Sunday, April 19, 2009

Australian & New Zealand Weekly : Policy Outlook Inconsistent with Market Pricing

Week beginning 20 April 2009

  • Australia: policy outlook inconsistent with market pricing.
  • RBA Governor Stevens speaks Tuesday.
  • Australian data: Q1 PPI, CPI dominate in quiet data week.
  • US: home sales and durable goods orders previewed.
  • Key economic & financial forecasts
Next week we will receive the next read on inflation with the CPI and PPI for the March quarter being released. We expect to see headline inflation register a 0.9% increase in the quarter up from minus 0.3% in the December quarter which will reduce annual inflation from 3.7% to 3.3%. The Reserve Bank's preferred measure of inflation - the average of the trimmed mean and the weighted median is also expected to increase by 0.9% from 0.7% in the December quarter to lower annual underlying inflation from 4.4% to 4.0%.

The reversal in the headline number is partly explained by petrol which 'only' fell by 7.5% compared to the 18.2% fall in the December quarter. Note also that the headline measure of inflation is not seasonally adjusted and there are the normal large seasonal increases in utilities; public transport; education and pharmaceuticals which will contribute to the higher read for the headline measure.

However, we are also looking for an increase in the underlying price pressures in the March quarter. This is due to the lagged effect of the fall in the Australian dollar through the second half of 2008; the heavy discounting that occurred in the December quarter; some upward price pressures associated with retailers' anticipation of consumer spending associated with the fiscal stimulus and resilient retail deposit rates as banks competed aggressively for household deposits.

This increase in quarterly inflation is unlikely to disturb the Reserve Bank. There will still be a solid fall in annual underlying inflation from 4.7% six months ago to 4%. That is still outside the Bank's target zone of 2-3% but it must be pointed out this fall has been achieved at a time when the AUD has fallen by around 30%. With the labour market weakening and demand contracting, wage and price pressures will continue to ease through 2009. A year ago the quarterly underlying measure for the March quarter printed 1.3%. The fall through 2008 in the quarterly measure to 0.9% in the March quarter 2009 indicates that the required fall to an average of 0.7% in the final three quarters of 2009 seems easily achievable. That would see the Reserve Bank achieve its forecast of 3% annual increase in underlying inflation 2009.

Inflation data is highly unlikely to affect policy decisions through the course of 2009.

However we are perplexed by the current state of market pricing for official interest rates over the course of 2009 and 2010. Markets continue to expect that the lowpoint in the current rate cycle will be 2.5% - above our current target of 2% (to which we attach downside risks). That lowpoint will be largely determined by the success of the rate cuts in feeding into private sector borrowing costs. Around 40% of banks' funding costs are affected by the bank bill rate but the remainder are determined by retail deposit rates (40%) while around 20% of funding costs are independent of market rates (capital; non interest bearing deposits).

With banks focussed on growing retail deposits the lower pass through of rate cuts to private borrowing rates is to the benefit of retail depositors. (We assess that retail deposit rates have fallen by only 200-250bps while the Reserve Bank has cut the cash rate by 425bps). A more modest pass through by banks as they attempt to hold up deposit rates may allow them to continue passing through rate cuts for longer allowing the Reserve Bank to consider reducing rates below our 2% target.

We should not lose sight of the fact that banks have passed through around 375bps of the 425bps of Reserve Bank rate cuts. Our research indicates that housing affordability in Australia has improved by as much as has been the case in the US and UK. However 70% of that improvement has been due to lower mortgage rates and only 11% to lower prices (18% due to rising incomes). That compares with US (51%) and UK (41%) where price falls have been the dominant factor. In effect, the RBA's success in reducing mortgage rates has eased downside the pressure on prices. An aggressive central bank and a strong banking system are likely to prove to be key reasons why our house prices can continue to be much more resilient to the current global crisis than has been the case in US and UK.

Our second concern with current market pricing is the timing of the up cycle in rates. Markets are currently pricing the RBA's overnight cash rate to start rising in Australia early in 2010 (see chart below) and be up by 100bps by year's end. We don't expect the tightening cycle to begin until near the end of 2010 or even into 2011. We expect that the period of most rapid deterioration in the labour market will be in that 2009H2/2010H1 period when the unemployment rate could rise by up to 3ppts. We would be very surprised if the Reserve Bank saw the need to raise rates at such a tense time for the economy.

