Sunday, July 5, 2009

Australian & New Zealand Weekly : Medium Term View on Interest Rates

Week beginning 6 July 2009

  • RBA to leave rates on hold.
  • Medium term view on Australian interest rates.
  • RBNZ: signs of stabilisation make further rate cuts unlikely
  • Australian data: jobs, sentiment, housing finance due.
  • US data: non-mfg ISM, trade, cons sentiment focus in light weak.
  • Key economic & financial forecasts.

The Reserve Bank board next meets next Tuesday. There is little chance the Board will decide to change rates next week. In our note last week we pointed out that the two key factors (apart from an unexpected global meltdown) that will influence the Board from this point will be the unemployment rate and the need to support business lending.

The Bank is unlikely to watch a sharp increase in the unemployment rate (we expect our forecast move from 5.7% to 7.5% will be enough) without action particularly given the relative level of our rates.

Customers often ask for a longer term perspective on rates. Below we set out our thinking for the medium term outlook.

The future profile of interest rates will be largely dictated by the timing and the shape of the economic recovery over the next few years.

We expect that growth in the Australian economy will be particularly insipid over the next 18 months. For the second half of 2009 we expect the Australian economy to actually contract at a 1.6% annualised pace and to grow by only 1% in 2010. Thereafter we expect growth can pick up markedly as the massive headwinds from the global financial crisis ease significantly.

For Australia, with considerable excess capacity being accumulated through 2009 and 2010 as the unemployment rate settles around 8% (4 ppts above the lowpoint in early 2008) the economy will be able to react smoothly to a recovery in demand and confidence to more normal levels without pressuring inflation.

However we are suspicious about the current sharp increase in confidence which has many commentators talking about a 'V'-shaped recovery for both Australia and the major economies, the US; Europe and Japan. The clear issues for us are the reliable observations that economies take longer to recover from a recession associated with a financial crisis. That points to the recovery year (2010) being marked by very weak growth although an improvement from the savage contractions of 2009.

Markets are currently priced for central banks taking back a good part of the aggressive rate cuts which they implemented during the financial crisis but we expect that the profile of the recovery will be fragile and central banks will be reluctant to risk 'killing' the recovery before it gains a much more solid foundation than we expect will be likely through 2010. The attitude of central banks is likely to be that mistakes have been made in the past in countries like the US (1930s) and Japan (1990s) in tightening policy too early in the cycle only to see economies fall back into recession - we expect that central banks will view it as better to leave rate hikes as late as possible but then to move swiftly.

For that reason we expect that the Reserve Bank of Australia will keep rates steady through 2010 prior to a rapid move back to 'neutral' in 2011. That is likely to herald the beginning of a 12-18 month cycle of rising rates culminating in rates moving into the contractionary zone (5% - 6.5%) in 2012.

Swap rates have moved too far too quickly in this cycle with current pricing implying a 100-200 bp's increase in the cash rate in 2010. We expect swap rates will ease back over the course of the second half of 2009 as markets become more aware of the "patience" that the Reserve Bank and the US Federal Reserve are likely to exercise in 2010. We expect the unemployment rate to rise by around 2ppt's to 7.5% by the end of 2009. That is likely to be met with a couple of 25 bp rate cuts from the RBA shaking the conviction of swap markets that the RBA will be reversing those moves as soon as early in the following year.

However, through the course of 2010 as the damage from the global financial crisis eases and the national unemployment rate appears to be stabilising, markets will more confidently focus on above trend growth in 2011 and a rapid rate hike response.

Note that when the Australian economy finally emerged from the aftermath of the early 1990's recession with growth prospects approaching 5% the swap rate soared to be over 400 bp's above the cash rate as the market envisaged a very sharp increase in the cash rate. This time we are unlikely to expect such a sharp increase in cash rates so we would envisage a more sustainable 300 bp peak excess of the 3 year swap rate over the cash rate. That peak spread is likely to be reached shortly before the RBA begins its tightening cycle.

