Sunday, April 26, 2009

Australian & New Zealand Weekly : CPI Reveals Dramatic Squeeze on Bank Margins - Questions Capacity to Pass on RBA Rate Cuts

Week beginning 27 April 2009

  • Australia: CPI reveals dramatic squeeze on bank margins - questions capacity to pass on RBA rate cuts.
  • Australian data: a quiet week with RBA private credit data due.
  • New Zealand: RBNZ to cut OCR 50bp to 2.50%, but statement important for longer-term rate expectations.
  • New Zealand data: business confidence, merchandise trade and building consents.
  • US data focus: consumer confidence, advance Q1 GDP, ISM manufacturing and factory orders.
  • US FOMC: statement to most likely maintain the status quo, but could speak of some stabilisation.
  • Key economic & financial forecasts.

Last week's data releases were dominated by the CPI for the March quarter. The headline number (0.1%qtr) was well below our forecast of 0.8% but this discrepancy was entirely due to the item "deposit and loan facilities". That component fell by 14.1% - a staggering move in the quarter for any component of the CPI and contributing 0.66ppts of the 0.7ppts by which we missed with our forecast.

Naturally that component did not figure in the Trimmed Mean CPI (one of the RBA's two preferred measures of underlying inflation) which gives the measure after eliminating those items that explained the top and bottom 15% of moves after adjusting for weights. The Trimmed Mean actually registered higher than our forecast (1.0%qtr vs 0.8%) and the fair conclusion from the release is that underlying price pressures were a little stronger than we had anticipated despite the plunge in the headline measure. The combination of the lagged effects of the 30% fall in the AUD/USD through the second half of 2008 and reduced discounting, possibly in anticipation of the spending of fiscal stimulus packages, seems to explain most of the slippage.

However, we have maintained our view on monetary policy for the remainder of the year.

True, with a 1.1%qtr read for the March quarter (average of the trimmed mean and weighted median CPI) it will now be difficult for the RBA to achieve its 3% annual underlying inflation forecast for 2009. That will require an average of around 0.6% per quarter (down from 1.1%) for the remainder of the year. Certainly the lagged effect of the currency depreciation will fade and the slowdown in wage and demand pressures will see the underlying inflation rate moving in the right direction. Certainly housing costs (the largest component of the CPI) and holidays (down 4.5% in Q1) are pointing to powerful downward pressures associated with demand that can be expected to remain a big drag on inflation through 2009.

Probably the most important aspect of the CPI result from a policy perspective was the plunge in the "deposit and loan facilities" component. That component was incorporated in the CPI in 2005 to try to capture the interest rate effect on inflation without the interest rate feeding directly into the Index.

This is an unusual measure which the Bureau of Statistics has developed to measure the 'price' of retail financial services. Essentially the methodology is to sample banks deposit and loan rates and take a mid point. The price of deposit services is assessed as the difference between the mid point and deposit rates. The price of loan services is measured as the difference between the mid point and loan rates.

If the spread between loan and deposit rates narrows it means that either the price of deposit services has fallen or the price of loan services has risen or, as was the case in the March quarter, a substantial change in the relativities (spread contraction).

The staggering 14.1% fall in this item in the March quarter indicates that the extent of the fall in inflation (annual inflation fell from 3.7% to 2.5%) was largely due to the narrowing of the loan/deposit spread. The key dynamic would have been the full pass through of the 100bp RBA rate cut in February to mortgages and other personal loan products which was not matched by a comparable cut in retail deposit rates.

This is not the first time this series has behaved strangely (up by 9.5% in 2008Q2) although the average move prior to Q1 had been 1.2% and the biggest fall since it was included in the CPI was -2.1%. The large move, however, does emphasise the challenge banks are dealing with by having to compete for retail deposits while keeping the official family happy on the mortgage rate side in a period of falling RBA rates.

This damaging collapse in the retail spreads for banks provides a persuasive explanation as to why the pass through of the latest 25bp rate cut by the RBA was so muted - banks' retail spreads are under pressure.