Certainly the labour market can be seen as a lagging variable but those lags can be expected to be more apparent near the end of 2010 and into 2011 when the unemployment rate is likely to still be rising albeit at a much slower pace. "Lead" variables such as building approvals; share prices; credit growth; can all be expected to have "turned" through late 2009 and into 2010 but we expect that central banks globally will favour the approach of delaying the tightening cycle as long as possible to be entirely sure that they do not disturb a fragile recovery.

For example, in the case of Australia we have already observed how important rate cuts have been to improving housing affordability and reducing the risks to house prices. A reversal of that improvement at a time when unemployment is rising quickly would risk a very painful deterioration in the housing market; deter both investors and new owner occupiers and risk a damaging negative wealth affect.

The policy of waiting longer but moving quickly to restore rates to neutral points to around a 300bp rate rise over the course of 2011. Central banks will recall the "Greenspan mistake" of only tightening in 25bp steps in 2004/05 which established a solid liquidity base to fuel the subsequently devastating housing boom.

As we move through 2009 we expect markets to gradually push out the timing of rate hikes although they will also move towards pricing in a much more rapid move back to neutral (around 5%) once the tightening cycle begins.

Australia: Data Wrap

Mar NAB business survey

  • The latest survey reported some improvement in March.
  • The business conditions index rebounded a little but remained very negative, rising 2.8pts to -16.8 and still points to a contraction in domestic demand with the risk that the business conditions index softens a little further in coming months.
  • Business confidence recovered for the second month, after collapsing to a record low of -31.6 in January. The index rose by 9.4pts to -12.5. That was against the backdrop of increased optimism on global markets - most notably equity markets. Despite this we would still expect to see businesses cutting back on investment and hiring, notwithstanding this partial rebound in confidence.

Feb Westpac-MI Leading Index

  • The annualised growth rate of the Westpac-Melbourne Institute Leading Index, which indicates the likely pace of economic activity three to nine months into the future, was -5.1% in February well below its long term trend of 2.9%. The annualised growth rate of Coincident Index was 0.7%, also well below its long term trend of 3.4%.
  • The Index continues to signal that the Australian economy will enter a recession. The consistent run of negative reads for the growth rate is comparable with Australia's previous recessions which began in 1961, 1974, 1982, and 1990. However, the rate of deterioration of the growth rate of the Leading Index this time is remarkable and points to downside risk to the growth outlook.

Q1 international trade price indexes

  • Export prices fell 4.6% in Q1 after a 15.9% surge previously, as weaker global commodity prices came home to roost without a significant valuation offset from the AUD. The fall was led by metalliferous ores and metal scrap, non-ferrous metals and petroleum, with partially offsetting gains in coal and gold.
  • Import prices were weaker than expected, falling 2.8% in Q1 after a 10.8% jump previously, led by weaker than expected mineral fuels (-32.5%). Food and beverage prices also pulled back somewhat (-3.0%). Abstracting from these non-core items, core import price pressures were actually higher than expected, rising 1.8%qtr (imported weighted AUD TWI fell only 0.6%), likely reflecting some residual pressures from the currency's sharp fall in Q4.
  • The data has no implications for our Q1 CPI forecast - although the residual pressures in core import prices affirm our expectation for less than usual post-Christmas retailer discounting, the main reason behind our forecast higher quarterly underlying CPI pace. However, the downside surprise for the MPI overall has lowered our Q1 PPI forecast to 0.3%qtr and 4.7%yr (from 0.6%qtr, 5.0%yr forecast prior to the data).