The tightening cycle which is expected to begin in early 2011 should last 12 - 18 months. The last tightening cycle (first tightening to last tightening) started in May 2002 and ended in March 2008. That cycle was unusually long. The combination of solid growth without an associated rise in inflation enabled policy makers to run relatively easy policy. However it is generally accepted that during that period central banks kept rates low for too long sowing the seeds of the housing and credit excesses that have since been so devastating for the world economy. Prior tightening cycles were much shorter - 9 months (1999/2000) and 5 months (1994).

We are providing forecasts out to December 2013. The tightening cycle is likely to cover 2011 and into 2012 prior to a period of steady rates through the remainder of 2012 and 2013. The year 2013 is likely to be a year when cash rates are held at their peak. That peak will be below the previous peak of 7.25%. High levels of household gearing, which are not forecast to ease significantly in this cycle, are likely to bite hard when mortgage rates rise by at least 400 basis points. That likely growth slowdown should see markets expecting rate cuts by 2014 and swap rates easing below the cash rate by the end of 2013.

Forecasts (% pa)

Current Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013
Cash Rate 3.0 2.5 2.5 5.0 6.5 6.5
3 Year Swap rate 4.8 4.0 5.5 6.0 7.0 6.0

Australia: Data Wrap

May private credit

  • Credit to the private sector has been weak since late 2008 as national income is hit by the global downturn. Credit contracted outright in May, declining 0.1%, following increases of 0.1% in each of the three months prior.
  • The response of business to the global and domestic recession is coming through. Business credit contracted by 0.7% in the month and declined by 2.3% over the last half year.
  • Housing credit disappointed in May, increasing by 0.5%. While new lending, housing finance is rebounding, existing households are looking to pay down debt more quickly.
  • Going forward, while the RBA's sharp cuts to interest rates will continue to drive an upswing in new lending to the housing sector, we expect credit growth to be constrained by the weak economic environment - in particular, by business cutting back on spending and credit. Tighter lending standards will also be a constraining factor.

May retail sales

  • Retail sales rose 1.0% in May after a 0.3% rise in April and a 2.2% rise in March. Sales are up 7.1%yr. The May result was above consensus forecasts of a 0.5% rise. However, there was a wide range on forecasts for the month reflecting uncertainty over the timing and spending impact of fiscal payments.
  • Despite the continued strength of retail sales and hints of a revival in discretionary spending, the short term outlook is still for a wind back as the fiscal boost to spending ends. June sales should hold up but a 'let down' in the order of 1-2% is likely through July-August, beyond which a modest cyclical revival in spending should become more apparent.

May building approvals

  • May dwelling approvals data were much weaker than expected. Total dwelling approvals fell 12.5% after rising 21.2% in the previous three months. Consensus was looking for a solid 3.3% gain.
  • The May slump was heavily concentrated in private units (including apartments), which plunged 43.6%, the biggest monthly fall on records back to 1983. While this is a volatile segment, the size of the decline suggests difficult funding conditions are again contributing to weakness.
  • Private sector house approvals saw a more modest decline of -2%mth, with the trend in this segment still positive and accelerating, consistent with finance approvals.
  • By state, the falls in private units were heaviest for NSW (-54%mth), Qld (-38.7%mth) and Vic (-34.9%mth). Private houses were flat in NSW and Qld but slipped 0.6%mth in WA and 1.4%mth in Vic.
  • The May approvals report casts a dark cloud over the upturn in new dwelling construction. Much of the fall may be due to volatility and there is a tendency for estimates to be revised up following late returns. However, the scale of the fall in apartment approvals is disconcerting and suggests there is a renewed credit squeeze impacting on activity. This in turn implies a much weaker initial upturn.

May international trade balance

  • The trade deficit was higher than expected, rising from an upwardly revised $282mn in April to $556mn in May (consensus -$125mn, WBC f/c -$700mn).
  • Exports saw further price-driven weakness as we expected, down 5.2% in a month when the RBA AUD commodity price index fell 10.7%, suggesting higher volumes. This volumes resilience is unlikely to persist - note reports today of weakness in Brazil's iron ore exports in June after three strong months. The figures now incorporate an assumed 31% iron ore price fall from March to May. With the AUD non-rural commodity price index down 10.7%mth, non-rural and other exports fell 7.3%, with trend growth a weak -4.5%mth and -3.0%mth for total goods and services.
  • Imports also saw a further price-led fall as expected, and continued to indicate volumes resilience in aggregate after their sharp falls through Q4 2008 and Q1 2009 had taken volumes below levels consistent with the slowing in domestic demand. While imports fell 3.8%, the 7.0% AUD/USD rise would have hit prices more, implying higher volumes. The detail showed falls in all categories, but concentrated in capital goods (-13.8%) reinforcing signals of weak business equipment investment. Trend imports growth was -1.9%mth with consumption goods -0.2%mth and capital goods -2.5%mth on their trends.

