Wednesday, 19 February 2014 21:21

RBA Minutes - rates on hold for now

BillEvans_small_headshot_WIBIQThe minutes of the February 4 RBA Board Meeting confirmed that the Bank now has a neutral bias and has desisted from further talking down the AUD. On interest rates: "the most prudent course would likely be a period of stability in interest rates". Whereas in the December Board minutes the AUD was described as "uncomfortably high" the language used early in 2013 has been restored with "the exchange rates has also depreciated further since the December meeting. If sustained, a lower exchange rate would be expansionary for economic activity and would assist in achieving balanced growth of the economy". Of course that fall has not been sustained with the AUD around US 91c at the time of the December Board meeting falling to US 88c at the time of the February Board meeting but now having rebounded to around US 90.50c, only slightly below the "uncomfortable level" at the time of the December Board meeting.

Commentary around the domestic economy is generally upbeat. Consumption, dwelling investment, business conditions and exports are described as being "more positive". In fact the minutes note that "survey measures suggested that business conditions had improved noticeably in recent months, to be above average levels". Of course the labour market was still described as weak but this was partially dismissed by describing the labour market as a lagging variable. Consistent with that theme, and, in line with the view around spending, the minutes note that the forward looking indicators of labour demand had shown signs of stabilising although were described as "consistent with only moderate growth of employment". There appears to be little consideration in this analysis of the feedback effects from a weak labour market to household confidence and incomes. Indeed the Bank expects that the rise in house prices will boost spending leading to falls in the savings rate.

The unexpected increase in inflation clearly played an important role in discussions. Four different explanations were given for this lift with interestingly the first one mentioned being "an element of noise that occurs in economic data". Other explanations related to: the faster than normal pass through from the lower exchange rate: "a slower than expected pass through from weak wages growth"; and finally the possibility that there was less spare capacity in the economy enabling retailers or wholesalers to increase their margins. The Bank concludes that it was not possible at this stage to distinguish these explanations and it was likely that some combination of these four explanations was at work.

A number of vulnerable remarks appear in these minutes. Firstly, the 3% decline in consumer sentiment back to average levels made the comment "consumer sentiment had recorded a modest decline around the end of 2013" somewhat out of date. A more disturbing issue was around the Bank's forecast for growth of Australia's trading partners which is expected to increase to be above average in 2014. It would be our view that with Chinese growth likely to decelerate this growth outlook seems overly optimistic.

Conclusion

There are no significant surprises in these minutes. If the Bank had decided to continue talking down the AUD possibly with less strident language than "uncomfortably high" then it is likely to have been covered in the Governor's statement accompanying the decision two weeks ago. With no lead from the Governor it was not surprising that the language around the AUD has reverted back that period in 2013 when there was no explicit effort to talk down the AUD. The Governor also made it clear that policy had been moved to a neutral stance and these minutes confirm that view. There are a number of behavioural assumptions in the minutes. Firstly it is assumed that the labour market will lag economic growth with feedback effects from employment to incomes and confidence tending to be overlooked. It is therefore assumed that the rise in house prices will prompt a marked lift in consumer spending through the wealth effect and therefore a reduction in the savings rate. We tend to be more sceptical around that dynamic given the ongoing attitude of households since the Reserve Bank started to cut rates in November 2011. However we do accept the explanation that the unexpected lift in the inflation rate most likely shows some noise; a faster than expected response to the fall in the currency and a slower response to soft wages growth. With the AUD now stabilising and wages growth remaining soft the wages story is likely to be the dominant driver of inflation through 2014.

Our forecast that the RBA will need to cut rates further in the second half of 2014 clearly hinges on the likely outlook, at that time, for growth in 2015 . Factors that will impact on that outlook will include the ongoing downturn in mining; fiscal consolidation; the impact of a fall in the terms of trade; and two important macro dynamics which the Bank appears to be understating. These are the direct feedback effects on confidence and incomes of the weak labour market and ongoing caution amongst business and consumers.

Bill Evans - Chief Economist - Westpac Banking Corp

DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

Published in Investment Advice
Monday, 06 January 2014 08:43

Fed Tapering - what it means for investors

Wall St ImageKey points

- After much talk since May, the US Federal Reserve is finally reducing (or tapering) its asset purchase program - by $US10bn a month.

- However, the Fed has enhanced its very dovish forward guidance, highlighting that interest rate hikes are still a long way off and dependent on the economy.

- Fed policy remains market friendly & generally supportive of further gains in shares.

- While, Fed tapering and speculation around it has and will contribute to bouts of market uncertainty, it should be seen as good news as it indicates the US recovery is becoming more sustainable.

Introduction

In what was perhaps the most anticipated event this year the US Federal Reserve has announced it will reduce the pace of its third quantitative easing (QE3) program by $US10bn a month. The Fed has been foreshadowing a “tapering” since May 22nd so it’s a surprise to no one. This note looks at what it means for US monetary policy and investment markets.

