RBA to hold next week, but expect October rate cut: Bill Evans

RBA to hold next week, but expect October rate cut: Bill Evans
RBA to hold next week, but expect October rate cut: Bill Evans


The Reserve Bank Board meets next week on September 3.

We expect that the Board will decide to keep rates on hold at the meeting but continue to expect the next rate cut to occur in October.

A key signal around the Governor’s Statement following the decision next week will be whether the Governor continues with the wording “ease monetary policy further if needed”.

“If needed” was used in both July and August and seemed to imply a degree of patience with rates remaining on hold at the August and, we believe, the September meetings.

However, those words were not used in June and we saw a follow up move in July.

If the “if needed” is still used in the Statement then it will not necessarily preclude a move in October – it might be considered prudent to break with that signalling approach but an absence of “if needed” will certainly be very encouraging for our October view.

October has some advantages – we saw the response in the Westpac Consumer Sentiment Index to consecutive cuts in June and July, with Sentiment actually falling by 4% following the July cut only to recover by 3.6% after rates were on hold in August. This result is likely to have impressed upon the RBA the need to avoid a policy response, such as consecutive months or a 50 basis point move, that might unnecessarily unnerve households.

We are aware that the Governor is concerned about global developments and probably would like to retain some flexibility to respond to an unexpected global shock – better to cut rates in October and allow flexibility to move again in December rather than delay until November and have to do consecutive November/ December moves.

There also seems little reason to delay beyond October – we know that the August inflation, wages, and unemployment forecasts were revised down despite assuming two more rate cuts – one in 2019 and one in early 2020.

We do not expect any further downward revisions in November that might require an immediate policy response.

The forecasts also embed a lift in growth momentum in 2019 from 2% (annualised in 2019 H1) to 2.75% in 2019 H2.

The June quarter GDP report will print the day after the September Board meeting. In our preview we expect that Q2 will print 0.5% growth, including consumption growth of 0.4% up from 0.3% in the March quarter.

We think this report is unlikely to impact any decision for an October cut since the real question around GDP will be the extent to which spending responds to the rate cuts in June/July; a lower AUD; the tax offset payments, which are now rolling out ($7.7 billion); the election result and the lift in auction clearance rates in Sydney and Melbourne.

This information is unlikely to be sufficiently clear by November to justify waiting until then.

In this note I also wanted to comment on some of our other financial market forecasts.

We are not anticipating further sharp falls in fixed interest rates.

The Australian 3 year swap rate has now fallen to 0.70% - 30 basis points below cash but only around 30 basis points above the expected terminal cash rate. That compares with around 50 basis points that the swap rate averaged over the 1.5% cash rate that held between August 2016 and June 2019. That period was marked by expectations of rate increases, although those expectations faded badly by the second half of 2018. Nevertheless we are now dealing with the expectation of an incredibly flat curve even when markets resume some form of equilibrium.

For those reasons our current swap rate forecasts envisage the swap rate holding around current levels despite further rate cuts from the RBA.

The current shape of the curve is likely also influenced by the market’s expectation that some form of QE may impact the term premium. Such policy could be implemented by the RBA (a direct asset purchase program) or via the banks (through direct funding from the RBA which flows on to other rates).

Of course the other way that current swap rates could fall further would be through an even lower terminal cash rate than the 0.5% which we currently envisage. To be sure, a package of QE and a cut to 0.25% would significantly lower swap rates further.

There are similar considerations for the 10 year bond rate. The bond rate has fallen to 0.90% - around 50 basis points above the market’s terminal cash rate, of around 0.4%. That compares with a margin of around 100 basis points between the 10 year bond rate and the steady 1.5% cash rate in the 2016-2019 period. Without an even lower terminal cash rate or some QE program by the RBA (directly or through the banks) it seems a stretch to expect any further sustained falls in that bond rate despite two more rate cuts coming from the RBA.

The comparison with the US is interesting. The market’s terminal federal funds rate is now around 0.9% by early 2021. A current US 10 year bond rate of around 1.5% is largely in line with our expected equilibrium margin in Australia of 50 basis points.

Westpac’s forecasts for the terminal cash rate in Australia are now broadly in line with the market. While our current federal funds rate forecast currently entails three more cuts in 2019 followed by some stability at a federal funds rate of 1.375%, the speed that we envision this easing is more aggressive than market pricing of 2½ cuts by end 2019 and therefore consistent with the US bond rate staying down at these levels for the rest of this year.

In 2020, we are certainly not expecting a recession in the US despite the inverted 2-10 year bond curve signal. US 10 year rates are distorted by the negative bond rates in Europe and Japan, and indeed, that also partly explains the unprecedented flat curve relative to the market’s expected terminal federal funds rate which we highlighted earlier. Instead, we look to a more cautious White House in 2020 as the Presidential election nears. However we do acknowledge that the FOMC might eventually move even closer to the cash rates in other markets as US economic growth drops below potential in 2020 and 2021.

BILL EVANS is the Chief Economist at Westpac

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