February, 2013

Outlook for Interest Rates in 2013

topics

Outlook for Interest Rates in 2013

The RBA’s decision to cut rates in December was a close call. Extracting a few key phrases from the meetings minutes we gain some interesting insights to what economic indicators the RBA will look to in 2013 and five key trigger events for future rate changes.

"The Board considered whether to wait for further information…" and "…on balance, members saw merit in reducing the cash rate at this meeting."

"Further confirmation that the peak in resource sector investment was near…" as well an easing in wages pressures "…and softening labour market conditions".

“For inflation to remain contained, ongoing productivity growth and a further sustained moderation in wage growth would be needed. The forward-looking labour market indicators had generally declined recently, suggesting that employment growth would remain modest in the months ahead”.

“For the global economy, data received over the previous month had been somewhat more positive. In particular, the US economy continued to expand at a moderate pace and there were signs that the pace of growth in China may have stabilised. Recent policy announcements in Europe had helped to bolster financial market conditions, though economic activity there remained weak”.

So the RBA is telling us that in 2013 it will be focusing on domestic inflation, unemployment & wages growth as well as global economic conditions (the US & China & Europe in particular).  Below we look at 5 possible trigger events that could cause the RBA to substantially move rates from their current levels in 2013.  Bearing in mind that the baseline expectation is for rates to remain unchanged but poised for easing based on a tepid US recovery, Europe fumbling its way through its debt woes and China hitting its official growth targets for 2013.

  1. 1. AAA Rating

Australia loses its AAA rating: the major ratings agencies retain a stable outlook on Australia.  Our strong fiscal position is a key rating protection, however this position has weakened with the recent backing away from the Australian Federal government budget surplus commitment.  Analysts at S&P, for example, have compared Australia’s position with that of Spain pre GFC.  To quote Kyran Curry (Sovereign Analyst at S&P) in an interview with the AFR “For us, we look to Spain, which was Australia’s closest peer four or five years ago in terms of having a very strong fiscal position, very similar to what Australia has at the moment, its external position was weaker, like Australia’s, and it got routed very quickly…The government needed to provide support to the banks, it had to shore up growth in the economy and its debt levels more than doubled…We can see that happening in Australia’s case.

Our external financing requirement is also high by AAA standards due to a shortfall between domestic savings and investment. So the risk of a ratings downgrade is greater than most assume and is certainly a potential trigger event in 2013.  S&P last removed Australia’s AAA rating in 1986 then gave it back again in 2003.  In our view it is only a matter of time before we are downgraded again.

2. AUD Climbs to $1.20

The AUD climbs to $1.20: in January 2009 the AUD stood at USD $0.67 by December it stood at USD $0.90, a huge surprise to all market commentators.  Many of the economic stories that caused the AUD to climb that high that fast are still playing out.  The Chinese urbanisation and industrialisation process is incomplete.  Interest rates remain structurally higher in Australia than elsewhere.  The combination of Quantitative Easing (QE) by the US Federal Reserve (we are now seeing the third installment or QE3 in action, and this time the unlimited version), official interest rates so low in the US that when taking into account inflation there is actually negative real rates, and a large current account deficit, will keep downward pressure on the USD.

If the AUD held $1.20 for any extended period of time the RBA would be forced to enter the market and effectively lower interest rates to help depreciate the AUD.  In our view this is rated as an unlikely possibility, especially when viewed in conjuction with the likelihood of a sovereign ratings downgrade occurring.

3. Crash in Property Prices

The often forecast crash in house prices finally happens: everyone from economist Steven Keen to hedge fund manager Jeremy Grantham has had a go at predicting when a crash in Australian residential values will occur.  Will 2013 be the year it finally happens?  The US S&P Case-Shiller Composite 20 Index puts US house prices at 180 - around 29% below their peak (in June 2006).  In contrast, Australian house prices are 31% higher than levels reported in mid 2006.  The IMF has suggested that Australian house prices are 10-15% overvalued.  Some private sector commentators have much higher estimates, and a recent Demograpia report rates the Australian housing market as the most unaffordable in the world when compared to incomes.