The Fed tapers

The key aspects of the Fed’s decision to taper are:

  • A cutback in QE from $US85bn a month to $US75bn.
  • This to be focussed on both reduced Treasury bond purchases (which drop from $US45bn a month to $US40bn) and reduced purchases of mortgage backed securities (which drop from $40bn a month to $35bn).
  • Tapering is not a “not on a preset course” but dependent on further economic improvement & higher inflation with Chairman Bernanke implying the wind down will be such that QE will likely continue into late next year, implying an ongoing reduction of about $US10bn in bond purchases each meeting, which is slower than many expected,
  • More dovish guidance on the outlook for interest rates with the Fed indicating rates will remain near zero well beyond the time when unemployment falls below 6.5% and 12 of the 17 Fed committee officials not seeing a rate hike until 2015. In other words the clear message is that tapering is not monetary tightening and does not mean that the first rate hike is any closer.

The Fed’s dovish guidance is significant as Fed research suggests it has greater effects on the economy than signals about asset purchases.* Specifically, it’s aimed at pushing back against rising bond yields as it has led to higher mortgage rates.

Our assessment

The first thing to note is that the Fed’s move is positive as it indicates the US economy is getting stronger and the recovery more self-sustaining and so the US can start to be gradually taken off life support. However, the emphasis is on gradual. It’s quite clear the Fed is still committed to easy monetary policy until more spare capacity is used up. While the economy is on the right path, it’s still got a way to go, particularly with inflation running well below the Fed’s 2% target.

In this regard, tapering is not the same as monetary tightening. Pumping cash into the US economy is continuing but at a slightly lower rate. It’s very different to the premature and arbitrary ending of QE1 in March 2010 and QE2 in June 2011 that went from $US95bn & $US75bn respectively in monthly bond purchases to zero overnight at a time when US and global economic data was poor and contributed to 15-20% share market slumps at the time. This time around QE is only being reduced gradually and only because the economic data shows the US economy improving.

More fundamentally, tapering does not signal earlier interest rate hikes. Quite clearly the Fed has gone out of its way to stress this message by indicating that near zero interest rates will likely remain well beyond the time when unemployment falls below its previous target of 6.5%. Our own view of the US economy is very similar to the Fed’s in seeing growth of around 3% next year driven by housing, business investment and consumer spending. However, barring a much faster acceleration in growth, interest rate hikes are still probably 18 months or more away:

  • Growth is still far from booming.
  • Spare capacity is immense as evident by 7% official unemployment, double digit labour market underutilisation and a very wide output gap (ie the difference between actual and potential GDP).

Image 1
Source: Bloomberg, AMP Capital

  • A fall in labour force participation has exaggerated the fall in the unemployment rate. While much of this is structural some is cyclical and at some point will start to bounce back slowing the fall in unemployment.
  • Inflation is low at just 1.2%.

Comments during her nomination hearings quite clearly indicate that Janet Yellen, the likely next Fed Chairman after Bernanke’s term ends at the end of January, will not be rushing to raise interest rates.

Put simply the Fed may be easing up on the accelerator, but they are a long way from applying the brakes.

Finally, while the US is slowing its monetary stimulus this is not so in other key developed regions with both the ECB and Bank of Japan likely to ease further if anything.

Implications for investors

While the days of expanding US monetary stimulus are probably over, the message from the Fed remains market friendly. The pace of quantitative easing is slowing only gradually, this is contingent on the US economy continuing to strengthen and rate hikes are unlikely until 2015, at least.

For sovereign bonds our medium term view remains one of poor returns. Despite the back up in yields, they remain low relative to long term sustainable levels suggesting the risk of rising yields and capital losses over time as the global economy mends. Even if bond yields stay flat at current levels they offer poor returns, eg just 2.9% for US 10 year bonds and just 4.3% for Australian ten year bonds. However, a 1994 style bond crash which saw extreme long bond positions unwound triggered by a sharp 300 basis point rise in the US Fed Funds rate looks unlikely.

For shares, the period of dirt cheap share markets and support from ever expanding monetary stimulus seems over. More significantly, taper talk since late May has clearly made some nervous given the positive relationship between rounds of quantitative easing in the US and share markets, with many fearing that a move to end it will be followed by slumps as occurred after QE1 and QE2 ended. See the next chart.

Image 2

Source: Bloomberg, AMP Capital

Slowing QE suggests share market returns are likely to slow from the 20% or so pace of the last 18 months. Bouts of uncertainty regarding the Fed’s intentions are also likely, as we saw in May-June and more recently. However, the overall picture remains favourable for shares:

First, the tapering of QE3 is very different to the abrupt and arbitrary ending of QE1 and QE2. This time around US data is stronger and the wind down in QE3 is dependent on further improvement in US economy.

Second, although the Fed isn’t undertaking monetary tightening many tend to see it as such so past monetary tightening moves, which have been via rate hikes, are instructive. The next table shows US shares around the first rate hikes in the past 8 Fed tightening cycles. The initial reaction after 3 months is mixed with shares up half the time and down half the time. But after 12 and 24 months a positive response tends to dominate. So even if this were the start of a monetary tightening cycle it’s not necessarily bad for shares.

The reason for this lies in the improvement in growth and profits that normally accompanies an initial monetary tightening. It’s only later in the cycle when rates are going up to onerous levels to quell inflation that it’s a worry. Right now we are seeing improving growth and profits, but with the start of rate hikes (let alone rises to onerous levels) looking a long way off given very low inflation.

