Weekend Economist: Rates wait

Unlike other November meetings, this Melbourne Cup day there is no chance the Reserve Bank will move interest rates.

The Reserve Bank board meets next week on November 4.

November has been a remarkably popular month for the RBA to move rates. In the first six years of the governor’s tenure every November proved to be a moving month (2006-2011). In 2012 the bank was certainly 'in play' with moves occurring in both October and December while, arguably, the bank was also 'in play' in November last year.

Next week will be the first November of the governor’s long tenure that there is no chance of a November move.

In fact it seems highly unlikely that there will be any major surprises. In his statement the governor is likely to maintain the two key assertions which have been used all year: an overvalued currency; and the expectation that rates will remain unchanged for some period.

Specifically, we expect the statement to repeat key phrases: “the exchange rate… remains high by historical standards”; and “the most prudent course is likely to be a period of stability in interest rates".

We were surprised that the October statement did not include something along the lines of the 'warning' contained in the minutes to the September Board meeting, that “policy also needed to be cognisant of the risks to future growth that could accompany a large further build-up in asset prices, particularly if that was associated with an increase in leverage".

Even the minutes to the October Board meeting were not as strident around the RBA’s concerns about asset prices and leverage. With house price inflation slowing from its 2013 H2 pace, it appears the RBA might be easing up on its concerns around the property market. There is still likely to be some RBA/APRA package of initiatives announced before year’s end but, given the authorities do not appear to be inclined towards 'heavy handed' actions and the flexibility of Australia’s financial system, particularly around an active non-bank sector, it seems unlikely that these moves will have a marked effect on the availability of credit overall.

The second important RBA missive next week will be the Statement on Monetary Policy (SOMP). Of considerable interest will be its revised GDP growth and inflation forecasts. As discussed in last week’s note we do not expect any significant changes in either of these. Supporting an upgrade to the growth forecasts will be a new set of Australian dollar forecasts (given the around 5 per cent fall in the currency since the last SOMP in August). However confidence measures and the terms of trade have also fallen since August and the global outlook appears more uncertain. That is likely to see the RBA's growth forecasts stay around the same levels (GDP growth of 2.5 per cent annualised, in 2014 H2; and 3 per cent in 2015).

A weak global growth environment is certainly weighing on markets.

We are decidedly nervous about the fact that markets are predicting Australian dollar rates to remain unchanged over the course of both 2015 and 2016. In contrast Westpac is expecting 50 basis points of hikes in the latter half of 2015 and a further 100bps in 2016.

Back in March we were quite out of step with the economics community. We did not expect the RBA to begin hiking until August 2015 whereas 60 per cent of forecasters expected rate hikes by the March quarter and 15 per cent expected rate cuts.

All those rate hawks have been forced to revise their views. The latest survey indicates that 85 per cent of economics forecasters are still predicting higher rates by end 2015 (with 50 per cent expecting hikes to begin in the June quarter – but expect that proportion to dwindle by 
year’s end). Only 15 per cent (four forecasters) are pushing the market’s line.

Unusually we find ourselves buried in the economists’ consensus. Why are we comfortable with a view that is so at odds with the market?

We expect that the economists’ consensus is giving most weight to house prices and leverage. We are focussing on world growth and Australia’s own growth dynamics.

We think the market is being too pessimistic about the world economy and Australia’s likely growth profile in 2015 and 2016.

On the world economy we are expecting growth to lift from 2.9 per cent in 2014 to 3.7 per cent in 2015 and 4.5 per cent in 2016. 

That 2016 outlook will hold the key. In particular, it requires US growth to lift from 2.5 per cent in 2015 (long run potential) to 3.25 per cent in 
2016 (well above long run potential). With the strongest bilateral links between the major economic blocs being from US to China we expect a strong US economy to boost China’s exports pushing a 1-percentage-point contribution to China’s growth from net exports. That will lift 
China’s economic performance in 2016 to 8 per cent growth.

