Weekend Economist: Two-way bet?

It's curious the Governor has increased the barrier for a rate cut, while arguing for a lower Australian dollar as well.

On December 4, last week we changed our interest rate forecast to expect a rate cut of 25 basis points in February to be followed by a second cut of 25 basis points in March. By yesterday the market had moved to price in a probability of 40 per cent for a rate cut next February and 70 per cent for one cut by March. Another way to look at this is to note that the market expects 18 basis points of cuts by March compared to our own view of 50 basis points of cuts.

These ideas have been dashed by an interview with Governor Glenn Stevens which appeared in the Australian Financial Review today (December 12). In the interview the Governor opines that he would like to see the Australian dollar at $US0.75 but argued that maintaining stability in rates was the best way to support confidence.

Markets have immediately moved to lower the probabilities of a rate cut in February to an insignificant 16 per cent and a cut by March to 50 per cent. Later in the interview the Governor does note that any decision to lower rates would need to be part of a positive narrative, “a positive narrative might be that inflation is not any impediment to even lower rates if they would be helpful”; other reasons could be softer wages growth or “a calmer housing market”.

Of concern is that he seems to understate the importance of lower rates for the Australian dollar. Note that last week as the market “warmed” to the prospect of lower rates the Australian dollar fell from around $US0.85 to $US0.83.

Recall that over the period April-October this year the Governor “jawboned” the Australian dollar with “the exchange rate remains high by historical standards” but because he maintained a neutral policy bias “period of stability for interest rates” the Australian dollar was largely unresponsive, remaining in the overvalued range of $US0.92–$US0.94. The Australian dollar only really started to plummet when iron ore prices fell sharply.

It remains to be seen whether stronger language around the Australian dollar but an implied reluctance to cut rates to support that strategy will be successful.

We will see how markets respond to the Governor’s strategy over the next six weeks in the lead up to the next board meeting.

Of course the emergence of a much more “hawkish” US Federal Reserve which reports next week might sharply raise the US dollar and see the Australian dollar tumbling towards the Governor’s stated $US0.75 target. We give that prospect a low probability. Markets are likely to have already adjusted to some change in the language from the Fed and significant changes that would sharply lift the US dollar seem unlikely.

Given such uncertainties we are content to retain our current call while recognising that the Governor has, curiously, significantly boosted the barrier to a near term rate cut while, at the same time, arguing for a substantial fall in the Australian dollar against the US dollar. (Note that against the TWI the Australian dollar has only fallen around 4 per cent over the year).

However, on the positive side, he has largely overridden the “period of stability” constraint. If the Australian dollar fails to respond to the jawboning strategy and the December quarter CPI prints a low number then the contents of the interview indicate that the Governor could still cut rates in February.

The board minutes, which will be released next week, can provide a detailed discussion around the need for a lower Australian dollar.

We have previously argued the logic of a February move. That argument is essentially that the bank produces its statement on monetary policy three days after the February meeting. That statement will include the bank’s new forecasts. The decision to cut rates should be associated with a lowering of the growth forecasts. For now, that argument was also diluted by the Governor’s interview, "the economy, jobs and inflation were roughly where the central bank expected them to be”. We would still be surprised if the RBA does not lower its growth forecast in February.

In the interview the Governor nominated $US0.75 as his Australian dollar “target”. Our insight here is that in November last year he nominated $US0.85 as a “fair value” for Australian dollar. At that time $US0.85 was the bottom of the range for our fair value model. The lower bound for our fair value model is now $US0.78 – within range of $US0.75.

Apart from the national accounts and the interview another important development since the meeting has been the letter from APRA (Australian Prudential Regulation Authority) on December 9 to all ADI’s (Authorised Deposit–taking Institutions). The letter represents the much awaited macro prudential policy approach to containing excesses in the Australian housing market.

The key lines in the letter are, ”Given the current very strong growth in investor lending, supervisors will be particularly alert to plans for rapid growth in this part of the portfolio. For example, annual investor credit growth materially above a benchmark of 10 per cent will be an important risk indicator that supervisors will take into account when reviewing ADIs’ residential mortgage risk profile and considering supervisory actions.” In another section of the letter APRA refers to “further supervisory action, including the consideration of individual Pillar 2 capital requirements”.

The threat of individual capital requirements which would be applied to individual ADI’s rather than a system wide change in capital requirements would be particularly concerning to ADI’s who would be at a competitive disadvantage with their peers.

In short, these initiatives would give the RBA considerable comfort that it could cut rates without risking over stimulating investor housing.

The case for lower rates has also been strengthened by the latest print for the Westpac Melbourne Institute index of consumer sentiment.

The Westpac Melbourne Institute consumer sentiment index fell 5.7 per cent from 96.6 in November to 91.1 in December. The index is now at its lowest level since August 2011 when it briefly fell below 90. However, you have to go all the way back May 2009 to see a period when the index printed consistently below December's level.

Not surprisingly respondents have increased their anxiety around the labour market. The Westpac Melbourne Institute index of employment expectations increased by 4.4 per cent to 159.5 (a higher level indicates more heightened concerns around job security). Apart from one higher print in March this year this is the highest read since June 2009 when respondents were particularly traumatised by the global financial crisis.

Optimism around the housing market has dissipated. The index, "time to buy a dwelling” fell by 10.7 per cent and is now down by 19.2 per cent over the year. Consistent with that sentiment, the outlook for house prices deteriorated sharply.

Finally we saw the November employment report. Total employment rose 42,700. However, the breakdown of the of the survey detail highlights a soft labour market. Full-time employment rose 1,800 following a 27,000 rise in October while part-time employment surged 40,800 following a 13,300 decline in October. Annual growth in full-time employment is 0.7 per cent compared to 2.5 per cent for part-time employment. In November the participation rate rose from 64.6 per cent to 64.7 per cent. This saw the unemployment rate rise 0.1ppts to 6.3 per cent but at two decimal places it was basically flat (6.26 per cent from 6.25 per cent in October). Youth unemployment continues to rise hitting a 16 year high of 14.5 per cent in November. Also highlighting a soft update was the –0.3 per cent fall in total hours worked.

This report would not change the RBA’s generally downbeat outlook for the labour market. “Conditions remain subdued and there is still a degree of spare capacity. The unemployment rate is elevated; the participation rate is low;… a sustained decline in the unemployment rate is not expected for some time” (November SOMP).

At this stage we are comfortable to retain our recent call for two cuts in February and March while recognising that the exact timing has had a significant jolt from the Governor’s interview. Like the Governor we will “take a fresh look at all these things in the new year” while maintaining that the appropriate policy is to cut rates early in that new year.

Bill Evans is chief economist of Westpac.

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