US shares after first Fed monetary tightening moves

First rate hike -3 mths +3 mths +6 mths +12 mths + 24 mths
Oct 80 4.8 1.6 4.2 -4.4 2.4
Mar 84 -3.5 -3.8 4.3 13.5 22.5
Nov 86 -1.5 14.0 16.4 -7.6 4.8
Mar 88 4.8 5.6 5.0 13.9 14.6
Feb 94 2.9 -6.4 -4.9 -2.3 14.9
Mar 97 2.2 16.9 25.1 45.5 30.3
Jun 99 6.7 -6.6 7.0 6.0 -5.6
Jun 04 1.3 -2.3 6.2 4.4 5.5
Average 2.2 2.4 7.9 8.6 11.2

Source: Thomson Reuters, AMP Capital

Thirdly, the rally in US shares recently has been underpinned by record profit levels. It’s not just due to easy money.

Finally, shares are likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since 2008 is gradually reversed with some going to shares.

Image 3

Source: ICI, AMP Capital

While next year will no doubt see a few corrections in shares along the way, the key point is that the broader picture – of reasonable share market valuations, improving global growth and still very easy monetary conditions - suggests the bull market in shares has further to run.

The Australian share market is also likely to benefit from the rising trend in global shares, but is likely to remain a relative underperformer reflecting better valuations globally and a bit more uncertainty over the Australian economy. Sector wise, mining stocks look cheap and best placed to benefit from the global recovery.

In terms of the Australian dollar, Fed tapering may make life a bit easier for the RBA in getting the $A down. While I wouldn’t get too excited as near zero interest rates in the US look like remaining in place for some time, the broad trend in the $A is likely to remain down.

Finally, in the very short term getting the Fed’s taper decision out of the way likely clears the way for the seasonal Santa rally in shares that normally gets underway around this week and runs into early January.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

 

Published in Investment Advice
Tuesday, 19 November 2013 16:17

RBA Board minutes for November 2013

BillEvans_small_headshot_WIBIQBill Evans, Westpac Chief Economist

As expected, the Minutes to the November RBA Board Meeting retained the key statement that  “The Board’s judgement was that, given the substantial degree of policy stimulus that had been imparted, it was prudent to hold the cash rate steady while continuing to gauge the effects [of the earlier rate cuts], but not to close off the possibility of reducing it further should that be appropriate to support sustainable growth in economic activity”. The Minutes did, however, not contain the comment “nor signal an imminent intention to reduce them” as did the October Minutes. While technically this may open the door for a December move, we doubt the RBA has any imminent intention to reduce the cash rate. Rather, the Board clearly has an easing bias and they would like to highlight the fact.

The Board is “continuing to gauge the effects, including in the housing market, of the substantial degree of monetary policy stimulus that had been put in place over the past two years. There was mounting evidence that monetary policy was supporting activity in interest-sensitive sectors and asset values”. They argue that it is “too early to tell whether this improvement would signal a willingness of businesses to take on new risks and thereby add to employment and investment”.

The Board also gave some insight into why they are in a watch and see, rather than primed to go, mode. “Nationally, dwelling prices were above their late 2010 peak, with prices over the three months to October increasing significantly in Sydney. Housing turnover and loan approvals had picked up noticeably. Improved conditions in the established housing market were providing an impetus to dwelling investment, with residential building approvals increasing over the year". This an expected development from the low level of interest rates and something the Board is hoping will spur on wider domestic activity.

So why does the Board still have an easing bias? They appear to have acknowledged concerns in regards to non-residential investment outlook noting rising office vacancy rates at the same there’s a clear decline in government employment. Downward revisions to the growth outlook have also been noted due to a stronger currency and a larger than expected fall in mining investment.

In addition, employment is forecast to continue to grow below the rate of population growth and hence the unemployment rate is expected to continue to rise gradually for the next year or two. Inflation forecasts are little changed and underlying inflation is forecast to remain consistent with the inflation target for the forecast period.

The other key reason for the rate cut bias is the Australian dollar. It was noted that “the Australian dollar, while below its level earlier in the year, remained uncomfortably high” and that a lower level of the exchange rate would likely be needed to achieve balanced growth in the economy". No doubt the strategy of maintaining an easing bias is partly motivated by the need to "talk down" the AUD.

Nevertheless, the Board is holding to the view that “in time, non-resources business investment was also expected to increase given the low level of interest rates and recent substantial increases in measures of business confidence and conditions”.

The Bank’s forecast for growth appears to be predicated on the current housing story flowing through to consumer spending which as the Board notes “household spending looked to have remained below average in the September quarter, consistent with softness in the labour market weighing on income growth". This is unlikely to materialise until consumers become much more comfortable with their job security.

Note also that the Bank lowered its growth forecast for 2014 from 3% (trend) to 2.5% (below trend) citing a lower trajectory for both mining and non mining investment.

Discussions on the international scene focused on the fact that Australia’s main trading partners growth remained around average. Chinese growth had lifted a little and was consistent with the Government target of 7½% while the Japanese economy continues to grow, albeit at a slower rate than the relatively strong pace seen in the first half of the year. In the rest of Asia, growth has continued around trend.

