Monday, March 30, 2009

Australian & New Zealand Weekly : RBA on Hold in April, Aiming for Flexibility

Week beginning 30 March 2009

  • Australia: RBA on hold in April, aiming for flexibility.
  • Australian data focus: credit growth, dwelling approvals, retail trade, trade balance previewed.
  • New Zealand: building consents, business & employment confidence.
  • US data deluge: Mar ISM's & Fed factory surveys, house prices, consumer confidence, pending home sales, construction spending, factory orders and non-farm payrolls all due this week.
  • Eurozone: ECB to cut rates 50bp to 1.00% this week.
  • Key economic & financial forecasts.

Over the last week we changed our forecast for the next RBA Board meeting. At the time markets were close to pricing in a rate cut of 50bp's (around 40bp's in probability terms) although this probability has now come down to around 100% probability of a 25bp cut - ironically our previous forecast. Below we set out the details of that earlier note.

"We have changed our forecast for the RBA's rate decision on April 7.

Westpac had expected that the RBA Board would decide to reduce the overnight cash rate from 3.25% to 3% on April 7. We now expect that the RBA will decide to keep rates on hold at that meeting. We still expect that the lowpoint in the cash rate for this cycle will be 2% but anticipate the Bank taking longer to reach that target.

We have argued in the past that the most efficient policy approach should be to reduce rates as quickly as possible to ensure maximum stimulus for the economy. However the actions by the Board at the March meeting, when it decided to pause despite particularly disturbing data on the Asian economies and a further deterioration in the Australian outlook, indicate that the Bank has decided to take a different tactical approach to these last stages of the easing cycle. Unlike the US Federal Reserve which despite an effective zero Federal funds rate was still able to adopt the policy of buying Treasuries in order to lower the cost of fixed rate mortgages, the RBA really only has one policy option to influence private sector rates. That is to change the overnight cash rate to directly affect the prime variable mortgage rate.

It appears that the Bank has decided to conserve its flexibility to further influence rates in fear of being in a position of not having any scope to respond to unexpected negative events over the course of 2009 and possibly beyond. It is reasonable for the RBA to assume that a rate cut in response to negative domestic or overseas developments provides some boost to confidence with the knowledge that the RBA is still 'on the case'.

We assess that after cutting aggressively by 400bp's in just over 5 consecutive meetings the Board expects that it has only 125bp's at the most in future flexibility. Accordingly we expect that the Board will conserve that flexibility for a period when international and/ or domestic conditions deteriorate sharply. We anticipate that such events remain likely in 2009 and through to 2010 but the period leading up to the next meeting does not fit into that category. On the contrary, confidence in global financial markets has soared with equity markets in particular showing near record increases (recent 2 week surge in the US market is the strongest since 1930's).

We do not think this confidence will be sustained and in particular expect dismal economic data to continue to print for the world economy (my recent trip to China has not convinced me that China is back on a sharp upward trajectory). Australian data will also deteriorate sharply particularly for business investment and employment. For now, however, the Bank will take some confidence from the recovery in new lending for housing, although we would argue that it is too narrowly based relying mainly on the First Home Buyer while investors remain on the sidelines .

A pause to assess the Government's second stimulus package which is currently being implemented also makes some sense. In that regard we would certainly not rule out a continuation of the pause in May. However we maintain the core view that an eventual 2% floor will be reached probably in the fourth quarter."

One of the key reasons why the Bank would be careful to retain some flexibility relates to recent forward indicators for the unemployment rate.

On the next page of this note we set out our core forecast for the unemployment rate which we expect to reach near 8% by the end of 2010 (Figure 2) while recognising the more disturbing prospects currently being signalled by some of our partial lead indicators for employment growth. Our core view on the unemployment rate is derived from our forecast for domestic demand growth over the course of 2009 and 2010 (Figure 1). That profile envisages a collapse in investment spending not dissimilar to the profiles of the two previous recessions in the early 1980's and early 1990's. Consumer spending is likely to remain subdued due to the constraints on labour income (from rising unemployment) and concerns with repairing damaged household balance sheets. Housing construction will also detract from growth in 2009 although we expect a return to positive growth in residential construction in 2010. That will reflect the extreme current housing shortages, the recent sharp improvement in housing affordability and attractive positive margins which rental yields now enjoy over funding costs in many markets. Overriding this profile will be a very strong contribution to growth from public spending.

