- April 1, 2010
- Posted by: admin
- Category: Finance News
The Reserve Bank Board next meets on April 6. Markets are currently pricing a probability of around 60% that the Board will decide to lift rates by a further 25 bp’s. While we have consistently argued that all Board meetings over the course of 2010 are likely to be ‘live’, we do not expect to see a rate hike at the April meeting. We continue to expect a 25bp hike in May to be followed by a further hike of 25bps in July/August prior to an extended pause through to the second quarter of 2011. Markets had expected only one hike by July but are now in line with our thinking that rates will be increased by a total of 50bps by July/August. However, market pricing differs significantly from our expectation of an extended pause. Markets expect the cash rate to reach 5% by December and 5.25% by March 2010. Our thinking is partly driven by our estimate that the RBA sees ‘neutral’ or ‘normal’ as 4.5% – only 50bps from the current level. Our estimate has been based on comments from RBA officials that the margin between private sector rates and the official cash rate has increased by 100bps since the GFC began. The average cash rate over the period January 1992 (when inflation had settled around its current levels) and December 2007 was 5.5% and underlying inflation averaged 2.6%. It’s reasonable to assess that the Bank would consider the ‘old normal’ as 5.5% – hence our assessment of the ‘new normal’ as 4.5%. This assessment was given support from comments by Assistant Governor Lowe who noted last week that mortgage rates are currently 50bps below the “average of the last 1½ decades”. Our difference with market pricing may represent the market’s view that the ‘new normal’ is higher than 4.5% or more likely that it expects that growth momentum in the second half of 2010 and early 2011 will be sufficient to require an immediate move into ‘contractionary territory’ for monetary policy. We accept that the stimulus to incomes in the economy from the return to 2008 highs in the terms of trade over the course of 2011 will require policy to eventually move into the contractionary zone. However, we expect that the economy will face a number of headwinds over the second half of 2010.
(i) Unwinding of the Fiscal Stimulus.
We will see the winding down of most of the stimulus initiatives from the Federal Government. These contributed around 60% (2ppts) of the growth in expenditures in 2009. Over the course of 2010 as programs are unwound or phased out we can expect the stimulus effect to detract around 1ppt from growth in demand. While the economy probably felt stronger in 2009 than it actually was it will feel weaker than it actually is through the course of 2010.
(ii) Sensitivitivity of Consumer Sentiment.
The next stage of rate hikes is expected to significantly reduce Consumer Sentiment and moderate the pace of domestic spending. A movement to 4.5% is likely to see the variable mortgage rate reach nearly 7.5%. At the equivalent stage of the last tightening cycle in March 2005 the increase in the variable mortgage rate to 7.5% resulted in a violent 15.5% fall in Consumer Sentiment. While there were other factors at work the severe jolt to confidence contributed to rates remaining on hold until May 2006.
Furthermore, the current very strong read on Consumer Sentiment is not seeing the style of surge in consumer spending normally associated with these lofty levels of the Index. We note in our survey work that consumers are currently much more risk averse than at similar stages of past recovery cycles. In the March Consumer Sentiment Report we noted that the proportion of respondents who indicated that “pay down debt” was the wisest place for savings reached record levels. Those factors point to a more modest upswing in consumer spending in 2010 and 2011 than would have been the case in previous cycles.
(iii) A modest fall in the unemployment rate.
While our forecasts are for jobs growth of 3% through 2010 we are only looking for a reduction in the unemployment rate to 5.0% by year’s end. That will be largely because of an expected increase
in the participation rate and the ongoing rise in the labour force associated with the almost doubling of population growth over the last 5 years. We have argued that a central bank will be very nervous
if rates are below “neutral” and the unemployment rate is below the NAIRU (non accelerating inflation rate of unemployment). We assess that the NAIRU for Australia is 5% – only 0.3ppts below the
current level. If we are wrong with this assessment and the unemployment rate has fallen below, say, 4.5% through 2010, then it is likely that current market pricing WILL be franked.
(iv) Credit supply.
The provision of credit will also be more constrained in this upswing than in previous cycles. Prior to the GFC, banks were able to access adequate wholesale funding at very narrow spreads. That allowed them to easily accommodate any unexpected increase in the demand for credit from households or business. Now banks are more restricted by market conditions. Funding costs in term wholesale markets have contracted by around 70bps over the last year but are still around 100bps over bond for 3 year issuance rising to more than 200bps for 10 year funds. Australian banks would also be anxious about the sheer volume of long term wholesale debt. In 2009 banks issued $177bn in term wholesale debt compared to $92bn in 2008 and $58bn in 2007. In addition, new regulations are likely to restrict the extent to which they can access wholesale funds whilst requiring significantly more holdings of sovereign debt. Total credit growth is currently running at an anaemic 1.5% p.a. We expect that credit growth in this cycle will peak at around 9% by end 2011 – well down on the average annual pace in the last 10 years of around 12%. In effect the banks will be performing some of the function of financial tightening which has been the sole responsibility of the Reserve Bank and interest rate policy.
(v) Prospects for growth in the Developed World look grim.
Finally, we are less than optimistic about growth prospects in the developed economies. Headwinds associated with excessive levels of official debt; unwinding of stimulus policies; shortages of bank capital; regulatory uncertainty; structural changes in the labour market; and deleveraging of the household sector point to growth disappointments in the US, Europe and Japan over the course of 2010 and into 2011.
Source Bill Evans, Chief Westpac Economist