The RBA is going to cut today but they will do so reluctantly and with extreme caution as they remain concerned about the impact of Mining Boom Mark II. The inflationary pulse of 2008 that was a direct result of the extra burden that Mining Boom I placed on the economy remains large in the RBA’s mind.
Indeed the RBA is not hiding the fact that they are grappling with the ghost. In last month’s statement from Governor Stevens after the Board meeting he committed a large chunk to this inflation fear and said:
In underlying terms, inflation was around 2½ per cent in 2011. CPI inflation was higher than that but will fall over the next quarter or two. It is currently expected that inflation will be in the 2–3 per cent range over the coming one to two years. This forecast abstracts from the effects of the carbon price and also embodies an assumption that productivity growth in the economy increases somewhat as a result of the structural change now occurring. At its next meeting, the Board will have the opportunity to reassess the outlook for inflation, taking into account not only data on demand and output but also forthcoming information on prices.
So the RBA used the inflation outlook, or should I say their uncertainty around it – even though they have consistently been saying it is going to be well within the band on average, as the excuse not to cut last month. But the 0.1% print for last quarter has probably assuaged this fear to a large extent.
So this month they will cut – perhaps as former RBA Governor Bernie Fraser advocated on the 7.30 Report last night they will “get ahead of the game” and give us a 50 point cut (5.49 mark in the video).
I’m not sure, I hope they do because I have advocated in these pages for well over a year now and for clients for many years now, that the Australian economy is in real strife under the weight of the deleveraging that is occurring in the household sector and the negative impacts of the mining boom, such as an Australian Dollar holding firmly above parity.
I hold firmly that the RBA is behind the curve and have held that for some time but I also understand why.
Last March while I was working at Newcastle Permanent as Treasurer a question from the Chairman of the Board prompted me to say that the RBA now had a bias to tighten. It prompted this piece I wrote at MacroBusiness at the time but the research of reading every RBA senior staffers speech over the previous 5 or 6 years gave me an insight to better understand the thought and monetary policy setting processes the RBA follows. That is, the RBA holds a core view and then assesses the risks around this core view when setting monetary policy.
It is this approach that enabled the RBA to hold fire and then cut last year against most pundits mid year expectations mid year even as it held a strong belief in the mining story, was worried about inflation, and was actually comfortable with the structural change that is being wrought on the economy – particularly the improving funding and balance sheet structure of the Australian banking system and households. So having cut twice these concerns held their hand off the trigger for the last few months. There is no doubt that even though I think the RBA is behind the curve at the moment that as Houses and Holes wrote yesterday the Steven’s RBA is doing a very credible job at a difficult time and with substantial historical legacies. Largely I think this is why the RBA has been slow to change its view about the outlook for the economy.
But the market clearly thinks it is going to be different in the year ahead with pricing of more than another 105 points in rate cuts as you can see in the chart below from Bloomberg:
You can see that before the RBA embarked on the rate cut agenda last year the market had pre-empted the move and was expecting a cycle of around 150 basis ponts in cuts. Equally you’ll note that the rhetoric coming out of Martin Place earlier this year had these expectations wound all the way back to just another 50 basis points of cuts after the November and December cuts. Markets are now bullish on rates again and when we factor those in and current expectations we are back at the original expectation of a cycle over 12 months of 1.50% of cuts.
This re-affirmation of another substantial downleg in cuts can be coupled with moves in the 3 year swap rate to give us the best indicator of just where rates in Australia are heading in the next year or so beyond the ebb and flow of one or two months worth of RBA meetings.
Indeed looking further out there is evidence that the swaps market is looking at substantial rate cuts as well.
Looking at the long-term history of the relationship between the RBA’s cash target rate and the market 3 year swap rate, you can see the market this past year followed the conventional interest rate strategist wisdom for more than a decade which is, and has been, that the 3 year swap rate often peaks or troughs around the time of the first couple of moves by the RBA. Sometimes its difficult to tell because the RBA cycles can be drawn out as they seek to “do least harm” (at least in my view) but it’s there nonetheless:
You can see in the recent experience that the 3 year swap rate followed this play book precisely and actually headed back through the cash rate before embarking on this recent rally and it now sits at 3.75% as at last night’s close. That means that on average, at present, the market is betting that the average 90 day bank bill rate, which trades at a premium to the cash rate usually, is going to average 3.75%. That speaks volumes about the outlook that traders and bank balance sheets (who use swaps as part of their hedging strategies) hold about the outlook for the economy.
When I put my trading/technical hat on I reckon the 3 year swap rate is going all the way back to test the GFC crisis low at 3.28% as you can see in the chart below. If it gets through there then it’s another 1% for a move to 2.26% – lets hope we don’t get that because it would tell us some terrible news about our economy:
Now obviously the single most important thing about the charts above is the axiom that I hold dear which is that fixed rates are always more volatile than variable rates – Orange line versus White line. So just because the market prices it doesn’t make it so.
But for me when I look at the fundamentals of the global economy, I can see that Europe has dodged a bullet but that its economic future remains moribund. I see that the US economy is struggling to regain sustainable forward momentum but that it is a very thin and uneven economy. I see a world where de-leveraging and austerity is the path of the future and thus a low growth path, and I see China as struggling with its own demons and thus unlikely to be able to drag us or the global economy through the mire as it has for the past few years.
So not necessarily a catastrophe but certainly a weaker growth profile than many surmised a year ago.
Back at home it’s austerity Australian style as the government tightens its belt at a time when households are reducing debt and rebuilding balance sheets. Part of this is to take advantage of the high Australian dollar and bypass holidays in Australia for cheaper alternatives offshore, bypass shopping in the high street or the malls in favour of online shopping, particularly offshore. And off course Australian industry and companies are suffering as a result of this.
The market is saying that rates are going down another 1% over the next 12 months, with a risk of more. I agree.
Have a great day
Gregory McKenna
www.twitter.com/gregorymckenna
Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.