Round-up of local data released last week

Date Release Previous Latest Mkt f/c
Tue 30 May private credit 0.1% -0.1% 0.2%
Wed 1 Jun AiG PMI 37.5 38.4 -
May retail sales 0.3% 1.0% 0.5%
May building approvals 4.1% -12.5% 3.3%
Thu 2 May international trade balance, AUDbn -0.282 -0.556 -0.125
Fri 3 Jun AiG PSI 39.9 50.2 -

New Zealand: Week ahead & Data Wrap

Easing off

With the New Zealand economy showing some signs of stabilisation, we have revised our interest rate forecasts and no longer anticipate further OCR cuts in this cycle.

Over recent months the RBNZ will have noted the resilience of activity in developing Asia and Australia, an improvement in credit market conditions, rising business and consumer confidence, a pickup in the housing market, and a strong turnaround in net migration. The latter is particularly important for the RBNZ. Just a few months ago they were forecasting a net inflow for this year of around 6,000; as of May, the annual inflow was over 11,000 and appears set for a net inflow of more than 20,000 this year. While the cause of the turnaround in migration is different from previous cycles - mostly New Zealanders either staying or returning home - history shows that the net flow can have a powerful influence on economic activity.

We acknowledge that there are still substantial risks to an economy that's already a year and a half into recession: the NZ dollar is stubbornly and unhelpfully high, longer-term interest rates have pushed up, swine flu has the potential to extend the recession for another quarter or so, and there is always the risk of another round of upheavals in global financial markets. But in our minds, these are not enough to justify further rate cuts as a central view.

While the market is pricing in rate hikes by early 2010, we think it will be more like the latter part of 2010, as the RBNZ has signalled. Initially, rate hikes will be aimed at taking the OCR back to neutral from extremely low levels, once the economy is on a firmer footing. But the RBNZ has plenty of time on its side - the spare capacity that has built up in the New Zealand and global economies after the prolonged recession will keep inflation pressures at bay for some time.

This week's data releases were generally on the positive side. The trade balance rose to an $858m surplus, the strongest May outturn on record. Exports of primary products performed well, due to stable or stronger commodity prices in NZ dollar terms, while imports were soft (especially fuel and vehicles) due to a mix of lower prices and volumes.

Residential building consents rose 3.5% in May following April's 11.2% increase, with much of the strength coming from apartments. Consents are up 29% from the multi-decade lows seen in January this year, but with net migration on the rise, a further pickup in building activity will be needed to deal with an emerging shortage of housing. Meanwhile, the value of non-residential consents was boosted by large projects for a second month (an airport redevelopment in April and sports stadiums in May).

The Westpac-McDermott Miller employment confidence survey rose from 93.2 to 96.1 in Q2, after taking a pounding in the previous six months. While workers remain very pessimistic about current conditions in the jobs market, they were more positive about the outlook for jobs and pay a year from now. Growing confidence about jobs could translate into consumers taking a less cautious stance in coming months.

The monthly NBNZ business confidence survey rose again in June, moving further away from the record lows seen in the first three months of this year. However, the details were mixed - generally better activity expectations, but parlous profits. The results also varied greatly across sectors - confidence in the construction sector was the highest since May 1999, perhaps reflecting the pickup in the housing market and anticipation of government infrastructure spending. However, the agriculture sector was less confident than in May, following Fonterra's payout forecast of $4.55/kg for the 2009/10 season, which was at the low end of expectations.

