart) indicate that a deterioration in global conditions is not expected to build until the second half of 2013. We are forecasting a solid fall in the iron ore price during that period. Any moves to cut further before then will be predicated on a deterioration in the domestic economy. Just as we saw in the first half of 2012, the Reserve Bank might prove tough to shift for domestic reasons after it moves on these grounds in March.
Our current forecast is that the steady rate approach will hold throughout 2013 after the March move. Markets are expecting a total of two more cuts, with the low point in rates around mid 2013. Our view is that the risks to our current view are not around the markets' scenario of a steady series of moves through 2013.
Rather, the rate risks, which are clearly to the downside, increase the further we go into 2013 as global conditions deteriorate, with the low point well into 2014.
Bill Evans is Westpac's chief economist.