Monday, December 13, 2010

Revision - Weekly Commentary

Last week saw the RBNZ revise down  its projections for interest rates over coming years, while Fonterra revised up its payout forecast for this season. Meanwhile, overs and unders on sectoral indicators for Q3 left us with no revision to our GDP forecast yet.

The December Monetary Policy Statement indicated that rate hikes are unlikely to resume until the September quarter next year. The near-term economic picture has proven to be much softer than expected:
June quarter GDP growth of 0.2% was well below forecasts, and the RBNZ now  anticipates average growth of just 0.4% in the subsequent three quarters.

On the more positive side, the Canterbury earthquake – while still a negative for the nation’s finances – will go a long way towards filling the hole that was emerging in the construction sector’s order books, something that the RBNZ wasn’t able to incorporate into its previous forecasts in September.
Reconstruction will boost the level of activity over several years, with the peak impact expected to be in late 2011.

These factors were known at the time of  the October OCR review, when the RBNZ seemed to regard them as balanced. But in its latest statement the RBNZ has decided that the weaker starting point trumps the expected boost to growth next year. Even with the economy returning to its potential within the next few years, the cumulative pressure on resources will be less than previously thought, implying less inflation and lower interest rates over the medium term.

However, the RBNZ went even further than this by again lowering its assumption of the ‘neutral’ cash rate – broadly speaking, the rate that is consistent with the economy running at potential, with inflation stable and
expectations within the target range.

Since the RBNZ sees itself returning the cash rate to ‘neutral’ as the economy recovers, this amounts to a lower projected peak in this OCR cycle. The RBNZ now suggests that the OCR will top out at around 4.25% – lower than the trough of previous cycles.

The RBNZ argues that in the post-GFC environment, a 3% cash rate appears to be less supportive than previously thought, therefore the neutral level of the OCR may be lower. The reasoning is fine, but we’re concerned that the RBNZ has ratcheted up this judgement twice in the space of three months. We’re not
convinced that there’s been enough additional information to support the latest change in view – economic data is volatile, and the economy has been buffeted by poor weather, a serious earthquake, and some
major tax changes. We suspect the RBNZ wouldn’t be as eager to revise up its assumption about the neutral rate (which is inherently a long-run concept), if faced with a three-month stretch of stronger economic data.

Nevertheless, the message for now is that the RBNZ will be lifting the OCR  only begrudgingly, and almost certainly not within the next six months. So it’s a small reprieve for borrowers; the decision about when to fix can be put off for a while longer.

Fonterra raised its milk price payment for the 2010/11 season by 30c to $6.90/kg of milksolids, with international prices holding up better than expected. The forecast range for distributable profits was unchanged at 40-50c per share. On its own, the payout increase would be worth around $400m extra in industry revenue.

However, there are increasing concerns about drought this season: north of Auckland has been declared a mediumlevel drought zone, and the Waikato – the largest dairy-producing region – is also very dry. Although national production for the season to date is modestly higher than the same time last season, there have been some notable reductions in production in recent weeks. The net effect is that compared to a month ago, our forecast for industry revenue this season would be around $250m higher.

This week’s GDP indicators were weaker for the September quarter, though that in itself wasn’t a surprise. Residential building activity fell by 5.3%, following an exaggerated 9.7% rise in Q2 that represented a catch-up to the rise in building consents through 2009. Nonresidential building fell just 0.7%, holding up much better than we expected.

However, manufacturing sales fell by 1.4%; we expected to see a small rise in Q3, after outsized declines in some subsectors in Q2. Finally, the terms of trade showed that net exports will make a sizeable negative
contribution to GDP, as we expected.

While agricultural export volumes fell sharply in Q3, the hit to production actually came in Q2; overseas sales were maintained by running down inventories. With that run-down finished, inventories will make a large positive contribution to Q3 GDP.

The highlight for this week is likely to be the Government’s half-year fiscal update. A weaker than expected recovery and a shortfall in tax revenue mean that the operating deficit for the current fiscal  year could reach $11bn, or 5.5% of GDP. Tighter control of spending will be flagged as a top priority for next year’s Budget.

Fixed vs. floating: The RBNZ’s more cautious stance suggests that floating rates will remain on hold for several more months. Fixed-term rates could rise in that time, but only if there is a substantial turnaround in sentiment on the global economy. As a result, there is no urgency to fix right now.
Full report: Revision - Weekly Commentary

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