The US outlook is critical for the RBA as the tapering by the US Federal Reserve will be key factor in their desire to see a stronger US dollar and thus, a weaker AUD. The partial government shutdown in the US is expected to reduce growth only slightly in the December quarter although it is too early to tell as several data releases have been delayed. While house prices have risen further, it was noted that US housing starts and mortgage applications for purchases had declined since earlier in the year. Overall, the US economy was described as growing at a moderate pace.

Conclusion

The Bank has noted the recent strength in consumer and business confidence as well as the upswing in house prices and dwelling approvals. However, there are clear question marks on the sustainability of this upswing and if it can be maintained into 2014 given the downbeat outlook for non-residential construction; an expectation for a rising unemployment rate; the slowdown in mining; weak government spending; and the drag on our external sector from an "uncomfortably high AUD".

There are many dimensions of uncertainty in the outlook. The Bank is looking for the wealth/employment/confidence boost from the housing upswing to feed into the weak area of the economy mainly explained by business decisions on employment and investment.

It is our view that the pass through will be slow and uneven requiring further monetary stimulus in 2014. The minutes confirm that the decision to cut is not imminent and will depend on how those dynamics interact.

We continue to expect the Bank will become increasingly aware of the need for lower rates in 2014.

It is our view, that two further cuts in the cash rate will be required in 2014.

 

 

Published in Australian Economy
Tuesday, 06 August 2013 07:09

RBA cuts rates to 2.50%

bank-building-icon1Surprisingly moves to neutral bias.

As widely expected the Reserve Bank Board decided to lower the cash rate by 25bps to 2.50% at its August Board meeting.

For us by far the most significant aspect of the Governor's statement was the decision to move back to a neutral bias from the consistent easing bias that we have seen in recent statements.

It does not hold that a central bank should necessarily move to a neutral bias following a rate move. An easing bias was used in the May statement despite delivering a rate cut. The words used were: "The Board has previously noted that the inflation outlook would afford scope to ease further ... at today's meeting the Board decided to use some of that scope". That is a more dovish explanation for a rate cut than that used today "The Board judged that a further decline in the cash rate was appropriate".

We were expecting that the Bank would choose to maintain downward pressure on the AUD by repeating the rhetoric from the June and July statements which said: "The Board judged that the inflation outlook ... may provide some scope for further easing should that be required to support demand". In today's statement the key final sentence was: "The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time" – a clear neutral bias.

Other aspects of the statement were more encouraging from the perspective of our forecast which has been and remains for another cut in November. Firstly, the statement followed the structure in July by pointing out that although the Australian dollar has depreciated 10% since early April it remains at a high level. The only change in this statement was to revise that change up to 15%.

The other really important point was that despite the 15% fall in the currency the Governor repeated his confidence that inflation pressures are expected to remain under control. Comments on the real economy did not change from the July statement with growth being described as "a bit below trend" and the unemployment rate being recognised as edging higher.

The international outlook remains unchanged with global growth being described as "running a bit below average this year". A new observation is the linking of volatility in the global financial markets with a downturn in a number of emerging market economies. That link to emerging markets was not made in July.

Conclusion

In choosing not to maintain a clear easing bias it seems very unlikely that the September meeting will be 'in play'. Of course, with that meeting being timed for four days before the Federal election it would have been quite surprising to see any change in monetary policy so close to an election. We are not unnerved by today's approach because it in no way implies that rates have reached some form of institutional low and that should the economy evolve in the way we expect the Bank will cut rates again.

The calling of the election, by providing some political certainty by early September, might boost confidence measures but hard decisions showing up in the data to raise employment and investment seem a lot further off. We also agree with the Reserve Bank that the fall in the currency is most likely to impact importers' margins rather than consumer prices. A much stronger demand environment would be required for importers to confidently pass on price increases. We have not doubt that the Bank expects there is more work to be done. Note that the Government raised its unemployment forecast for 2013-14 from 5.75% to 6.25% and expects it to remain there over the course of the next year. We expect that the Reserve Bank feels the same way, although Friday's Statement on Monetary Policy will only include growth and inflation forecasts.We expect the Bank would therefore have no hesitation in cutting rates again once more information is available on inflation which will print in late October and the response of business/consumers to the election result has been clearly signalled.

We also believe that these dampening forces will be sustained through into early 2014 providing scope for another cut in February.

 

Written by Bill Evans

Chief Economist - Westpac Banking Corporation

Published in Australian Economy

We have spoken previously about current cash levels in Australia in term deposits, as a supporting factor share prices going forward.  Should investor confidence improve, and investors look to invest some of this, it would be positive for share prices.

The chart below highlights the weight of money still sitting in the safety of cash at a time where cash returns are likely to be further depressed by RBA interest rate cuts.

Funds in Australian bank term deposits are at record highs of $546bn.

20130730_cash

 

 

 

 

Published in Fixed Interest
Thursday, 18 July 2013 03:07

The US Federal Reserve, Rates and Bonds

Introduction

As the US economy continues to recover, it was inevitable that investor focus would shift from the need for more stimulus, which has been the dominant issue over the last few years, to when the US Federal Reserve will actually start to reverse the stimulus. This is important because easy monetary conditions on the back of poor growth and low inflation – first low rates and then QE – have helped underpin a fall in bond yields to record lows. This in turn has underpinned strong returns from sovereign bonds and gains in bond-like high yield investments, notably corporate debt, real estate investment trusts (REITs) and high yield shares, such as banks and telecommunications companies in Australia.