Key risks to this dynamic are difficulties for the states (65% of public spending) achieving their spending targets as they deal with budget constraints and rationing of funding for the investment vehicle favoured by residential investors (apartments). Note that approvals for apartments are down by 55% over the last year partly reflecting credit difficulties.

Figure 3 shows a more disturbing indicator for the unemployment rate in 2009. The latest Labour Market Composite Index from the Westpac-ACCI Survey of Industrial Trends is indicating a contraction in employment growth of around 2¼% through 2009 compared to our base case of 1.5%. That sharper fall (Figure 4) would see the unemployment rate reach towards 8% by the end of 2009 rather than taking until 2010 to reach that level.

Figure 5 shows the lead from the Unemployment Expectations Index which is derived from the Westpac MI Consumer Sentiment Index. It is pointing to an unemployment rate of above 8½% by year's end (Figure 6).

Lead Indicators are important tools for economic forecasters but cannot be relied upon for tight point estimates. The history of Australia's last two recessions shows that in the worst two years of those recessions, the unemployment rate 'only' increased by 2ppt's each year. These indicators are pointing to 3ppt's and 3½ppt's in 2009 respectively - hardly likely and certainly not Westpac's forecast. However they do emphasise the extreme uncertainty under which economic forecasters (including the Reserve Bank) are currently operating as the world economy confronts its greatest challenges since the 1930's.

From the Bank's perspective better to retain some flexibility to be seen to be dealing with such events rather than expend all flexibility too soon.

Australia: Data Wrap

RBA Financial Stability Review

  • The comments and conclusions in the RBA's semi-annual Financial Stability Review (FSR) and a paper on the housing sector are cautiously optimistic, while acknowledging the challenging global backdrop.
  • RBA Head of Economics, Anthony Richards, speech on "Conditions and Prospects in the Housing Sector" highlights that since the housing boom slowed in 2003, there has been a significant degree of consolidation, as evident from the behaviour of the household sector over the past five years. The Bank concludes that this will reduce the vulnerability of the household sector in the current slowdown.
  • The RBA also asks "whether a period of quite low mortgage rates in Australia could lead to the type of problems that are being seen in the United States". The Bank concludes there is not a major risk that low rates will lead to an expansion of lending to risky, marginal borrowers, citing the historical quality of Australian mortgage lending and the tightening of lending standards evident of late.
  • The major conclusions of the FSR were largely unchanged from the September 2008 update.
  • On the international banking system and economic environment, the FSR highlights the adverse feedback loop that has developed. Addressing financial system problems is a prerequisite for a sustained economic recovery. This will require "de-risking" of bank balance sheets and bolstering bank capital. It could take some time before it is clear whether recent US initiatives have been sufficient.
  • The Australian banking system is considerably better placed to weather the challenges than many other systems around the world, with banks solidly capitalised, profitable, and strengthening their balance sheets further with the use of Government guarantee arrangements. Loan arrears have risen and will rise further, but from very low levels.
  • The household sector has entered a period of balance sheet consolidation and demand for credit has slowed. The past year has seen some signs of increased household financial difficulties, although loan arrears remain relatively low.
  • Balance sheets of most firms remain in good shape, although there are difficulties for a small number of highly geared firms that have relied heavily on short term funding. Businesses have become more risk averse and are looking to "de-risk" balance sheets.

Round-up of local data released last week

Date Release Previous Latest Mkt f/c
Mon 23 Federal Treasurer Wayne Swan speech - - -
Tue 24 RBA Assistant Governor Lowe speech - - -
Wed 25 RBA Governor Stevens speech - - -
Thu 26 RBA Financial Stability Review - - -
RBA Head of Economics Richards speech - - -

New Zealand: The Week ahead & Economic Wrap

Quite contrary

It's been another crazy week. Interest rates and the NZD both jumped again, with swap rates sitting some 30-40bp higher than a week ago, and the trade-weighted exchange rate index up another 3% on improved risk sentiment around the globe. Major banks increased their medium to long-term mortgage rates in response to the increases in wholesale rates. Financial conditions just keep going the wrong way for the RBNZ, and we continue to expect that the RBNZ will have to cut the Official Cash Rate below the 2.5% floor implied by their March forecasts. We also believe that the cash rate will be kept low for considerably longer than the market is currently pricing in.

