Weekend Economist: The Fed factor

The RBA's 'period of stability' line is unlikely to go until the Federal Reserve's intentions are clear. But when the Fed hikes, it could hike hard.

The Reserve Bank board meets on October 7.

There will be no policy change but the statement that will be issued by the governor will be of interest.

Consider the developments since the last board meeting on September 2.

  1. The Australian dollar has fallen by around 7 per cent in US dollar terms and 4 per cent against the trade weighted index.

  2. The Australian share market has fallen by 6.5 per cent.

  3. The board minutes, which were released on September 16, stated: "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”. That compared with the governor’s statement after the September meeting of only: “the increase in dwelling prices continues”.

The governor’s statement following the September meeting confirmed that: "The exchange rate, on the other hand, remains above most estimates of its fundamental value, particularly given the declines in key commodity prices ... On present indications, the most prudent course is likely to be a period of stability in interest rates".

The October statement is likely to be less strident about the currency but still indicate that the bank expects it is still too high. The “period of stability” for interest rates is likely to be maintained in the statement.

However we must bear in mind that on July 3 the governor remarked, "Long before any thought were to be given to an increase in rates, it would probably be sensible for the board to cease references to a future ‘period of stability’ and revert to the more normal formulation that the stable policy settings ‘remained appropriate’ or something like that".

We must be alert to that possibility but I do not expect the “period of stability” sentiment to be dropped until the RBA has a clearer understanding of the intentions of the US Federal Reserve.

(The current issues around investor housing should not be seen as a catalyst to removing that phrase given ongoing weakness in the rest of the economy.)

In that regard, the most recent meeting of the Federal Open Market Committee, September 17-18, showed that the average view amongst FOMC members was for the Federal Funds rate to reach 1.5 per cent by end 2015 and 3.0 per cent by end 2016.

We believe that profile will prove to be overly aggressive and prefer to use the indications of what we like to refer to as the “two reasonable doves” (2RD’s) in the FOMC. We believe that there is a reasonable chance that these 2RD’s are the FOMC Chair Yellen and FOMC Vice Chair Dudley, two very influential members of the FOMC.

Critically important, the 2RD’s see the rate cycle around 1 year behind the FOMC average, as indicated in Figure: 1. The 2RD’s see the level by end 2016 (1.5 per cent) as the level seen by the FOMC average by end 2015, while the end 2015 level is 0.4 per cent (only one 25 basis point hike).

Current market pricing for the US yield curve is somewhere between the FOMC and the 2RD’s with the target rate for end 2015 at 0.75 per cent and end 2016 at 1.75 per cent.

We are much closer to the 2015 assessment of the 2RD’s, expecting only two 25bp hikes in 2015 (in September and November). Although, we anticipate that the US economy will be growing considerably faster than the 2RD’s expect in 2016 (2.5 per cent vs 3.25 per cent). Our target rate for end 2016 for the Federal funds rate is 2.25 per cent, significantly lower than the FOMC average (3.0 per cent) but 50 basis points higher than the 2RD’s.

But what about the Australian yield curve? Figure: 2 compares the current market expectations for cumulative rate moves in the RBA cash rate relative to our own expectations.

The market is expecting only a 30 per cent probability of 1 rate hike by end 2015 and only one full 25 bp move through the whole of 2016. (Presumably the market is expecting a much weaker world environment and stronger domestic headwinds than our central view.)

This still seems to be an extraordinary anomaly given the outlook for US rates, even taking into account the modest moves expected by the 2RD’s.

Recall that in the 15 years prior to the GFC the RBA cash rate averaged 150 basis points higher than the Federal Funds rate.

With Australia’s cash rate expected by the market to reach 2.75 per cent by end 2016 our expectation of a 2.25 per cent Federal Funds rate by end 2016 would have that margin contract to just 50 basis points. Even assuming the 2RD’s end rate in 2016 of 1.75 per cent would see the margin hold at 50 basis points below the average.

Our own forecast for the RBA cash rate by end 2016, of 4 per cent, would see that margin at 175 basis points, slightly above the historical average.

Another factor which is likely to put some upward bias on the RBA cash rate is the possible action of banks in the next tightening cycle. Recall that pre-GFC the spread between the variable mortgage rate and the overnight cash rate was 130 basis points.

That spread has now increased to 260 basis points. As the banks sought to raise their share of funding in the retail sector a “deposit war” ensued. Higher deposit rates reflected rising mortgage rates. Banks have now stabilised their retail deposit shares and are now refocusing on growing assets. Arguably this “asset competition” might see banks absorbing some of the RBA rate moves in the next tightening cycle requiring more RBA moves for any given targeted increase in the mortgage rate.

Westpac’s outlook for the overnight cash rate in the next tightening cycle is significantly out of line with market expectations.

A key driver of the next tightening cycle will be an improving outlook for the world economy particularly supported by a strong uplift in growth momentum in the US in 2016. While we expect that the timing of the first move by the FED next year will be later than favoured by the FOMC (average forecast) and market pricing we expect that the pace of hikes in 2016 will be faster than market expectations; the expectations of the 2RD’s; and the average FOMC forecast.

A faster pace of FED hikes and a strengthening world economy will put some pressure on the RBA particularly during 2016. Markets expect the RBA cash rate to be around 2.75 per cent by end 2016 compared to our own expectations of 4 per cent. That “4 per cent” will be 175 basis points higher than our target FOMC rate by end 2016 – the average margin between the RBA cash rate and the FOMC over the 15 year pre-GFC period is 150 basis points.

If we are right about the FOMC (still much more conservative than the FOMC forecast average) then the market’s current estimate that the RBA cash rate will be 2.75 per cent by end 2016 seems significantly out of line.

Bill Evans is chief economist with Westpac.

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