We now expect that the low point in this easing cycle will be 2.75 per cent rather than the 3.25 per cent which had previously been our expectation. We expect further cuts in July and August to be followed by a final cut in the fourth quarter.
We do not favour the 50bp cut scenario in June. The decision to cut by 50bps in May was mainly driven by direct concerns around the domestic economy. To us, there appeared to be an element of catch up with the bank holding steady in February–April when the domestic case for a cut was strong. The decision next week will be built around the impact that the deterioration in global confidence will have on the Australian economy. Since the board meeting in May, US 10-year bond rates are down from 1.9 per cent to 1.6 per cent and the Australian equivalent is down from 3.6 per cent to 2.9 per cent. However, there are a number of key risk events over the next few weeks (Greek elections on June 17 for example) which will be critical for global confidence. We expect a more orderly approach to addressing these issues and thus a more ‘considered’ 25bps move. However nobody can be particularly confident in gauging the bank's meeting-by-meeting strategy for dealing with these issues.
This is a change in our previous forecast position. We had been expecting that the board would decide to hold rates steady in June, with two further moves expected in both July and August of 25bps each. We now expect that the low point in this easing cycle will be 2.75 per cent rather than the 3.25 per cent which had previously been our expectation. We expect further cuts in July and August to be followed by a final cut in the December quarter.
These two extra cuts are based on our assessment that the global environment – read Europe – has deteriorated even further since we revised down our call for the low point from 3.75 per cent to 3.25 per cent. In turn, this deterioration is expected to have a more severe impact on confidence in Australia than had earlier been expected.
The stance of policy is currently only mildly expansionary despite the official cash rate being at 3.75 per cent, its lowest level outside the Global Financial Crisis.
We gauge that it is only mildly expansionary because the stance of policy should be assessed in the context of private sector interest rates. With the gap between the Standard Variable Mortgage Rate (SVMR) and the official cash rate now being 140bps wider than in 2007, we assess that the neutral rate has fallen from 5.5 per cent in 2007 to 4.1 per cent. That puts the official cash rate only 0.45 per cent below neutral today – certainly only mildly accommodative.
Another way of assessing this stance is to compare the SVMR with its long-term average. The long-term average SVMR is 7.5 per cent, so the current SVMR, at 7.05 per cent, is also only 0.45 per cent below the average.
A move to 2.75 per cent in the official cash rate is likely to see the rate somewhere between 100bps and 145bps below neutral, depending on the movement in private sector rates in response to the fall in the official cash rate. If there was a full 100bp reduction in private rates then the official cash rate would bottom out 145bps below neutral.
If the reduction in private rates was along the lines of the reduction following the rate cut in May then the official cash rate would bottom out 115bps below neutral. The same logic would mean a SVMR of between 6.05 per cent and 6.5 per cent.
In the three previous easing cycles the official cash rate has bottomed out at 150bps (2008/09); 125bps (2001) and 50bps (1996-97) below neutral.
In those periods the SVMR bottomed out at 5.8 per cent (2009); 6.05 per cent (2001); and 6.7 per cent (1997).
The contrast with 2009 is important. Despite the cash rate falling below its GFC trough, we expect the SVMR will bottom out well above the 2009 level.
In the more recent two periods above, the final rate cut in the cycle coincided with an increase in the unemployment rate of 1–2 ppts over the preceding year: 6 per cent to 7 per cent in 2001 and 4 per cent to 5.9 per cent in 2008-09. In 1996-97 the increase in the unemployment rate was only around 0.5ppts, as this was a mid-cycle slowdown rather than a fully- fledged slowdown.
The contrast with those earlier periods the implied stance of policy should also take into account the level of the Australian dollar. In 1997 the AUD/USD was around 68 cents; in 2001 around 50 cents and in 2009 around 70 cents. Clearly the AUD was providing a much more complementary stimulatory support for the economy than in current circumstances where, despite recent weakness, it is still around 98 cents.
The labour market comparison argues that current market pricing is somewhat excessive. Market pricing implies that rates will eventually fall by 140bps (just above 2.25 per cent) which implies a range 125bps to 175bps range below neutral.
Because market expectations are still significantly more aggressive than even this revised view, we still expect fixed rates to increase should our forecasts prove correct. For example, with markets giving a significant probability to a 50bp cut next week we would expect fixed rates to increase modestly if we are correct and "only" a 25bp move is delivered.