Nervousness about a change in direction from the Fed has been building this year, particularly over the last month following Fed Chairman Bernanke’s comments that he is prepared to slow or “taper” the pace of quantitative easing “in the next few meetings”. This would likely mean cutting the US$85 billion a month it is buying in government bonds and mortgage-backed securities to around US$60 billion a month.

Fearing this signals a shift towards the start of US monetary tightening, expectations for interest rate hikes in the US have been brought forward a year or so, bond yields have increased sharply and beneficiaries of easy money in the US, such as non-government debt, REITs, emerging market debt and equities, high yield shares and the A$ have all been under pressure. This has happened at a time when not all US economic data has been strong, leading some to fear a premature tightening by the Fed.

So the Fed’s latest monetary policy setting meeting was much anticipated for greater clarification around these issues.

The message from the Fed

The basic message from the Fed may be summarised as follows.

First, Chairman Ben Bernanke confirmed that the Board may start to slow the pace of QE later this year. He added that the reduction is likely to be gradual and that QE could end by mid next year. However, he also noted that this is conditional on the economy continuing to improve as the Fed expects, with growth projected to accelerate to 3-3.5% next year. While the immediate reaction in share markets has been negative, taking the lead from confirmation that QE is on track to be phased down, the fact it will only be phased down if the economy continues to improve is likely to be supportive for shares going forward, as this means stronger profits. When it does start to taper, the Fed is likely to prefer a meeting after which it has a press conference where it can explain its actions. This would suggest action will be taken at the September meeting at the earliest.

Second, the pace of QE can still be increased or decreased in the future, depending on how the US economy is performing. In other words, just because the Fed might start to taper in say, September, doesn’t mean that all the next moves will automatically be towards a further reduction. In fact, Bernanke appears to have made a steady decline in QE towards ending the program in mid-2014 contingent on expectations being met that the unemployment rate will fall to around 7% by then. For growth-oriented investments, this is effectively what some have called the “Bernanke put”, i.e. either the economy and profits improve (supporting share markets) or QE continues. It’s very different to the first two rounds of QE that automatically ended in March 2010 and June 2011, only to be followed by significant share market weakness.

Third and most importantly, the Fed reiterated that any decision to slow QE does not mean that interest rate hikes are any closer. In fact, 15 of the 19 Fed meeting participants don’t expect the first Fed Funds rate hike until 2015 or later. This is one more than in March. Moreover, the Fed continues to indicate that near zero interest rates will be justified at least as long as unemployment remains above 6.5% and inflation expectations remain low, with Bernanke pointing out that the 6.5% unemployment rate is a threshold, not a trigger. This suggests that the move forward over the last six weeks in money market expectations for the first Fed rate hike from mid-2015 to mid-2014 is premature. Expect rate hike expectations to settle down again and push back into 2015.

Our assessment

Our assessment is that while the Fed will likely start to slow quantitative easing later this year, this will actually be a good thing because it will only occur because the Fed’s mission has been accomplished. In other words, the US economy can start to be taken off life support. Moreover, by the time this occurs it will be a surprise to no one.

However, as the Fed keeps telling us, it is unlikely to want to rush into raising interest rates, given that:

  • Growth is still a long way from booming and is still relatively fragile as the private sector continues to reduce debt ratios. This is evident in bank loans growing at just 3%p.a and fiscal stimulus now being reversed. This is also evident by the mixed tone of recent economic indicators, with a solid housing recovery but soft readings for the ISM and most other manufacturing conditions indices.
  • Spare capacity remains immense as evident by a 7.6% official unemployment rate and double-digit labour market underutilisation and a still very wide output gap (i.e. the difference between actual and potential growth), as shown in the next chart.

Source: Bloomberg, AMP Capital

  • As the labour market continues to strengthen, labour force participation will likely start to bounce back, slowing the fall in the unemployment rate and achievement of the Fed’s 6.5% threshold.
  • Inflation is low and falling, currently just 1.4%.

So short of a sharp acceleration in the US economy, it’s very hard to see the Fed raising interest rates for the next year at least. This is important because the 1994 ‘bond crash’, which saw US 10-year bond yields rise nearly 300 basis points, was triggered and underpinned by an aggressive rise in the US Fed Funds rate (its official short term interest rate). See the next chart.

Source: Bloomberg, AMP Capital

Implications for investors

Despite an initially negative reaction, the message from the Fed remains reasonably market friendly. The pace of quantitative easing will only slow when the economy is stronger and rate hikes are unlikely any time soon.

The bottom line is that at this stage, a 1994-style bond crash still seems unlikely.1 US interest rates are unlikely to rise any time soon and in Japan, Australia and probably Europe, monetary conditions are still in the process of being eased.

However, we remain cautious of sovereign bonds, given that yields remain well below long term sustainable levels, for which potential nominal GDP growth provides a good guide. See the next table.