Confidence won't have been helped by recent developments in dairy prices. The monthly commodity price index recorded a 3.3% drop in world dairy prices, and Fonterra's latest online auction saw a similar drop - and that's in US dollar terms. The resilience of the NZ dollar in recent months adds further downside risk to forecast payouts to NZ dairy farmers. However, we caution against extrapolating from current conditions in such a volatile international environment. We expect world dairy prices to remain weak for the rest of 2009 as world demand remains soft and stockpiles build in the US and EU, but some reduction in global supply is expected to emerge in 2010. And, notwithstanding the inherent difficulty of forecasting the currency, we do expect the NZD to ease lower in the second half of this year.

The key release next week is the NZIER's Quarterly Survey of Business Opinion on Tuesday. The QSBO is a useful indicator of contemporaneous GDP, though in the last two quarters it has pointed to much worse outcomes than the actual GDP outturns of -1.0%. Some of the difference may have reflected the fact that the survey doesn't cover the agriculture sector, which was a relative bright spot in previous quarters. By the same token, the Q2 survey could be relatively insulated from the recent concerns about dairy payouts. We expect to see an improvement in general business conditions, in line with the monthly confidence survey. The main focus, however, will be around any evidence of further slackening in the labour market and in capacity pressures.

Round-up of local data released last week

Date Release Previous Latest
Mon 29 Jun May merchandise trade NZDm 319 858
May building consents s.a. 11.9% 3.5%
Tue 30 Jun Jun NBNZ business confidence 1.9% 5.5%
Wed 1 Jul Q2 employment confidence index 93.2 96.1
Thu 2 Jul Jun ANZ commodity prices 2.8% 0.2%

Data Previews

Aus RBA policy announcement

Jul 7, Last: 3.00%, WBC f/c: 3.00%

Mkt f/c: 3.00%, Rankge: 3.00% to 3.00%

  • The RBA is expected to again leave rates unchanged at its July meeting. The Bank has been in 'watch and wait' mode since March, assessing the impact of previous aggressive rate cuts. With a recovery gaining traction in the housing sector and evidence of stabilisation abroad the Bank is unlikely to see an immediate need for additional stimulus.
  • At 3%, the cash rate is at an extreme low. Market interest rates are also at historic lows with variable mortgage rates in particular at their lowest levels in 40 years.
  • Despite this, we continue to see the RBA making additional cuts by year end to counter an expected deterioration in labour markets. The timing and size of moves will be a tactical decision but we see 2.5% as the eventual low point.

Aus Jul Westpac-MI Consumer Sentiment

Jul 8, Last: 100.1

  • The Westpac-Melbourne Institute Index of Consumer Sentiment jumped 12.7% in June from 88.8 in May to 100.1. This was the biggest monthly rise in 22 years. The burst of exuberance was mainly due to the release of Q1 GDP figures, which showed a small rise in activity, meaning the economy had dodged recession - or at least its 'technical' definition of two consecutive quarters of contraction.
  • The July survey is in the field in the week ending July 6. Sentiment is likely to be impacted by: some slippage in equities (ASX down over 2% since the last survey); but better than expected retail sales figures for May (+1%) and more signs of firming in housing markets (albeit with a surprisingly sharp fall in dwelling approvals in May). Tax cuts rolled out on July 1. The CBA also increased its floating mortgage interest rate 10bps (though other banks left their rates unchanged). The survey is being conducted before the RBA's rate decision.

Aus May housing finance

Jul 8, Last: 0.9%, WBC f/c: 2.5%

Mkt f/c: 1.3%, Range: flat to 2.5%

  • We're forecasting housing finance approval numbers to rise by a moderate 2.5% in May. However, we're mindful of the risk of disappointment in May given uncertainty at that time. While the boost to the first home buyers grant has now been extended, on 24 April the Prime Minister said "All good things must come to an end".
  • More generally, the upswing in housing finance is set to continue given extremely expansionary settings, pent-up demand and brisk population growth.
  • New lending to owner-occupiers surged 32% over the eight months to April. Over the last four months, finance to upgraders rose by 16% and to first home buyers by 22%. Investor finance, jumped 15% over the last two months, but is only up 4% since last August.