Round-up of local data released last week

Date Release Previous Latest Mkt f/c
Tue 14 Mar NAB business survey -19.6 -16.8 -
Wed 15 RBA Head of Financial Stability Ellis speech - - -
Feb Westpac-MI Leading Index % ann'lsd -4.8%r -5.1% -
Fri 17 Q1 export price index %qtr 15.9% -4.6% -3.5%
Q1 import price index %qtr 10.8% -2.8% -0.3%

New Zealand: Week ahead & Data Wrap

Band on the run

Consumer prices rose by a modest 0.3% in the March quarter, bringing annual inflation down to 3%, back (just) within the RBNZ's 1-3% target band. This situation is unlikely to last long - disinflation will be the dominant theme of 2009, and the RBNZ will soon face a breach of the lower edge of the band.

The details of the CPI were much in line with our expectations, with quarterly inflation being boosted by a 1.2% increase in food prices, along with the usual annual increases in tobacco excise tax and education fees. Food price inflation has remained stubbornly high, although we do anticipate some easing over coming quarters. Dampening inflation in Q1 was a 16.5% drop in international airfares, substantially more than the usual seasonal decline. This helped pull down prices in the overall transport group by 1.5%, despite a 3.4% increase in car prices.

The tobacco tax increase and education fee increases helped lift non-tradeable prices by 0.7%, although this was a tick less than we or the RBNZ expected. This is the genuinely weakest quarterly nontradeable result since 2002 (setting aside the second half of 2007, which was affected by government subsidies for healthcare and early childhood education).

A 0.1% downside surprise on non-tradeables inflation is hardly earthshattering news for the RBNZ, but it is interesting to note that the housing components were soft across the board. Rents rose just 0.3%, property maintenance costs were up 0.2%, while the purchase of new housing component was flat. Meanwhile, prices for real estate services fell 1.1%. The long-sought easing in housing-related inflation has now arrived.

All told, quarterly inflation was slightly below the RBNZ's forecast of 0.4%, and while current inflation is not that important for monetary policy decisions, at the margin the mild downside surprise is another tick in the box for delivering further interest rate cuts. The more important consideration is that the deepening recession is rapidly creating a significant degree of slack in the economy, which is expected to keep inflation subdued around the bottom end of the RBNZ's target band through 2009 and 2010. It is this outlook that suggests the RBNZ should not be shy in delivering further cuts to the OCR. We continue to expect a 50bp cut at the 30 April review, a view that is increasingly shared by the rest of the market.

The release of the OECD Economic Survey of New Zealand garnered some market attention on Thursday. The OECD projected a sizeable 2.8% contraction in the New Zealand economy this calendar year - consistent with their pick for a 2.7% contraction in the global economy, one of the gloomiest predictions out there. The report also noted that NZ is in a particularly difficult position in the current global crisis, having already entered recession in 2008 and being highly reliant on offshore funding.

With regard to policy, the report stated that: "Given the risks to the government's credit rating and to market confidence and the heavy dependence on foreign debt funding, there is little room for more fiscal expansion... monetary policy should be the primary tool used to provide further stimulus." While this is not a new opinion, it is one that is increasingly being expressed (the IMF made similar comments after its ‘Article IV' consultation last month). While the RBNZ has been counting on a weaker currency and the fiscal stimulus already in train to provide the necessary support for the economy, the ball is now firmly back in their court.

The other data release this week was retail sales, which rose 0.2% in February. However, the gains were largely in fuel, with petrol prices up 16% for the month. Sales of durable goods remain under pressure, especially cars, which fell another 3.2% in the month after a 12% drop in January. Furniture and floor coverings, appliances, hardware, and department store sales are also well down on a year ago.

Against a backdrop of declining job security and reduced earnings expectations, consumers are being prudent in their spending decisions. How long the save-rather-than-spend mentality will dominate remains to be seen, but our recent consumer and employment confidence surveys suggest it will be a while yet. We expect real consumer spending to remain weak throughout 2009, with any sustained pick-up unlikely before the end of the year.

The data calendar turns quieter next week, ahead of the 30 April OCR review. The most notable release is external migration on Tuesday, and while this is generally not a market-mover, it is a significant factor in the RBNZ's forecasts. Net inward migration has turned upward again, with a particularly large jump last month, with more New Zealanders staying (or returning) home as job prospects in the UK and Australia dry up. We expect the annual inflow to reach more than 10,000 by the end of the year - well short of the 42,000 peak in mid-2003 that helped to fuel the housing boom, but a substantial positive for growth nonetheless.