Bond yields are well below sustainable levels

Source: Bloomberg, AMP Capital

After four years of record inflows, US bond funds are at risk of seeing big outflows as investors start to see lower or poor returns. In fact, they have started to see outflows in the last few weeks and this could have a long way to go if sentiment towards bonds really turns negative. And of course, this in turn will create upward pressure for bond yields.

Finally, periodic bouts of nervousness regarding the Fed will likely continue as the US economy continues to improve. As a result, we remain of the view that sovereign bond yields will continue to gradually trend higher, resulting in poor returns for bond investors.

Against this backdrop, the chase for yield will likely continue as interest rates will remain low, albeit with perhaps less enthusiasm than seen over the last year. However, returns from assets that have already benefitted immensely from low bond yields like credit and real estate investment trusts will likely slow.

Shares have also benefitted from lower bond yields, although it is worth noting that in relation to US shares, gains have been underpinned by record profits. Moreover, they still trade on relatively high forward earnings yields compared to bond yields. See the next chart.

Source: Bloomberg, AMP Capital

This suggests that earnings yields on shares still offer a reasonable buffer as bond yields normalise, albeit a too rapid or great an increase in bond yields will result in more short term volatility as we have seen over the last month.

One final point to note is that a move towards the end of quantitative easing in the US will further reverse the upward pressure seen on the A$ since 2009. This will be good news for the Australian economy as the stubbornly strong A$ has been a key factor holding the economy back recently. Expect the A$ to fall to around US$0.80.


1. See “What’s the chance of a bond crash?” Oliver’s Insights, Feb 2013.

 

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.
Published in Investment Advice

665200-health-insurance-moneyAs expected the Reserve Bank Board decided to leave the cash rate unchanged
at 2.75% at its June meeting.

The Governor's statement accompanying the decision presented taken as a
whole leaves us comfortable with our existing position: a 2% terminal rate
with the next easing in August.

The key concluding paragraph retained a clear easing bias but also made it
clear the Bank was in assessment mode – not only on the need for further
support for demand but also the degree to which the inflation outlook
afforded scope for further measures. Monetary settings were judged to be
'easy' and sufficient to "contribute to a strengthening of growth over
time, consistent with achieving the inflation target". And settings were
seen as "appropriate for the time being", the phrasing indicating the
Bank's views may be reassessed month to month.

However, the closing sentence gave a more uncertain view on the scope for
further easing: "the inflation outlook, as currently assessed, may provide
some scope for further easing, should that be required to support demand."
That contrasts with the statement accompanying the May decision to cut
rates which had a more definitive assessment that "the inflation outlook
would afford scope to ease further ..." with the Board choosing to "use
some of that scope". The changed emphasis points to the RBA seeking more
comfort on inflation, suggesting any follow on move is more likely to occur
post CPI in August than at July's meeting.

The sharp decline in the AUD is also likely a factor in the more qualified
view on 'scope'. The Bank may be seeking not only to reassess what impact
this may have on inflation but where the current move settles. Notably, the
statement acknowledges the decline in the currency but asserts that the
exchange rate "remains high considering the decline in export prices". That
aligns with our own view that the decline has merely reduced the degree of
overvaluation rather than eliminated it altogether (in USD terms we see the
decline as having reduced a 10c overvaluation to one around 3c). The Bank
may also share our concern that the change in market expectations on Fed
policy (a 'tapering' in QE purchases), which has been a key driver of
recent currency moves is misplaced and could reverse quickly.

The rest of the Governor's statement was brief. Global growth was seen
running a bit below average with "reasonable prospects of a pick-up next
year".  =Australia's growth was seen as "a bit below trend" and inflation
consistent with the medium term target.

The description of the impact of previous policy easing was decidedly more
downbeat though. In April, the Governor's statement boldly asserted that
there were "a number of indications that the substantial easing of monetary
policy during late 2011 and 2012 is having an expansionary effect on the
economy". In May, the view was that there had been "a strengthening in
consumption and a modest firming in dwelling investment". In June though
the statement looks less convincing with simply: "The easing in monetary
policy over the past 18 months has supported interest-sensitive areas of
spending".
Also of note, the view on business investment statement is not touched on
at all. This may be due to heightened uncertainty around the timing of the
mining investment cycle but is notable given the resilience of investment
plans revealed in last week's ABS Capex report.
We saw this has a key factor in the RBA leaving rates on hold this month
and it might have been put forward as a positive sign but instead the Bank
has opted not to discuss the investment outlook directly at all.

Conclusion
The Reserve Bank has retained an easing bias, but it is not an urgent one.
The path of easing from here will depend on developments in demand; the
financial markets (the $A, as it jointly impacts demand and inflation) and
the inflation story itself. The most important piece of information on the
latter front will come to hand between the July and August meetings, in the
form of the second quarter CPI. We have a more downbeat view on global growth next year and our domestic forecasts are also lower than the Bank's. As such we
already see a strong case for further monetary policy easing. However, the
tone of today's statement implies that the RBA Board is looking for further
evidence before acting again, which points to rates being kept on hold in
July.  However, it is likely to signal at that meeting that the forthcoming
inflation print could provide scope for it to support demand further within
the context of its target. That intent would then be actioned at the August
meeting. Beyond that point, we see two further 0.25% rate cut moves, in the last quarter of
this year and the first quarter of next year.