Market pricing is reflecting extreme uncertainty, and it is distorted by hedging activity by offshore investors who are not taking a pure position on Australian monetary policy, and it is therefore highly volatile. The uncertainty emanates from:
– The European outlook, highlighted by the risk of Greece withdrawing from the Euro and excessive instability in the Spanish banking/sovereign nexus.
– The state of the Chinese economy and prospects for counter cyclical policies to be a) enacted and b) to gain traction.
– Prospects for the US economy where the recovery seems to be losing momentum
– The impact on private sector rates in Australia of official rate cuts and the spillover to confidence.
– The state of the labour market in Australia following the surprise fall in the unemployment rate from 5.2 per cent to 4.9 per cent.
– Prospects for the interest rate sensitive parts of the Australian economy – housing and consumer expenditure and the investment and employment decisions of those firms which service those sectors.
Our forecasts are based around a general outlook that while Greece is unlikely to leave the euro the European "scene" will be marked by rolling crises and bailout packages against a back drop of protracted recession in the region. That would avoid the "worst case" scenario that might be partly priced in by the market but would ensure an ongoing drag on confidence, both consumer and business, in this country.
Recent news from Europe has reinforced our concerns for the region, particularly for Greece and Spain. For Greece, the June 17 election looms as a crucial event. The most recent polls point to far-left party Syriza being in the ascendency; if this poll proves correct, then a tense stand-off between the new government and the Troika is almost assured. The eventual outcome is highly uncertain although our base case leaves Greece in the euro.
Spain’s financial ill-health has also rapidly come back to the fore over the past month, primarily due to the need to fully nationalise banking conglomerate Bankia, formed in 2010 through the union of seven stressed regional banks. The €19bn price tag for the nationalisation is troublesome given the Spanish sovereign’s urgent need for austerity and difficulty in accessing cost-effective capital. However, the reported €180bn of bad loans (industry estimates) for the system as a whole, combined with the enfeebled financial position of Spain’s regional governments, make a positive outcome increasingly improbable. The need for a support package for Spain would be a serious test for the financial and political capital of the region. Our concerns about the impact of these issues on confidence in Australia have increased in recent weeks.
Recent information out of China has been in accord with our long held views that the cyclical downturn of the first half of this year will be progressively relieved by policy accommodation. That will see a recovery underway later this year, which will get 2013 started on the front foot. Our forecast for 2012 remains at 7.8 per cent and our 2013 forecast remains 8.7 per cent. A weaker than expected export profile, driven by European problems, would lower near-term growth, but would strengthen the policy response in the second half, which would help the 2013 numbers. We note that the RBA's approach to the Chinese slowdown has been to attribute it to policy choices which can be reversed if needs be. Thus we might expect that the board will have been heartened by the recent move towards growth support in China. That adds up to a position whereby China is a neutral for the policy outlook detailed here.
The US economy is likely to lose further momentum through the Northern spring and into summer. Deteriorating job and domestic demand growth are expected to result in another round of quantitative easing. Further weakness in equity and/or house prices would give further justification for action. As evidenced from the April FOMC meeting minutes, so too would a deterioration in Europe and/or concerns over the potential impact on activity of the 2013 ‘fiscal cliff ’.
Overall, we continue to expect global growth of "only" 2.8 per cent in 2012 compared to official estimates of 3.5 per cent. We expect that recent developments in Europe will prompt a downward revision to official estimates moving towards our own view.
While off shore issues are likely to dominate the board's explanation behind its decision to cut rates next week there is also a domestic case for lower rates. We were surprised by the insipid 0.8 per cent increase in the Westpac Melbourne Institute index of consumer sentiment in May, despite a 35bp cut in mortgage rates – the biggest cut since February 2009. We are wary of the recent fall in the unemployment rate noting the unusual circumstances of a rise in jobs and a fall in the labour force. We note that Treasury is forecasting the unemployment rate to reach 5.5 per cent by mid-2013, with, presumably, a higher rate earlier in the year. We also point to the Westpac Melbourne Institute index of unemployment expectations which has "job insecurity" on a par with 2001. While the headline unemployment rate looks solid the underlying story around the labour market is perplexing.
In the year to April total employment has lifted by 87.3k jobs. However, 71.7k were part-time jobs and 57.3k were female. So the employment growth this year has been concentrated in part-time and/or females jobs. It is also worthwhile noting that to date, WA is still the centre of growth for employment having added 35.7k to its workforce this year.