Aus Jun employment chg

Jul 9, Last: -1.7k, WBC f/c: -30k

Mkt f/c: -20k, Range: -40k to flat

  • Although employment fell only 1.7k in May, full-time was weak (-26.2k), trends continued to deteriorate and the unemployment rate continued its uptrend. Total jobs trend growth slowed to 0.14%yr (weakest since May-93), trend fulltime jobs fell 6.7k (9th consecutive fall) and annual full-time trend growth fell to -1.01%yr (weakest since Oct-01).
  • While signs of turning points in our preferred leading indicators of labour demand saw us bring forward (to 2008Q4) and raise our low point for jobs growth (to -1.6%yr) in the cycle, the indicators remain consistent with a more rapid jobs deterioration over 2009H2 in the interim. Also, despite recent gains, our short-term labour demand indicator points to a fall in 3m MA jobs growth towards -12k from the current -4.4k pace. Hence, we continue to look for near-term weakness, forecasting -30k in June, slowing trend growth to -0.04%yr.

Aus Jun unemployment rate

Jul 9, Last: 5.7%, WBC f/c: 5.9%

Mkt f/c: 5.9%, Range: 5.8% to 6.1%

  • Without a large fall in total jobs to weigh, the participation rate reacted to the prior month's fall in the unemployment rate, rising to 65.5% in May from 65.4%. Stronger labour force growth boosted the impact on the unemployment rate (rose to 5.7% from 5.5%). The trend rate rose to 5.7% (highest since Oct-03) from 5.6%, up from a low of 4.1% in Apr-08.
  • With higher unemployment in May, and a larger fall forecast for June jobs, the participation rate should pull back. However, resilience in female and aged worker participation argues for a less than usual dip. We forecast 65.4% (-0.1ppts). This would partially offset the forecast 30k jobs fall, lifting unemployment to 5.9% (highest since Jul-03). Risks are to the upside from a greater jobs fall and/or more resilient participation rate, with our forecast 5.93% to two decimal places.

NZ Q2 NZIER business confidence

Jul 7, Last: -65%

  • The Quarterly Survey of Business Opinion was extremely weak in the March quarter, with many of the key components at or close to record lows. The survey indicated that firms were starting to feel the pinch from falling global demand, on top of the ongoing domestic recession.
  • Low interest rates, rising net migration and a stabilisation in the housing market have provided some support to domestic activity in recent months, and there are also signs that the pace of contraction in the global economy is slowing. Monthly business confidence surveys have risen sharply from their lows, and we expect the quarterly survey to do the same.
  • Since the QSBO excludes agriculture, it may not fully capture some of the recent negatives for the economy - weak world prices for dairy products and an unhelpfully strong NZ dollar.

Bank of England: no change to rates or QE

Jul 9, BoE Last: 0.5%, WBC f/c: 0.5%

  • The BoE policy committee left rates on hold and made no adjustment to the asset purchase program started in March.
  • Since the June meeting, there has been more evidence, acknowledged by BoE officials, that the economy might soon be bottoming out, even though the Q1 GDP contraction was revealed to be substantially deeper than first estimated (-2.4% vs -1.9% originally). Officials have also been musing about eventual policy tightening though that is still a long way off. The BoE's July quarterly credit survey found improved credit availability.
  • Although the BoE still has a further £25bn of asset purchases it could announce without Treasury consultation, we suspect that won't happen before the August forecasting round, if at all, and rates will definitely not fall any further.

US May trade deficit to widen further.

Jul 10, Factory Last: -29.2, WBC f/c: -30.5

  • The trade deficit widened for the second month in April, as exports fell more sharply than imports, despite rises in both import (mainly oil) prices and export prices. The underlying volumes picture was soft on both sides of the ledger, indicating ongoing weakness both in US and trading partner demand.
  • In May, import prices rose a steeper 1.3% but volumes likely slipped further, although export prices also posted a steeper (but lesser) 0.6% gain. Durable goods shipments were down a fairly sharp 2.1% in May, but the export component of the ISM factory survey was significantly less weak and Boeing reported increased foreign sales that month.
  • Assuming a 1% import rise, and flat exports, the deficit will widen by $1.3bn to $30.5bn in May.

Westpac Institutional Bank


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