 

Westpac Economics Team

 

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

Published in Australian Economy
Wednesday, 08 May 2013 04:02

How low can interest rates go?

Interest Rate ImageWe expect the Reserve Bank will complement its May rate cut of 0.25% with a follow up move of 0.25% in June. Rates are expected to eventually
bottom out at 2% by the first quarter of 2014 (that is 0.75% lower than today).

There are ample precedents for a May/June move. Over the last 10 years the Bank has moved rates on four occasions in May with two of those occasions being followed up in June.

The really key new developments over the last few weeks have been evidence
of an even lower than expected trajectory for inflation and, as pointed out
in this note, a Reserve Bank that is clearly open to further action.

Given this scenario we think that the most likely policy option is a follow
up rate cut in June of 0.25% which will be implemented for the same reasons
as we have seen today complemented by further evidence of softening
confidence and weak business investment.

We have also always argued that our assessment of the global economy is
more subdued than the consensus. The IMF is expecting 4% world growth in
2014 – we are closer to 3%. For Australia's terms of trade, the peak to
trough decline in the 2011–12 period was 17%, while we forecast a 2013–14
decline in the region of 10%. We have long maintained that from a world
growth perspective, 2014 will feel like 2012.

The threat of a disruptive event in Europe remains ever present.

The US story does not convince us. We confidently expect that the US
Federal Reserve will persist with its quantitative easing policy through
most of 2014.

China has already begun the process of recalibrating its monetary and real
estate policy settings and the support it received from the export sector
in Q1 is already receding. Indian domestic demand is flagging badly and the
required policy support has not been adequate. Japan is something of a
bright spot, but its gross acceleration will far exceed the net from a
global growth perspective as it takes back market share.

From June we expect the Bank will be patient to assess the impact on
domestic demand of the low rates. However by year's end it will become
clear that further stimulus will be required to offset the impact of a
softening world economy while the response to the low rates in the domestic
economy will be disappointing.

We anticipate two further rate cuts will be required in the December
quarter of this year and March quarter of next year. That would see the
cash rate bottom out at 2% from its current 2.75%. Having driven rates down
to that level we expect rates to remain on hold through the remainder of
2014.

Our specific profile for the Australian dollar, which had incorporated a
steady cash rate of 2.75% (with downside risks) and a softening world
economy, saw AUD back at USD 0.97 by June next year, partially due to a
gradual narrowing of the overvaluation premium.

With our lower RBA rate profile there is some modest room for further
moderation in the fair value of AUD with our June 2014 target being lowered
to USD 0.96. However, the key to a more significant fall in AUD is a more
marked reduction in that over valuation premium – something that lies
essentially outside the RBA's influence.

 

Bill Evans - Chief Economist - Westpac Banking Corporation

 

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

 

Published in Investment Advice

Interest Rate ImageAs expected the Reserve Bank Board decided to leave the cash rate unchanged at 3.00% at its April meeting. 

Given that there has been some discussion in the media around rates rising this year we were very interested to see whether the Governor indicated whether he still had an easing bias. That was confirmed by repeating the term: "The inflation outlook, as assessed at present would afford scope to ease policy further, should that be necessary to support demand". We read this as indicating that the Bank's current stance is that they see it more likely that the next move in rates will be down rather than up. Of course a further assessment of the inflation outlook will be available on April 24 and that will be an important input into whether the Bank still sees scope to ease. Our early forecast is consistent with inflation remaining contained and the Bank's medium term target for both headline and underlying measures to be retained at 2.5%. 

The second area of considerable interest from our perspective in the statement was the official assessment of the surprise jobs growth in February of 71,500. Comments from Bank officials following that print around sampling variability and continuing prospects for rising unemployment indicated to us that the number would be severely qualified. In the Governor's statement in March he referred to the labour market as: "with the labour market softening somewhat and unemployment edging higher conditions are working to contain pressure on labour costs". In today's statement he is much more concise: "labour costs remain contained". This suggests that the Governor is not prepared to accept that the job report signals an improving market but he is also not prepared to publicly dismiss the number. He has left the issue open until we see further evidence around the labour market.

There were some issues around the domestic economy where the wording was a little more positive than in March: 

1. "Dwelling investment appears to be slowly increasing" (March) vs "dwelling investment is slowly increasing" (April); 

2. "Demand for credit is low" (March) vs "Demand for credit has also remained low thus far" (April);

3. "Investment generally outside the resources sector is relatively subdued though recent data suggest some prospect of modest increase during the next financial year" (March) vs "the near term outlook for investment outside the resources sector is relatively subdued a modest increase is likely to begin over the next year" (April);

4. "Though the full impact of this [easing in monetary policy] will take some more time to become apparent there are signs that the easier conditions are having some of the expected effects" (March). Arguably  the following statement is stronger: "there are a number of indications that the substantial easing in monetary policy is having an expansionary effect on the economy" (April).

On the other hand there appears to be a little more urgency around the slowdown in mining: "the peak in resource investment is approaching" (March) vs "the peak in resource investment is drawing close" (April). Secondly: "the exchange rate remains higher than might have been expected" (March) vs "the exchange rate, which has risen recently, remains higher than might have been expected" (April).