Now this is a far from a spectacular number (just 21k per month) and the fall in the unemployment rate has been driven by the fall in participation rate. If the participation rate had held constant since September last year, the unemployment rate would have peaked at 5.75 per cent in Feb 2012 and even in April, following a run of better jobs numbers, the unemployment rate would still be 5.5 per cent. Overall we are not inclined to alter our forecast that the unemployment rate will exceed 5.5 per cent by year's end.
Recent data prints are also uninspiring. Retail sales for April (down 0.2 per cent); spending on renovations and additions (down 4.7 per cent in the March quarter) and residential building (down 1.9 per cent) and dwelling approvals (weak even abstracting for the WA element) have all been weak despite the rate cuts in November and December. While investment plans in mining from the Capex survey for 2012-13 remain strong we estimate that both manufacturing and services investment are expected to decline in 2012-13.
On house prices, the RP Data series (apparently favoured by the RBA, and also our favourite measure) estimates that house prices have continued to fall in 2012, despite the rate cuts, being down by 0.8 per cent in to April, with high frequency prints showing that prices fell further in May.
We expect there will also be adequate scope from inflation to further lower rates. With growth pressures mainly in the mining sector where the "escape" valve of imports can be used to contain inflation pressures and with those industries being affected by the high AUD and the deleveraging of the household sector needing to raise productivity, the inflation outlook is particularly encouraging. We expect another respectable productivity and unit labour costs outcome in the March quarter national accounts, due the day after the RBA meets in June. In its May statement on monetary policy the RBA forecast that inflation will remain near the bottom of the 2–3 per cent band over the next year.
We have always expected rates to bottom out in the second half of 2012 with most of 2013 seeing rates on hold.
That was not the case in 2009 when rates got to a more stimulatory level than we expect this time and fiscal policy both domestically and offshore was providing a huge complementary boost. In particular, the government's boost to housing with the First Home Owners Grant was very important.
However, as we progress through 2013, the interest rate debate will shift from anticipating additional rate cuts to the timing of the next RBA tightening cycle. On this, we make two key points.
The rate outlook for 2013 will differ from that during late 2009. On the earlier occasion, the view was that rates needed to be normalised, that borrowing rates needed to be returned to around average levels, in an orderly fashion. We assess that the stance of policy needs to remain on the expansionary side throughout next year. Notably, the global economy will remain fragile and vulnerable to shocks, even if the headline growth numbers return to around trend, as we anticipate. Domestically, the consumer is in a deleveraging phase, which means the housing sector needs more supportive settings. Moreover, the Australian economy is in a transition phase, with the relatively high dollar driving significant structural change. The tightening of monetary conditions associated with the high dollar needs to be taken into consideration.
Equally, it would be inappropriate for the Australian economy, which is on the right side of the shift in global growth to the Asian region, to leave interest rates around historic lows for a prolonged period. As the significant confidence drag from Europe begins to fade, but not disappear (markets become more comfortable with the likely adjustment process in Europe), rates will need to move off their lows. We envisage that the RBA will need to begin raising the cash rate during the second half of 2013. This would have the cash rate at 3.00 per cent on our forecasts by year's end.
Outlook for the Australian dollar
The AUD has recently reached our base September quarter forecast of 98 cents. At present there are a number of downward pressures operating on the currency – rate differentials, commodity prices, the shift back into trade deficit, weak risk appetite globally, diminished FX reserve accumulation in emerging markets – that will not dissipate in the short term. Therefore we feel that there is more to come in this depreciation phase. We now see a 96 cents rate by end September, with the strong likelihood that it goes lower than that rate in the meantime. In the short-term, we expect the USD index to show considerable strength, the yen's safe haven status to shine through as Japanese investors exhibit strong home bias in a low yield world, while the euro will understandably find few adherents. Asian currencies will also remain under pressure for the moment.
We do however retain the view that AUD/USD will be back above parity by year's end, in line with a pullback in the USD index. That call is largely predicated on an expected series of stimulus policies in Europe; China; and the US that will gain traction, particularly through the December quarter,. The combined effects of the more accommodative global policy environment will reverse the negative dynamics current swirling around the AUD (and other growth assets, like Asian currencies and commodity prices). We see the currency reaching $1.02 by the end of the year and moving even higher in early 2013, before levelling out at mid-year in the $1.05–$1.06 area.
Bill Evans is Westpac’s chief economist.