The Board of the Reserve Bank meets on February 7 next week. In July last year Westpac forecast that the next easing cycle would
total 100bps beginning near year’s end. Subsequently, the Board decided to ease the overnight cash rate by 25bps in both November
and December. Based on current information, we continue to expect a further 50bps of easings in this cycle with the next move
at the February 7 meeting and another to follow in May.
The case supporting a rate cut next week is strong. Market pricing is certainly arguing for a move: current pricing puts an 85%
probability on a 25bp cut.
Clearly, a key factor used by the Board to justify the decision to cut rates in December hinged around Europe and funding conditions.
The RBA Governor on December 6 noted, “Financial markets have experienced considerable turbulence and financing conditions have
become much more difficult”.
It is reasonable to argue that financial market conditions have improved since the December meeting. In the Board minutes it
was noted, “Australian banks had found long–term debt markets dislocated” and “wholesale debt markets appeared to be closed to
many financial institutions”.
The December meeting preceded the ECB’s Long Term Refinancing Operation (LTRO) which allowed 529 European banks to borrow
around €500bn for up to 3 years using an expanded list of collateral at 1% pa. That decision significantly eased European sovereign debt
financing conditions with banks now likely to be supporting the short maturities to arbitrage the attractive funding provided by the
ECB. For example, the Italian 1, 3, and 10 year bond yields were around 5.3%; 6%; and 6% respectively on December 7 compared to
current rates of 2.3%; 3.8% and 5.7% respectively.
Another LTRO window is set to open in late February with market expectations of a facility as large as €1trn.
Because these facilities are ‘non sterilised’ they are increasingly being assessed as a quasi–QE from
the ECB although the facility will be much less effective in allowing sovereign issuers to go out along the maturity curve.
Conditions have therefore improved but the pressures being faced, for instance, by Australian banks are still extreme.
A year ago Australian banks issued bonds at around 75–00bps over swap in the 3–4 year maturities. Australian banks recently issued
covered bonds at 165–175bps over swap in the domestic market, suggesting a theoretical spread on domestic unsecured paper
at around 200–210bps over swap in the 5 year maturity.
This pricing is consistent with issues now being mooted for Australian banks in the global markets. That is an improvement on December
when markets were virtually closed making pricing comparisons hard given thin trading and a dearth of issuance. Using CDS as a
guide and given the recent covered bond issuance volumes and subsequent performance, there are tentative signs of funding
stresses easing but pressures overall remain intense.
Note also that, after adjusting for a general fall in rates due to a weakening growth outlook, the European sovereign rates have
only improved marginally at the long end. Sovereigns will have to manage the maturity structure of their borrowings and really only
an unexpected sharp improvement in the outlook for sovereign risk or a decision by the ECB to enter into genuine Quantitative Easing
(where it purchases sovereign debt outright on an unsterilised basis) will provide sustained support to the long end of sovereign
yield curves.
With the growth outlook for the European region pointing to recession we doubt whether the Board will derive sufficient comfort
from these liquidity measures from the ECB to no longer see the need for another cut.
On the domestic front the case for a rate cut remains sound.
The 2.4% rise in the Westpac–Melbourne Institute Index of Consumer Sentiment in January was disappointing. Despite the
Reserve Bank having cut rates in both November and December by 25bps and the banks passing these moves on in full to new and
existing mortgage borrowers, the Index is still slightly below the level it registered before the first rate cut in November.
That read represents the sixth out of the last seven months where pessimists have outnumbered optimists. The average read over the
last seven months is 96.0, only 1.1% below the current level and 8.8% below the average for the previous seven months.
Labour market conditions are also softening. The loss of 29,300 jobs in December likely overstates the weakness – we suspect the
high degree of seasonality in December has exaggerated the move.
This would explain the puzzling fall in the unemployment rate, from 5.3% to 5.2% which was driven by a sharp fall in the participation
rate from 65.5% to 65.2% – the lowest level since May 2010. The participation rate is very important for the unemployment rate – if,
for instance, it had not fallen, then the unemployment rate would have printed 5.6%.
We expect the participation rate to bounce back in January.
A structural fall in the participation rate, along the lines we are seeing in the US, usually reflects a discouraged worker effect. However,
that is likely to only be a factor when the level of the unemployment rate is much higher. Seasonal volatility is a much more likely
explanation.
Setting these issues aside, the bigger picture for the labour market is clear from the annual figures for 2011: the economy added zero
jobs for the year as a whole, compared to 367,000 in 2010. We remain comfortable with our view that the unemployment rate will
reach 5.7% by mid 2012.
Also, inflation pressures have remained benign. The key average of the Reserve Bank’s two underlying measures printed 0.6%
(seasonally adjusted), up from 0.3% in the third quarter of 2011.
That sees the annual average RBA core at 2.6%, comfortably within the Bank’s target zone. With 0.8%qtr reads dropping out of the core
measures for both the March and June quarters, near term inflation prospects are encouraging. The result for the December quarter
will do nothing to change the Bank’s inflation forecasts which indicate that – carbon tax effects aside – inflation can be expected
to remain firmly within the 2–3% target band. Consequently inflation will not represent a constraint to targeting policy at the
risks associated with difficult global financial markets; weak global growth outlook; and deteriorating prospects for Australia’s labour
market.
Bill Evans, Chief Economist
Westpac Bank
Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts
are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.
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