Readers will recall that a key rationale for our choice of 2% as the low point for the cash rate in this cycle was the level of rates below which the banks would not pass on any further reductions to mortgage rates. It was predicated on the view that banks would want to be competitive in the retail savings market and would be reluctant to push deposit rates below a certain level - the level of deposit rates consistent with a 2% cash rate seemed a reasonable floor.

However the evidence from the CPI indicates that banks may already have reached the point where margins need to be protected and retail deposit rates must be held up.

The bank pass through should NOT be the determinant of how far the RBA can cut. Around 50% of banks' assets are direct housing loans while around 30% of loans would be linked to the bank bill rate. Even with no adjustment to mortgage rates, 'bank bill' borrowers will derive a benefit from lowering the cash rate. Banks themselves fund around 45% of liabilities out of the bank bill/ floating rate swap market and any fall in bank bill rates will benefit funding costs.

With bank funding costs currently rising sharply as 'cheap' pre-crisis term funding has to be replaced with 'expensive' post-crisis term funding, relief in the bank bill/floating rate swap market might avert actual increases in other loan rates, including mortgage rates.

In short, that rate level below which banks are unable to pass rate cuts through to mortgage rates may not define the low point in the cycle.

That leaves open an even lower rate level to define the lowpoint in the cycle. We are happy to retain our target rate of 2% with downside risks, with the flexibility to fall further not being restricted by the pass through capacity of the banks.

Our target of 2% by 2009Q4 is consistent with our growth profile of a contraction of 1% in GDP in 2009. Thursday, the IMF produced its latest forecast that GDP would contract by 1.4% in 2009 - more pessimistic than our view and weaker than the lowpoint in the previous recession in Australia when the economy contracted by 1.3% in 1991. A likely quarterly profile that would be consistent with the IMF's forecast would see the Australian economy contracting in the second half of 2009. In contrast our forecast envisages a return to anaemic but nevertheless positive growth in the second half of 2009. With business investment, employment, inventories and exports still contracting, despite some early stability in new housing construction and consumer spending, there would be ample justification for the RBA to cut rates through the end of 2009.

A profile envisaged by the IMF with the overall economy continuing to contract in the second half of 2009 would probably see the RBA cutting below our 2% target.

Australia: Data Wrap


  • Q1 Final Stage PPI inflation was well below consensus at -0.4%qtr (consensus +0.6%, Westpac +0.3%), cutting the annual rate to 4.0%yr from 6.4%, the lowest since 2007Q4.
  • Non-core elements subtracted slightly less from the PPI than expected, with weaker than expected food prices (fell 0.9%, subtracting 0.15ppts) but a smaller than expected fall in petroleum refining prices (fell 9.0%, subtracting 0.22ppts), giving a net 0.38ppt subtraction from the quarterly PPI.
  • The 0.9% fall in food prices followed a 3.1% rise previously. While CPI food prices are more margin dependent and not well correlated with PPI equivalents, the easing of PPI food price pressures suggests some downside risk to food within the Q1 CPI (our f/c is 1.8%qtr vs 2.0% prev).
  • Ex-food and petroleum, the core PPI was very subdued, despite some latent import price pressures from the currency's sharp fall in Q4. The core PPI was flat%qtr (weakest since 2003Q4) slowing the annual rate to 5.2%yr from 6.8%yr previously.
  • Although the AUD import weighted TWI fell 0.6%qtr in Q1 and the core MPI rose 1.8%qtr, core imports in the PPI were stronger, rising 4.8%qtr.
  • Abstracting from import pressures, domestic core pressures eased markedly, even outside of particular weakness in building construction output prices. The domestic core PPI ex-construction and utilities was -0.3%qtr and 3.0%yr (vs 0.9%qtr, 4.5%yr prev), the weakest quarter since we began this subset in 2002.
  • Building construction prices were -1.6%qtr. With house construction output prices -0.5%qtr, our CPI house purchase forecast has been revised to -0.5%qtr (from 0.6%).


