A rate cut is back on the table: Christopher Joye

At the start of this week I said that the RBA’s board meeting would be a non-event, with it likely to hold rates steady in spite of suggestions that “many” board members believe policy should be more accommodative.

I argued that the most valuable information on the future direction of rates would be drawn from the GDP and unemployment data. And so it has transpired.

Had GDP printed strong – at or above consensus expectations – and Thursday’s labour market report followed on from January with a second healthy increase in total employment (together with a flat or lower unemployment rate), we’d be sitting here today thinking that rates were on hold for the foreseeable future.

Only two events could then drive cuts: a surprisingly low first-quarter inflation number that would give the RBA room to reduce rates without jeopardising its inflation target; and/or the major banks independently jacking up  lending rates again to the point where the RBA felt compelled to negate this with another downward shift in its own cash rate.

The major banks have some interesting game theory facing them. It is absolutely indisputable that bank funding costs have plummeted since their extreme December/January spike on the back of the (at the time) burgeoning European crisis. Combine this with the circa 10-basis-point “top-up” the banks unilaterally added to lending rates after the RBA’s February meeting, and one is left to conclude that the banks’ net interest margins should be looking much healthier today.

Yet in the current low credit growth environment the banks can only drive their shareholder returns on equity and profitability through margin expansion and/or cost cutting (i.e., assuming that top-line revenue growth tracks national incomes). And there is little doubt that the banks have done a wonderful job convincing many commentators that they should be able to continue punching out 18% to 19% returns on equity. All power to them for doing so.

I suspect that references made by major bank CEOs to lots of little lending rate changes in the future is really code for incremental steps to further expand margins, which the big four can do given they have both lower funding costs and much better access to funding supply than their competitors.

The claim that it is a “free lunch” for the RBA to offset these changes by simply cutting the cash rate is spurious. The cash rate is currently at 4.25%, and it can only be reduced to 0% under normal circumstances. Accordingly, every time the RBA cuts the cash rate but the banks do not pass this cut fully on to their borrowers, the RBA (and borrowers) are effectively foregoing latent interest rate ammunition, or economic insurance, in order to preserve bank profitability. That is, there is a direct trade-off here between monetary policy flexibility and bank margins.

Now, the banks quite rightly argue that if they cannot profitably lend, then there will be no credit creation period, and we are all screwed. The challenge, then, is to find the right balance between bank returns, the ability of the RBA to manage monetary policy, and, ultimately, borrowing rates.

This brings me back to this week’s GDP and unemployment data. There is no question that the anaemic fourth quarter GDP print, which was well below the RBA and the market’s expectations, and the soggy employment numbers, with the jobless rate edging up, have created more uncertainty about rates and increased the probability of a future cut. The financial markets currently believe that there is a good chance the RBA will reduce rates once by the time its May meeting is concluded.

I would nevertheless venture that the RBA has a pretty sceptical view of the GDP data given the quite extraordinary historical revisions to it. For example, the March quarter was originally reported to be down 1.2%, but has now revised way up to just -0.3%. If the fourth quarter revises as much as the first, any insights based on it are likely to be rendered useless.

If you fuse that scepticism with the fact that: (1) the jobless rate is bobbing around 5.2%, which is close to its “full employment” level; (2) the RBA has already injected a couple of rate cuts (or thereabouts) into the system, which have yet to have their full effect; (3) the worst-case scenarios for the global economy are, unsurprisingly, not going to come close to being realised; and, finally, (4) the presence of more positive “leading-indicator” data on the state of the labour market, such as job vacancies, job advertisements and various business surveys, one exercises the option to wait until the March quarter inflation results are published. This means leaving rates unchanged until the May meeting.

Again, two curve balls here are: (1) what the banks do with their own lending rates, and whether they simply decide to throw caution to the wind and engage in further margin expansion; and (2) what happens to the Aussie dollar. At the time of writing, it is currently sitting at 106.46 US cents, which is up over one cent from yesterday’s lows near 105 US cents flat. The recent appreciation has been fuelled by market hopes that the Greek debt-swap deal will proceed more smoothly than had been anticipated by the bears.

It is not inconceivable that the Aussie surges back towards 110 US cents, and, if it does, the RBA sounds increasingly like it may wish to throw some sand in the wheels of the exchange rate either via direct intervention (i.e., selling), which it has not done since 2008, or by cutting rates, and thus reducing the differential in rates of return between Australian and US yields. The truth is that many sovereign states are manipulating their currencies, and these beggar-thy-neighbour policies could well force the RBA’s hand.

In summary, we are living in a highly uncertain and complex world where the probabilities of different paths can change materially every day. Years ago I argued this would be the case as the Australian economy became more closely tied to its Chinese, Indian and other Asian trading partners. I will repeat now what I said then: your best bet is to try to position yourself to capitalise on this volatility.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.