The Reserve Bank Board will meet on March 3 next week. It will be Super Tuesday in the US but there will be no “excitement” in Sydney. We expect the cash rate to remain on hold.
However, we do confirm our call for a cut from the RBA at the following meeting on April 7.
Prior to the surprise lift in the unemployment rate for January, which printed 5.3% from 5.1%, markets were only pricing a probability of around 25% for a cut in April. Pricing has now reached a 60% probability – a level of market pricing that the Board would see as reasonably consistent with a decision to move.
However, March pricing is still only around 10% and, given the most recent communications from the RBA, that pricing seems consistent with the likely outcome of the meeting.
Recall the RBA’s most recent communications: “If the unemployment rate were to be moving materially higher and there was no further progress being made towards the inflation target, the balance of arguments would tilt towards a further easing of monetary policy”.
“The Board also recognises that a balance needs to be struck between the benefits of lower interest rates and the risks associated with having interest rates at very low levels.”.
“A further reduction in interest rates could also encourage additional borrowing at a time when there was already a strong upswing in the housing market”.
The first point is a little surprising given that in 2019 a clear justification for cutting the cash rate from 1.5% to 0.75% was to accelerate progress toward pushing the unemployment rate to full employment which has been estimated by the RBA as 4.0%–4.5%. However, arguably, the lift in the unemployment rate through 2019 from 5.05% to 5.29% might already be deemed “material”. Certainly it would have been disappointing for the RBA to have seen a deterioration in the unemployment rate over the course of 2019.
The issue around “additional borrowing” is interesting. Presumably, there is some concern about “over heating” housing markets although from a credit/leverage perspective the issue is not relevant. Housing credit growth is currently at historical lows (3.1%) and, even allowing for a solid (20%) lift in new lending over the course of the next year housing credit growth will only lift to an anaemic 4% from the current 3.1%. This moderate outlook is partly explained by the tendency of households with existing debts to use rate cuts and tax cuts to pay down debt to strengthen balance sheets rather than over leverage, as feared by the RBA.
Further, note that “frothy” housing markets are characterised by excessive “investor” activity. That is not apparent in this cycle. Since the low point in house prices in May 2019 new lending to owner occupiers has lifted by 21%; first home buyers by 26%; but for investors by “only” 16%.
Contrast that with the last year of the 2016/17 housing boom when new lending to investors grew by 35% and, only, 12% to owner occupiers.
Finally, consider the progress towards the inflation target. In 2017 the trimmed mean grew by 1.7%; 1.8% in 2018; then slowed to 1.6% in 2019. The RBA is forecasting GDP growth in 2020 of 2.7% (around trend) and expecting that trimmed mean inflation growth will lift to 1.8% in 2020 and 2.0% in 2021, based on a growth forecast of 3% (above trend).
After adjusting for the impact of the COVID-19 on activity in the first quarter Westpac is forecasting GDP growth of 1.9% in 2020 – a widening of the output gap with little hope of a marked lift in growth in the trimmed mean.
So we expect that the RBA should have a very respectable case for cutting the cash rate in April.
Global developments will considerably strengthen the case. Readers will be aware that Westpac has consistently argued for three cuts by the FOMC in 2020.
The thinking around that scenario was a gradual slowing in the US economy to an annual rate of 1.5% (below trend of 1.75%) coupled with ongoing frustration that the FOMC has been unable to achieve its core inflation target (over the last 10 years their favoured inflation series, core PCE, has printed above 2% in only 11 of the 240 months). The FOMC wants the market to accept that its inflation target is symmetrical around 2% and will be aiming to hold core PCE above 2% for an extended period to emphasise the “symmetrical” target.
That indicates it will be prepared to push harder on the economy than if it was satisfied with its inflation performance.
Chair Powell has also indicated that he wants to extend the expansion for as long as possible; understands that there are special factors explaining the inversion of the yield curve (but would not want the inversion to last for an extended period); and, with his commercial banking experience, is particularly sensitive to credit conditions.
The extraordinary circumstances of the last week in markets where the S&P 500 has fallen by 12% from its recent peak; the US 10 year bond rate has fallen to 35 basis points below the federal funds rate; new issue credit markets have “closed” and credit spreads have “spiked” point to the FOMC making a material change to its forecasts and deciding to cut the federal funds rate by 0.25% at its meeting on March 17/18.
This decision will not be predicated on any “hard forecast” about the spread of COVID-19 but rather the expectation that the realised impact on financial conditions; business and consumer confidence; the outlook for earnings; and the risks to the global economy point to an urgent need to recalibrate policy.
This forecast change brings forward the profile for three cuts in June/ September/December we previously forecast to March/June/September, although an even greater concentration of the cuts, along the lines of the three consecutive meetings in 2019, is a real possibility.
Such action from the FOMC is likely to trigger rate cuts in those countries with scope to move, including an April cut by the RBA.
We have also lowered our near term outlook for the AUD with USD0.67 at March 2020 being replaced by USD0.65. This reflects current trends and the fact that further near term weakness for the AUD seems a realistic possibility.
However, we are retaining our forecast profile for AUD over the second half of 2020 with AUD in the USD0.66–0.67 range.
While markets are currently responding to unknown prospects for the spread of the virus outside of China, prospects for a genuine gradual improvement in China are very encouraging. New cases of the virus have slowed to around 500 in Hubei and 20–50 in other regions of China; factories are reopening; and travel is increasing. Travel bans still hold, including into Australia, but taking the medium term view it seems encouraging that those countries directly exposed to China can expect an easing and an eventual substantial boost from China’s recovery.