  • The headline CPI was weak in Q1 at 0.1%qtr (vs -0.3% prev). The result was below consensus (0.5%) and the bottom of the forecast range (0.2%). This took the annual headline inflation rate to 2.5% from 3.7% previously, the lowest since 2007Q3.
  • However, the headline result was well below our forecast courtesy of greater than expected price falls in just two areas - deposit and loan facilities, and holidays. These alone detracted 0.86ppts from the quarterly headline CPI pace. Deposit and loan facilities plunged 14.1%qtr (vs -1.9% prev) despite a similar proportional fall in mortgage rates to Q4, implying markedly greater pressure on bank margins from deposit rate competition.
  • The dominance of the heavy downward bias to the headline CPI from just two areas was also reflected in much higher than expected underlying CPI results. Large price falls in deposit and loan facilities, petrol and holidays dropped out of the trimmed distribution, while stronger than usual pressures in many items of discretionary retailing and increases in seasonally adjusted education were in the trimmed mean. We calculate the average of the RBA trimmed mean and weighted median measures was 1.07%qtr (consensus 0.8%), up from 0.74%qtr previously, providing only a slight fall in the average annual rate to 4.21%yr from 4.35% previously.
  • The main positive headline contributions were from pharmaceuticals, rents, secondary education fees, vegetables and electricity. These were largely offset by falls in deposit and loan facilities, petrol, domestic holidays and overseas holidays.

Round-up of local data released last week

Date Release Previous Latest Mkt f/c
Mon 20 Q1 PPI %qtr 1.3% -0.4% 0.6%
Tue 21 Mar merchandise imports, AUDbn 16.6 17.3 -
Apr RBA Board meeting minutes - - -
RBA Governor Stevens' speech - - -
Wed 22 Q1 headline CPI %qtr -0.3% 0.1% 0.5%
Q1 avg RBA underlying CPI %qtr 0.7% 1.1% 0.8%
Thu 23 Mar motor vehicle sales -4.0% -3.2% -

New Zealand: Week ahead & Data Wrap

The long game

Markets will be intensely focused on what the RBNZ has to say at next Thursday's OCR review, following a rate cut in March that actually kicked off a substantial tightening in financial conditions.

The outlook for the global economy has continued to deteriorate since the March Monetary Policy Statement. The latest growth forecasts by the IMF suggest that New Zealand's major trading partners will contract by 2.8% this year and grow by just 0.8% in 2010 - this compares to the RBNZ's March forecasts of -1.8% and +1.6% respectively. Forecasts for the Asia-Pacific region, which was previous expected to be relatively resilient, are now being revised down heavily.

This bodes poorly for any near-term recovery in the New Zealand economy, which is already starting from a weaker point than the RBNZ assumed. GDP fell by 0.9% in the December 2008 quarter, against the RBNZ's forecast of a 0.8% decline, and we think they will revise down their forecast of a 0.8% drop in Q1 as well. The latest Quarterly Survey of Business Opinion will have reinforced the sense that Q1 was at least as difficult as Q4 - indeed, without the contributions of agriculture and government (which are not covered by the QSBO), GDP in the last two quarters could have been on a par with some of the horrific outturns seen overseas.

On top of this, financial market developments have been less than helpful. In March the RBNZ was fairly cautious about the scope for further interest rate cuts, but their forecasts did rest on an easier mix of monetary conditions - largely through a weaker exchange rate. Instead, the New Zealand dollar has risen in recent weeks, and is currently tracking around 10% above the RBNZ's projections.

Of more concern is the sharp rise in long-term interest rates. The smaller than expected 50bp rate cut and weak easing bias in March initially pushed interest rates higher, which borrowers read as a signal that rates have passed the bottom of the cycle. This created a wave of demand to lock in fixed-term rates at what were historically low levels, which saw long-term swap rates rise by more than 100bp at one stage. This was of such concern to the RBNZ that on 1 April they issued a statement that “the rise in longer-term interest rates is unwarranted and inconsistent with the monetary policy outlook” - the first time in over ten years that they have given explicit guidance to the market in between OCR reviews, and a clear indication that things aren't going to plan.