Data this week did nothing to sway us from our view. The Westpac- McDermott Miller consumer confidence index fell back into pessimistic territory, hardly surprising given the grim global economic headlines in the newspapers every day, and unemployment ticking up. Concern about the current and near-term outlook dominated the result, with an increasing number of households stating that they would save a cash windfall. Consistent with this, we expect consumption to be flat well into 2010, as households face up to the debt burden accumulated over the past few years.

The annual current account deficit widened to 8.9% of GDP in Q4, but the quarterly seasonally adjusted balance improved for a second quarter, thanks to weak import demand and a reduction in the outflow of investment income. The underlying trend is thus towards a narrowing of the deficit, as is typical in a recession. NZ's large current account deficit raises wary eyebrows and is unhelpful when trying to raise offshore funding in nervous markets to cover NZ's large private debt. An improvement in the deficit is therefore welcome.

And finally, GDP fell 0.9% in the December 2008 quarter. This is the worst quarterly GDP outturn so far in this recession, but a quick glance around the world makes one feel relatively lucky. Quarterly Q4 GDP growth was considerably worse in many countries, e.g. US -1.6%, UK -1.5%, Germany -2.1%, Japan -3.2%, and Singapore -4.4%.

Economists and the market had consolidated their expectations around a 1.1% fall in GDP, whereas the RBNZ forecast -0.8% in the March Monetary Policy Statement. The outturn therefore fell between the two and the market response was relatively muted. Looking at the details, demand was weak across the board. Household spending was flat, residential investment fell 14.0%, other investment was down -1.8%, and export volumes fell 3.3%. Consumers have clearly saved the extra cashflow from lower interest rates, the October tax cuts, and lower petrol prices.

Lack of demand filtered back through the supply chain. Retail and wholesale trade, transport, and manufacturing all fell. Growth bright spots were agriculture (+4.0%, reflecting continuing production recovery from drought), communication (+1.5%), a surprise lift in the combined finance, insurance and business services sector (+2.2%), and government spending (+1.7%).

Manufacturing production was particularly weak (-3.8%). The fall was amplified by lower aluminium production from Tiwai Point because of a transformer failure and an almost 2 month shutdown for regular maintenance at the Kapuni urea plant, but was widespread. Manufacturing around the world is bearing the brunt of the economic slowdown. A couple of statistics illustrate the point: Japanese exports fell a startling 49.5% year on year in February, while Taiwan's industrial production in January was down 43% on January 2008. It's a good time to be a basic food producer rather than a manufacturer of technology. People can get by without a new television but have to eat.

Even if we're better off than some, this was the fourth consecutive quarter of decline in NZ GDP. We expect another hefty negative result for the first three months of this year, and ongoing weakness for the rest of 2009. This is in contrast to the Reserve Bank's fairly optimistic growth outlook for the second half of this year.

In other data, the February merchandise trade numbers revealed a collapse in car imports. Together with a fall in crude oil imports, this resulted in the strongest February trade balance since 2001. A rapid turnaround in the trade balance thanks to lower consumption and investment is a major driver of our expectation that the current account deficit will close rapidly over coming quarters.

Next week brings February building consents on Monday, which we expect will bounce back somewhat after plunging 13% s.a. in January. But with credit conditions remaining tight, confidence extremely low, and house prices continuing to fall, the risk is for further weakness.

On Tuesday, monthly business confidence numbers are unlikely to bring much cheer, as firms continue to hunker down in ongoing challenging conditions. Wednesday's Q1 Employment Confidence Index will hardly be a pick-me-up either. Confidence plunged in the December quarter, and since then news around the labour market has only gotten worse. Concerns about job security are a major driver of New Zealanders' new-found prudence.

And finally on Thursday, monthly commodity prices round out what looks likely to be a fairly uninspiring week. Although there are some tentative signs of spot prices bottoming on world markets, a stronger NZD will see domestic prices lower.