Such a crash would surely cause the RBA to drastically lower rates to encourage the property market.  In our view however this is an unlikely occurrence, and the hedge funders planning to make a killing shorting the Australian housing market will again be disappointed.  We actually predict a short term run induced by the recent cuts to interest rates followed by a flat or slightly declining residential market for the second half of 2013.   

4. US Default

A US Default: the current debt ceiling of $16.39trn was reached at the end of 2012, and the US Treasury is now funding the current deficit, which is running at a rate of about $1 trn annually, via “extraordinary measures” which means (among other things) suspending reinvestment in the Government Securities Investment Fund, a money-market defined-contribution retirement fund for federal employees.  This accounting maneuver brought Treasury about $130 billion in headroom last year.  If the US fails to raise the debt ceiling and the extraordinary measures are exhausted, the government would have to go into default on a significant portion of its current obligations.

In principle, it could continue to service the existing debt and meet part of its other financial obligations, but with nearly 40% of its current expenditures being financed by floating new debt, a lid on that new borrowing would force the government to stop payments in many areas.  Such a default would cause chaos in not only the US but the global economy as well and surely cause a significant downward movement in official rates by the RBA to boost the Australian economy.

In our view it is actually this chaos that will ensure a default does not occur and makes this event very unlikely.  China, whilst being the largest holder of US Treasuries after the Federal Reserve, would commit economic suicide if it were to call in all its chips, as the USA is also its largest trading partner and the largest purchaser of all the exports that have been the engine for China’s economic growth over recent decades.  The military consequences of calling in US debt also cannot be underestimated.

5. Possible Global Recovery

A US, European & Chinese recovery: this would breathe new life into the commodity prices, especially iron ore, which are already higher than they were only a few short months ago.  The graph below shows the correlation between the price for iron ore & the cash rate.

Inflation appears to be past the low point and parts of the non-mining economy are responding to earlier cuts.  The drivers for lower rates in 2012 may disappear in 2013.  The RBA was the first major central bank to lift interest rates in 2009 from “emergency lows” once it became clear that those low rates were no longer required and the global economy recovered.  This would move us closer to full employment and no doubt cause wages growth and inflation to rise. The RBA would be forced to raise interest rates.  Despite Mario Draghi’s recent comments that he sees “positive contagion” in the EU, given government debt levels in Europe & the US which will take generations to be repaid, our view is that recovery in these countries in many years away, and although the Chinese economy remains a growth story all three would need to be firing together to cause a jump in wages growth, inflation & employment in Australia and the commensurate jump in interest rates.

Conclusion

Whilst global markets have opened 2013 on a positive note, there are still many  factors that will keep world economic growth subdued in 2013 (the latest World Bank forecast is for 2.4%).

The US, Japan & Europe still have major debt problems that will take many years to fix.  The Australian economy, whilst having a relatively strong federal government fiscal position, faces a slowing commodities boom and a house market that by all measures appears overvalued and is possibly being propped up by easy monetary policy.  Given the global outlook and Australia’s relatively low inflation we expect the official cash rate is likely to stay put over the first quarter, however will be poised to be cut should unemployment start to rise, the housing market come off further in the second half of the year or the commodities boom slow down faster than expected.

Looking to the RBA’s February decision AAP's survey of 15 economists reveals a median forecast for December's Consumer Price Index to show an average increase of 0.5 per cent in prices over the December quarter.  Dr Shane Oliver (AMP Chief Economist) says "If the underlying rate comes in at 2.2 (per cent) or less then I think that could well clear the way for a rate cut, but if it comes in around 2.4 or more its probably not enough for a rate cut."

On balance, the five key trigger points for interest rates all point downwards in 2013.  Our following articles will monitor these issues as domestic and global developments occur.