On the international front there appears to be little recognition of the threats posed by Cyprus to Europe. Global growth is still described as "a little below average for a time" while "the downside risks appear to be reduced". That is a less confident commentary than "downside risks appear to have lessened over recent months" (March). Unlike March where financial strains in Europe are described as "considerably reduced" there is no commentary on developments on financial strains but Europe is now described as: "remains in recession". Whereas in March financial markets were described as "remain vulnerable to occasional setbacks" they now "remain vulnerable to setbacks" implying a higher probability of these developments.

Conclusion 
For the domestic economy there are a number of more positive nuances in this statement than we saw in March around dwelling investment; non mining investment; and the overall impact of the easing in policy. The Governor has sidestepped the issue of the February employment report but is no longer prepared to refer to a softening labour market or rising unemployment. On the other hand there is a little more urgency around the peak in the mining boom while the rising Australian dollar continues to represent concerns. 

By retaining the easing bias the Governor is signalling to us that in the Board's view, despite some more positive nuances, rates are more likely to be cut than increased at the next move. He has not moved to a neutral bias or used language to suggest that he expects rates to be on hold for an extended period. 

Accordingly, it is our view that the arguments around both domestic and international economies still support lower rates. Accordingly we retain our position that rates are likely to be cut by 25bps in June, or shortly thereafter.

Bill Evans
Chief Economist
Westpac Institutional Bank

 

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

665200-health-insurance-money
As expected Reserve Bank Board holds rates steady at March meeting

As we expected the Board of the Reserve Bank decided to hold the cash rate
steady at 3% following today's Board meeting.

There were minimal changes in the wording of the Governor's statement from
the statement issued on February 5 following that "no change" decision.

Of most importance was retaining the term "the inflation outlook, as
assessed at present, would afford scope to ease policy further should that
be necessary to support demand". Maintaining that statement indicates that
the Board retains an easing bias and future decisions will be impacted by
the growth profile.

By far the most important data release since the last meeting was the
Capital Expenditure survey for the December quarter. This survey provided
the first estimate of investment plans for the 2013-14 fiscal year. It also
provided the fifth updated estimate for investment in 2012-13. The news on
2012-13 was quite poor with substantial downward revisions to investment
plans. However, partly because the 2012-13 number was so low it was not too
big a stretch for the 2013-14 investment plans to show a solid increase.
Indeed by our calculations those plans indicated an 11% boost in investment
in 2013-14. That evidence is likely to have been a key factor in the Bank's
decision to hold rates steady. Indeed, while investment outside mining
continued to be assessed as "relatively subdued" the Governor did qualify
that with "recent data suggest some prospect of a modest increase during
the next financial year". Hence from the Bank's perspective progress in
rebalancing growth towards the non-mining sectors appeared to be underway.

Another aspect of the Capex survey indicated that the peak in resource
investment might be further out than previously assessed. However, there is
considerable uncertainty around those estimates and the Bank, prudently,
retained its general assessment that "the peak in resource investment is
approaching".

The themes that have figured consistently in previous statements were
repeated today – moderate growth in private consumption; near term outlook
for non residential building subdued; exports strengthening; public
spending constrained; inflation consistent with the medium term target; and
low demand for credit.

The wording on the housing market changed. Whereas in February it was
described as: "prospective improvement in dwelling investment", it is now
described as: "appears to be slowly increasing". This somewhat more
positive assessment is the direct result of a modest 2.1% reported increase
in housing construction for the December quarter. Higher dwelling prices
and rental yields are also noted.

The conviction that inflation will remain consistent with the medium term
target is given more support in this statement. Whereas the February
statement predicted that a soft labour market would be working to contain
pressures on labour costs this statement notes that this result has indeed
been "confirmed in the most recent data". In the February statement the
Bank raised the prospect of businesses focussing on lifting efficiency to
contain wage pressures and this sentiment is retained.

The description of the international situation is largely unchanged
although the Governor appears to be a little more confidence around
downside risks. Compare "downside risks appear to have abated, for the
moment at least" (February) with "downside risks appear to have lessened in
recent months".

The description of financial markets includes a more upbeat assessment of
the sharemarket, "share prices have risen substantially from their low
points". However, the Bank continues to point out that financial markets
remain vulnerable, adding "as seen most recently in Europe".

The key theme is repeated in this statement, "the full impact of this
[easing in monetary policy] will still take more time to become apparent,
there are signs that the easier conditions are having some of the expected
effects".

Despite the recent fall in the AUD (substantially more in USD terms than in
TWI terms) the Bank continues to point out that the exchange rate remains
higher than might have been expected.

Conclusion – expect the next rate cut by June.
This statement is clearly structured to signal that the Bank retains its
easing bias but will be patient before cutting rates further.

We believe that there will be another cut in this cycle but not until
around June. Forces that are most likely to highlight the need for lower
rates will be around: an ongoing softening in the labour market; contained
price and wage pressures; a disappointing response from business in terms
of investment; and a housing recovery that, while quite vibrant in Sydney,
will not be replicated around the country. We also expect that the
Australian dollar will be drifting higher through to mid year particularly
as foreign investors rebalance their appetite back towards high yielding
Australian assets.

Bill Evans
Chief Economist
Westpac Institutional Bank

 

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.

 

 

Published in Australian Economy
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