From Bill Evans:
The Reserve Bank Board meets next week on December 1.
We are confident there will be no change in the overnight cash rate.
Our reading on Reserve bank thinking at the moment is that the Governor is unconvinced that lower rates will boost activity.
In the Q&A following a dinner presentation on November 24 he noted that he was prepared to cut rates: “I am more than content to lower rates if that actually helps”.
However, the Governor also indicated that he expected that signalling a period of stability and pointing out the positive developments in the economy might have a more constructive impact on confidence and growth than lowering rates.
We know that the Bank sees interest rates as ‘bringing forward’ activity but doubts whether that effect would spread much beyond residential construction with non-mining investment decisions being unaffected by the level of short term rates. We have seen more evidence in the September quarter Capital Expenditure Survey around the weakness in investment, including services (down 10%qtr) with total investment falling a staggering 9% in the quarter. Of some comfort is a modest lift in the outlook for services investment in 2016/17 with the 6% fall we saw in the June survey being scaled back to 4%.
Non mining investment decisions are being impacted by high hurdle rates; a perceived need to further strengthen balance sheets; political uncertainty (significantly reduced with the change in leadership); and soft current and expected demand. The Reserve Bank appears to believe that lower short term rates would do little to offset those headwinds.
They appear to believe that lower rates would only bring forward housing construction activity creating an ‘activity gap’ later in the decade.
While this psychology persists there is little chance of a decision by the Board to cut rates.
Indeed the Governor encouraged market participants attending the dinner to effectively loosen up, enjoy the Christmas break and take another look at the economy next year. That eliminated any possibility of a December move – recall that as recently as a month ago market pricing implied a 100% chance of a cut by December, with 12 out of 28 economists also predicting a move.
However, when the Governor appeared to hold similar views this time last year, the following months saw a rapid reassessment.
The Governor’s statement after the December 2014 Board meeting repeated the constant theme through 2014 that the “most prudent course is likely to be a period of stability in interest rates”.
By February the following year the Board had cut rates by 0.25% and re-formulated its forecasts on the basis of a follow up cut in May.
Westpac predicted that rate cut despite the ‘stability’ remark being repeated in the December Statement.
That was because the print on the September quarter national accounts was particularly weak at 0.3%qtr; the annual national accounts had indicated a weaker economy for the year to June 2014 with annual growth revised down from 3.1% to 2.8% (mainly due to a weaker trajectory for consumption); investment plans in the September quarter capital expenditure survey continued to point to a sharp (7.5%) fall; and iron ore prices were falling sharply (down 26% over three months).
This time around we expect the September quarter national accounts to print 0.7%qtr (due to a 1.3ppt contribution from net exports although we expect a comparable 0.5ppt drag from contracting domestic demand); the annual national accounts only showed a 0.2% downgrade to annual growth being attributed to government expenditure and mining investment (rather than the structurally more important consumption); capital expenditure plans for 2016/17 have improved a little (from -24.3% in June to -20.9% in September) including that modest improvement in the outlook for services investment; and the fall in iron ore prices has been ‘only’ 20%.
It is also reasonable to assume that as rates move lower the ‘hurdle’ to cut rates gets more formidable.
The Australian dollar was also a bigger headwind last year holding around USD0.82 in December 2014 compared to USD0.72 currently with the realistic prospect of renewed weakness once the Fed begins its tightening cycle on December 18.
Of course there has also been a marked change in attitude towards the labour market. Last year the RBA believed that the unemployment rate would continue edging up until mid-2015 (at least) whereas the current forecast is ‘stability’ with some prospect of falls in the unemployment rate.
In conclusion we remain comfortable with our current view that the RBA will keep rates on hold through 2016. We are not expecting a repeat of the sharp ‘about face’ we saw this time last year.
But, undoubtedly downside risks are to the fore. Contracting domestic demand in the September quarter; falling iron ore prices; negative investment plans; and downgrades to GDP growth are all comparable with the main motivations behind the sharp reversal in policy in February this year.
Markets are currently pricing only a 32% chance of a move in February (down from 120% a month ago). We can be certain of one thing: expect more volatility as the rate debate extends into 2016.
There will be no cut this week, no. But the chances of a cut in February are good and the chances in Q1 excellent. The two prime drivers will be fading house prices and falling iron ore.
The RBA is right to fear it in-so-far-as more cuts are not likely to achieve much in the short term. But that does not mean that they won’t happen.
As the terms of trade keep falling, to not drop the dollar further will crush miners, nominal growth and the Budget, as well as leave house prices to fend for themselves in a brewing correction. If you want those factors to combine with the triple-header job shock coming in 2016 as the mining capex cliff steepens, the car industry closes and the residential construction boom ends then go right ahead and hold.
We’ll be in outright recession just as Glenn Stevens retires.