Round-up of local data released last week

Date Release Previous Latest
Wed 25 Mar Q1 consumer confidence 101.3 96.0
Thu 26 Mar Q4 current account NZDmn s.a. -4,008 -3,772
Fri 27 Mar Q4 GDP % qtr -0.5% -0.9%
Feb merchandise trade NZDm -104 489

Data Previews

Aus Feb private credit

Mar 31, Last: 0.6%, WBC f/c: 0.5%

Mkt f/c: 0.4%, Range: 0.2% to 0.8%

  • Credit growth has slowed as the economy losses momentum. Annual growth dropped to 6.1% in January, down from 16.4% at the end of 2007.
  • We're forecasting credit to increase by 0.5% in February, down a touch from the 0.6% rise in January. Business credit growth is expected to moderate.
  • Housing credit growth is accelerating - gradually to date. New lending (housing finance) is in recovery mode in response to very low interest rates and the First Home Buyer Scheme.
  • By contrast, business credit growth is choppy from month to month and on a weakening trend. After rebounding by 0.7% in January, we see the risk of softer results as firms cut back on investment and in turn, credit.

Aus Feb dwelling approvals

Apr 1, Last: -3.7%, WBC f/c: 5.0%

Mkt f/c: 1.8%, Range: -1.2% to 5.0%

  • Dwelling approvals disappointed in Jan with another 3.7% decline extending the slide seen since mid-2008 to a cumulative 28.5% fall. Although private sector houses recorded their first rise since April last year, the gain was disappointing and apartment approvals continued to fall sharply (now down 53% on a year ago). The credit crunch impact on developer finance is hitting this segment hard.
  • The continued weakness is in stark contrast to strong gains in housing finance approvals for the construction & purchase of new dwellings which are up 19% since Aug. Demand has clearly turned, aided by sharply lower interest rates and incentives for first home buyers. Our analysis suggests the impact of the credit squeeze on approvals may be starting to run its course. As such we expect strengthening demand to translate more directly to a 5% rise in approvals in Feb.

Aus Feb retail trade

Apr 1, Last: 0.2% (sa, trend series suspended), WBC f/c: -1.0% Mkt f/c: -0.5%, Range: -2.0% to 0.8%

  • Retail sales edged 0.2% higher in Jan, a strong outcome given the 3.8% jump in Dec. Strength through Dec-Jan reflected the impact of the Govt's $8.7bn in fiscal payments to households. Although this gave a big boost to sales, the response to date suggests households still saved about 80% of the cash. Indeed, the mysteriously weak consumer spending result in the Q4 national accounts (+0.1%qtr) suggests an even higher proportion of the payments may have been saved.
  • The fiscal boost will start to unwind in Feb but sales are unlikely to fall right back to Nov levels. Some of the stimulus would still have been filtering through. Consumers also saw further significant reductions in interest payments (the RBA cut rates by 100bps in Feb), although these have also tended to be saved rather than spent. All up we expect a 1% pullback in sales in Feb, although the risks around this are clearly high.

Aus Feb international trade balance, AUDbn

Mar 2, Last: +$0.970bn, WBC f/c: +$1.6bn

Mkt f/c: +$0.7bn, Range: -$0.15bn to +$1.9bn

  • The trade surplus rose $553mn in Jan to $970mn. X were weak, -5.0% led by non-rural vols and prices, taking trend growth to -1.2%mth (weakest since Sep-07). Non-rural X fell 6.7%mth, their 3rd straight fall, taking trend growth to -2.0%mth. But imports were weaker still, -7.3% to take trend growth to -1.2%mth (weakest since Apr-91). Consumption goods trend growth slowed to +0.5%mth, while capital goods plunged 15.2%, a sign that the resilience in business equipment spending in the Q4 GDP accounts will not last.
  • After two particularly soft months, export vols are likely to see a rebound in Feb. Meat & wool vols were strong, and with higher prices should lift rural X 5%. Non-rural vols should support a 3% non-rural X rise in a partial unwind of Jan's weakness. This gives +2.7% for total X and, with merchandise M data implying a flat M result, lifts the surplus to $1.6bn.

NZ Feb building consents s.a.