On a more positive note, net inward migration has picked up markedly in recent months, with fewer New Zealanders heading overseas as job prospects in Australia and the UK deteriorate. The RBNZ's last projection was for a net inflow of 5,700 this year, but with the annual pace already running at 7,500, they may revise their forecasts to as much as 15,000. Activity in the housing market has also picked up in recent months, though it has taken record-low mortgage rates just to achieve this modest rebound. And world prices for milk powder exports have bounced from their lows, though nowhere near enough to justify the recent gains in the NZ dollar.

On balance, the economic picture is even weaker than expected in the March MPS, implying a strong economic case for a 50bp rate cut next week. However, we admit that tactical considerations make this a much closer call between 25bp and 50bp. The RBNZ believe that there are consequences in taking the OCR to very low levels. The March press release noted that “New Zealand needs to retain competitiveness in the international capital markets”, implying that rates among New Zealand's peers (specifically Australia) may be a constraint on policy settings here. If that is the case, it means that the RBNZ has very little firepower left - they may prefer to hold some back, giving them room to respond to weaker economic data as it arrives later in the year.

The more important part of next week's statement may be how the RBNZ deals with keeping longer-term interest rate expectations in check. It's widely recognised that central banks have little direct control over long-term interest rates, but they can have a strong indirect influence, by clearly signalling their future policy intentions to the market. But what the market took from the March MPS was that the cash rate was unlikely to go much lower in the near term, and was expected to start rising again by mid-2010. No rate hikes for a year is certainly “an extended period” in real time, but when it comes to determining, say, a five year borrowing rate, it's not a long time at all.

The RBNZ faces a difficult balancing act in conveying to the market that interest rates will remain low for as long as necessary, without committing to a specific timetable (as a couple of central banks have done recently). But at the least, we think they will need to make it clear that interest rates are likely to be lower, and for longer, than anticipated in the March MPS.

The other data of note next week are business confidence, merchandise trade and building consents. We have revised down our near-term GDP forecasts and now expect another very weak outturn of -1% in the June quarter; this would be consistent with business confidence remaining at the historic lows seen in recent months. The trade balance is expected to improve further due to falling import demand, and building consents are expected to remain close to record low levels.

Round-up of local data released last week

Date Release Previous Latest
Tue 21 Apr Mar external migration ann. 6,160 7,482
Thu 23 Apr Mar credit card transactions 0.3% -3.1%

Data Previews

Aus Mar private credit

Apr 30, Last: 0.0%, WBC f/c: 0.2%

Mkt f/c: 0.3%, Range: -0.1% to 0.5%

  • Private credit growth is slowing as the economy contracts. We're forecasting a rise of just 0.2% in March.
  • With credit unchanged in February, three month annualised growth has eased to 1.4%. With business expected to lower investment expenditure the outlook is for soft credit growth.
  • On the plus side, housing credit growth is improving as new lending (housing finance) recovers in response to very low interest rates now in place, boosted by the First Home Owners' Grant.
  • Business credit declined by 0.6% in February and further declines are in prospect given the current economic backdrop. That said, monthly movements for this segment are volatile. It would not surprise to see a temporary lift in March, following the particularly soft February reading.

NZ Mar merchandise trade NZDm

Apr 29, Last: 489, WBC f/c: 450:

  • We expect a seasonal pickup in exports to $3.83bn, masking a gradual decline in the underlying trend as trading partner demand cools.
  • Imports are expected to rise to $3.38bn, which would still leave them down 3% on a year ago. Car imports rose in March after two exceptionally weak months, though the increase was skewed towards lower-value used cars.
  • We expect the annual trade balance to improve further this year, as imports are dragged down by weak consumer spending and falling business investment.