We are not expecting the Fed to start raising rates until September next year with two hikes in 2015. That is in line with market pricing (unlike FOMC 'dot' indicators of 150 basis points in 2015) but we expect the Fed to be more active in 2016, moving rates up by a further 150 basis points compared to current market expectations of 'only' 100 basis points. That is primarily based around a more upbeat view on the US economy in 2016 than we suspect is the view of the market.

With the Fed pushing rates up by a total of 200 basis points by end 2016 we struggle to see the market’s rationale that rates will remain on 
hold in Australia (note that the long term average margin between Australian and US rates is 150 basis points).

The market must also be more pessimistic around the outlook for Australia’s growth.

There are certain 'knowns' for the Australian economy: 

  1. the mining sector will continue to add around 1 percentage point to GDP growth (after adjusting the investment downturn for the lift in net exports).
  2. Australian businesses are cautious and are unlikely to lift employment, wages and investment until they see a sustained lift in demand.
  3. The balance sheet of Australia’s household sector has strengthened significantly and there are signs that the household sector is gradually lowering its savings rate.

The 10 years before the GFC, when house prices were appreciating solidly, Australians ran a negative 'gross' ex super savings rate. Since the GFC this savings rate has been positive. Reflecting this lift in savings household balance sheets have been bolstered by sizeable increases in liquid assets – term deposits; loan offset accounts; and online savings accounts. In addition, Australian households have benefitted from sizeable increases in overall wealth with the lift in property and equity prices complementing the boost in superannuation.

We are expecting to see further evidence of a gradual moderation in the savings rate (partly reflecting rising house prices) that will lift spending growth and signal to business that sustained improvements in demand are underway.

In turn that will encourage businesses to further lift employment; investment and wages growth.

That self- sustaining momentum can be “short circuited” by shocks. The most obvious “candidates” are an external shock or a policy shock (potentially associated with a financial crisis in either Europe or China). The sharp drags on confidence following the European financial crisis in 2011 or this year’s Commonwealth Budget are clear testimony to these risks.

Clearly, markets are much more sceptical about the prospects for a sustained lift in demand than Westpac – developments over the next 6 months will tell the tale.

The Melbourne Cup

Some loyal readers will be aware that we have picked the winner of the Melbourne Cup (Australia’s $6m race) in two of the last three years.

That is a decent record for such a competitive sporting event.

This year we are reasonably confident that we can find yet another winner in Admire Rakti.

This Japanese horse ran by far the best trial for the race with its storming win in the most reliable lead up race for the Cup – the Caulfield Cup.

Arguably, Japan produces the best stayers in the world – even ahead of their Irish counterparts.

Who can forget the last time Japanese horses ran in the Cup? That was in 2006 when the Japanese horse Delta Blues beat his Japanese compatriot Pop Rock by the narrowest margin (just half head) with a massive four and a half lengths to the next horse.

However, Admire Rakti has other history going against him. He is likely to be around 5:1 odds on the day. That will make him favourite. No favourite has won the race since Makybe Diva in 2005 and no horse has won the Caulfield Cup/Melbourne Cup double since Ethereal in 2001.

He will also have to carry 58.5 kilos (top weight) – average weight of the winner in the last decade has been 54 kilos. No horse has won with such a weight since the 1970s.

There are also unofficial reports that the horse is not considered to be in the top 20 horses in Japan.

Other contenders are: Protectionist (the German champion) and Lucia Valentina (beaten favourite behind Admire Rakti in the Caulfield Cup).

The English 'raiders' headed by Red Cadeaux look to be an ordinary lot this year.

In fact the clear danger from my perspective is Fawkner, surprisingly an Australian horse, who ran a mighty 2nd in our other key lead up race – the W S Cox Plate (Fiorente, last year’s winner, ran third last year).

As always, the usual disclaimers apply – "this does not constitute investment advice ... etc etc". 

But good luck and at least be consoled by the fact that your study will not be disturbed by any surprises out of the Reserve Bank which announces its decision 30 minutes before the big event!

Bill Evans is a chief economist at Westpac.

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