The latest outlook from Westpac's interest rate whisperer: Bill Evans

EXPERT OBSERVER

Markets are now broadly pricing in Westpac’s view on the outlook for the RBA cash rate with only around a 50% chance of a rate hike by the end of 2019. That is in stark contrast to a year ago when our call that rates would remain on hold in 2018 and 2019 was well out of market with markets anticipating around 75 basis points of tightening by the end of 2019.

A weakening housing market; soft inflation and wages growth; an uncertain consumer and pressures on funding have all conspired to cool markets’ expectations. That key dynamic around an uncertain consumer facing constraints on income growth with a falling savings rate always stood out as a key constraint on the ability of the household sector to lift spending in the way anticipated by the markets.

While markets have moved largely to embrace our view, the Reserve Bank still expects to be raising rates over the course of 2018 and 2019. I think that is apparent in their ongoing above trend growth forecasts for 2018 and 2019. But, as we have argued before, the Bank does not have a perfect track record with its forecasts (as none of us in the economics community do) and it will react to any differences between its forecasts and “reality” in a timely fashion.

On the other hand our forecasts for the US Federal Funds rate have been consistently above market expectations. Our analysis of the current market pricing is for around 65 basis points of further tightening through 2018 and 2019. We have expected a total of 75 basis points over that period with one 25 bps hike in September, followed by a pause, and then 25 bps hikes in March and June with the rate peaking at 2.625% in mid–2019.

We have expected that signs of the US economy slowing into the second half of 2019 (partly under the weight of a sharp slowdown in government spending) would see the FED curtailing its tightening cycle in anticipation of eventually cutting rates from 2021.

Under that scenario we had been arguing for a weakening AUD/USD which had subsequently peaked around 0.81 in late January this year.

Under our relative rate profile the AUD/USD cash rate differential would sink to an unprecedented –112.5 basis points by June 2019 (previous mark in the post stagflation history was –50 basis points in the late 1990s).

That was likely to take a heavy toll on the AUD/USD with our target being 0.72 by next June.

That sum of 75 basis points of hikes from the FED was still slightly above market expectations but we now believe we need to be even more bold on the FED forecasts.
Trends in core inflation; wages; and employment are increasingly casting doubt on a FED pause between September and March.

On a six month annualised basis, the core PCE is now running at 2.3% (to May) and the Employment Cost Index is rising at 2.9% (to March). This pace is somewhat faster than we had expected providing the FED with ample justification for not pausing. In that regard we note that the FED has emphasised the symmetrical nature of its inflation objective and therefore not indicating any immediate concern that the momentum in the core PCE is running above the 2% target. As such, we are still expecting the gradual (3 month intervals) approach to the tightening cycle.

Bill Evans is economic spokesman for Westpac and is head of economic research