Round-up of local data released last week

Date Release Previous Latest
Tue 14 Apr Feb retail sales -1.2% 0.2%
Fri 17 Apr Q1 CPI %qtr -0.5% 0.3%
Mar food prices 0.2% 0.5%

Data Previews

Aus Q1 PPI

Apr 20, Last: 1.3%, WBC f/c: 0.3%

Mkt f/c: 0.6%, Range: -0.9% to 1.1%

  • The Q4 PPI jumped 1.3%qtr to be up 6.4%yr. Non-core items subtracted 0.52ppts with weaker petroleum partially offset by a 3.1% jump in food. The key driver of the headline strength was core import prices which surged 16.9% as the AUD MTWI fell 18.5%. However, domestic core pressures eased, with the domestic core PPI ex-construction and utilities up 0.9%qtr (weakest since 2007Q4) vs 1.2%qtr previously.
  • The core PPI should be far more subdued in Q1, with the more stable AUD reducing core import PPI price pressures, and a further easing in the domestic core PPI ex-construction to 0.7%qtr despite seasonally stronger utilities, amidst weak demand. This gives a far softer overall core PPI 0.9%qtr (vs 2.3%qtr prev). Food prices should rise a tamer 0.5% and with petroleum down 20%, the total PPI forecast is a subdued 0.3%qtr, slowing the annual rate to 4.7%yr from 6.4%.

Aus Q1 CPI

Apr 22, Last: -0.3%, WBC f/c: 0.9%

Mkt f/c: 0.5%, Range: 0.1% to 0.9%

  • Our Q1 CPI forecast is 3.3%yr (vs 3.7%yr prev). Drivers of the higher quarterly pace inc: seasonal rises, exacerbated by the NSW Mini-budget, inc. public transport, tolls, CTP premiums, education, pharmaceuticals, electricity; a lesser fall in petrol (-7.5% vs -18.2%); stable cars after -2.4% in Q4 (w/s prices up Q1); and less than usual post-Xmas discounting due to a pull forward into Q4 and some retailers capitalising on the fiscal handouts to attempt to claw-back some of the strong import price pressures from Q4.
  • Our avg RBA underlying CPI forecast is 0.9%qtr, 4.0%yr (vs 0.7%qtr, 4.4%yr prev). The higher qtly pace is a function of the lower-than-usual post-Xmas discounting, and stronger than usual increases in some seasonal items courtesy of the NSW Mini-budget (eg. education fees, public transport fares).

US Mar existing & new home sales

Apr 23, Existing home sales: Last: 5.1%, WBC f/c: -1.5%

Apr 24, New home sales: Last: 4.7%, WBC f/c: 0.9%

  • Existing home sales have been volatile for the past four months, alternating between falls and rises greater than 4%. Given that February was a 5.1% increase, some pullback seems inevitable for March. However, looking through the volatility our forecast represents some consolidation or even trend improvement in house sales. Mortgage rates have fallen and lending has freed up a little, which combined with lower prices, may be tempting a few more buyers into the market.
  • New home sales are now running at less than a quarter of their peak 2005 level, with last month's 4.7% increase but a tiny concession to this brutal trend. With sales now so low, it is becoming hard to envisage them falling much further. But with so many near-new existing homes for sale so cheaply, it is also hard to envisage an aggressive rally in new home sales.

US Mar durable goods orders to pull back slightly

Apr 24, Last: 3.4%, WBC f/c: -0.3%

  • Durable orders bucked their recent trend with a surprise 3.4% increase in March, although that was only a partial recovery from the 7.3% fall in January. The Feb increase was exaggerated by military orders, although there was also a broad-based improvement across other categories. Ex-defense orders rose 1.7%, despite volatile non-defense aircraft orders falling.
  • For March we expect a small fall in most categories. Orders for civilian cars almost certainly increased from a low base, but the overall transport category may fall on reduced military orders. Military orders will likely fall after February's fall. However, civilian aircraft orders may rise.
  • Putting all this together we expect a small fall in durables goods orders, consistent with surveys suggesting the pace of deterioration in factory production is easing.

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