Mar 30, Last: -13.1%, WBC f/c: 6.4%

  • Dwelling consents collapsed in January to reach their lowest level since 1965. That now places NZ at strong risk of a housing shortage developing in the next few years.
  • We expect a 6.4% rise total consents in the month, as some of last month's weakness is unwound, particularly in the apartment segment. But with credit conditions remaining tight, confidence extremely low, and house prices continuing to fall the risk is for further weakness.
  • Non-residential consents are proving more resilient, with the trend value of consents up 15% in January. However, we expect this strength to be short lived, with businesses now strongly suggesting they will be cutting back on building investments over the coming year.

NZ Mar NBNZ business confidence

Mar 31, Last: -41.2%

  • Own-activity expectations remained close to record lows in February, with many key activity indicators heading to new lows. The balance of recent data suggests no further deterioration in the economy since then.
  • But there has been little in the last month to inspire fresh confidence either - the Government's Jobs Summit led to some underwhelming recommendations, and the RBNZ has suggested that there is little room for more monetary stimulus.
  • The sharp fall in inflation expectations may be halted this month by the rise in fuel prices since the start of the year.

NZ Q1 employment confidence index

Apr 1, Last: 104.0

  • Employment confidence plunged to its lowest level since survey began in 2004 in the December quarter as perceptions around employment conditions collapsed and job security fell to a new low. Views around earnings were more mixed with current earnings up, while expectations of future earnings were down. But overall, the survey painted a grim picture of the labour market at the end of 2008.
  • Since December, the news on the employment front has only got worse. Business surveys suggest layoffs will continue to rise, and evidence suggests that wage growth is slowing fast.
  • That will likely weigh heavily on confidence this quarter, despite the Government's best efforts to provide support to employment growth through the Job Summit.

US Mar ISM and Fed factory surveys

Mar 30, Dallas Fed Factory Index: Last: -57.3, WBC f/c: -45.0

Mar 31, Chicago PMI: Last: 34.2, WBC f/c: 36.0

Apr 1, ISM manufacturing: Last: 35.8, WBC f/c: 36.0

Apr 3, ISM Non-mfg: Last: 41.6, WBC f/c: 39.0

  • The regional Fed surveys rose in January, only to unwind those gains in Feb. So far in March, the New York and Philadelphia Fed indices have remained close to their Feb low, but the Richmond Fed index jumped all the way to pre-Lehman levels. The strong gain in durable goods orders for Feb adds to the sense that the Dallas and Chicago factory surveys are more likely to improve than deteriorate.
  • The ISM manufacturing index improved slightly in Feb, and we expect a modest further improvement in Mar.
  • ISM non-manufacturing has further to fall as the economic downturn continues to migrate from manufacturing/ construction/real estate into the broader economy.

European Central Bank to cut 50bps

Apr 2, ECB rate decision: Last: 1.5%, WBC f/c: 1.0%

  • The ECB cut rates 50bps in March and said it expected inflation to remain well below 2% in 2009 and 2010. That was a clear indication of the ECB's intention to cuts rates further, with the only remaining question one of intended timing. Since then, European industrial production and confidence has been awful. Recent ECB official commentary added weight to the notion that the next rate cut will come on April 2.
  • In March Trichet repeatedly noted that the deposit rate was very low. We expect the "corridor" between the deposit rate and the lending rate to be narrowed, with the lending rate falling from 2.5% to 1.5% while the deposit rate stays at 0.5%.
  • We do not anticipate any formal announcement of quantitative easing, although the ECB is sure to reiterate that it is open to the possibility.

US Mar non-farm payrolls sub -600k for fourth month

Apr 3, Last: -651k, WBC f/c: -630k

  • The pace of US job losses accelerated markedly in late-2008, before settling around 650k for the three months from Dec to Feb. The focus of job losses has broadened beyond manufacturing and construction to the services sector.
  • Initial unemployment insurance claims, layoff announcements, consumer job market expectations, and employment indicators from regional Fed indices all indicate that the pace of job losses has continued apace in March. It is too early for recent improved economic data to translate into milder payrolls outcomes.
  • We predict a fourth month below -600k in March. Earlier months may be revised lower, making March look like a slight improvement. Job losses at this pace imply unemployment will continue its inexorable rise, we are picking 8.5%.

Westpac Institutional Bank


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