NZ Apr NBNZ business confidence

Apr 29, Last: -39.3%

  • Own-activity expectations remained at record lows in the March quarter, broadly consistent with a 1% quarterly contraction in GDP. We expect this survey to signal a similar contraction in Q2 as well.
  • Monetary conditions have tightened considerably since the mid-March Monetary Policy Statement, consumer spending remains soft, and anecdotally, firms are shedding staff at a growing pace.
  • However, a stabilisation in commodity prices and rising house sales offer glimmers of hope for some sectors.

NZ RBNZ OCR review

Apr 30, Last: 3.00%, WBC f/c: 2.50%, mkt f/c: 2.50%

  • The economic outlook has worsened since the March Monetary Policy Statement. Global growth forecasts continue to fall, and financial conditions in New Zealand have tightened when the RBNZ expected them to ease.
  • There is a strong economic case for a 50bp cut next week, but other considerations make it a close call between 25bp and 50bp.
  • We think the RBNZ will need to strengthen their commitment to keeping interest rates low for an extended period, if they want to keep a lid on longer-term rates.

NZ Mar building consents s.a.

Apr 30, Last: 11.6%, WBC f/c: 0.6%

  • Dwelling consents bounced off their lows in February, largely as a result of a surge in apartment consents - an area that has been seriously lacking over the past year. Even so, dwelling consents remain close to multi-decade lows.
  • House sales are a good leading indicator of residential consents, and have clearly lifted off the bottom since the beginning of the year. That points to a pick up in consents over the next few months. We expect a 0.6% rise in total consents in March, on the assumption that ex-apartment consents build on the gains in February.
  • The trend in non-residential consents has been tracking lower since November last year, although the pace of decline has accelerated in the past couple of months. Business surveys point to a continuation of this trend in March.

US Q1 GDP advance

Apr 29, Last: -6.3% annualised, WBC f/c: -5.0% annualised

  • Although the US economy was in mild recession for most of last year, the pace of output decline steepened sharply in Q4, when the economy contracted 6.3% annualised, its weakest quarterly performance since 1982. Falling consumer spending explained about half of the decline, with business investment and housing retrenchment most of the rest.
  • Partial data point to another contraction in growth in Q1, but less steep than in Q4, mainly because consumer spending on durables looks to have stabilised, and other discretionary spending has benefitted from lower gasoline prices. Housing will again fall steeply but its impact on the GDP bottom line is less as it is such a small part of the economy now. Business investment spending is expected to have fallen even faster in Q1 (based on slumping orders and shipments). Inventory rundown is also likely to be a big drag on growth.

US FOMC rate decision

Apr 29

  • Following the March 18 FOMC meeting the Committee once again stated "that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period".
  • That will certainly remain the position following the April 29 meeting, though the statement may note some tentative evidence that activity may be stabilising at very weak levels in some sectors.
  • Also in March, the Fed finally stated that it was prepared to buy longer term Treasuries if considered appropriate, ending months of will they/won't they speculation.
  • The April 29 statement will most likely maintain the status quo - steady rates at close to zero; preparedness to "employ all available tools", but nothing new is expect to be announced.

US Apr ISM factory report

May 1, Last: 36.3, WBC f/c: 38.5

  • The factory ISM hit its low of 32.9 in Dec 2008, then recovered modestly to the 35-36 region through Q1 this year, still consistent with a rapid pace of industrial sector decline (official IP data averaged falls of 1.7% over the last five months).
  • The Fed surveys from the NY and Philly districts appear to have bottomed out early this year and both were significantly higher in April. This suggests that the national ISM should post a further gain in April, though continued weakness in the jobs component is to be expected.
  • Prior to the national ISM, watch for the Dallas and Richmond regional Fed indices on Monday 27/Tuesday 28 and the Chicago PMI on Thursday 30, all of which we expect to improve somewhat - but don't confuse improvement with strength: these surveys are all still pointing to declining output.

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