Australian Market Strategist, Saxo Bank Group
Summary: The Reserve Bank of Australia meets on May 7 in a scenario that makes the meeting more ‘live’ than has been the case for many months, with the interest rate decision likely to be a close call.
After a slew of weaker than expected data has confirmed the significant loss in momentum throughout the second half of 2018 has also permeated the first quarter of 2019, will disinflation be the trigger for a rate cut? Consumer prices were flat on the quarter as the “lucky country” has not managed to escape the pervasive disinflationary environment evident globally.
Following the weak CPI data the odds of a rate cut increased as bank bill rates and the yield on 3-year notes has plummeted. Futures were indicating a 48% chance of a rate cut at tomorrow’s meeting but these bets have been scaled back and are now sitting at around 37%.
A federal election less than two weeks away and stronger than expected March jobs data will play into staying the RBAs hand tomorrow, with the RBA wishing to remain apolitical and waiting for political uncertainty to subside before moving the official cash rate.
The RBA stated in its board meeting minutes earlier this month that “Members also discussed the scenario where inflation did not move any higher and unemployment trended up, noting that a decrease in the cash rate would likely be appropriate in these circumstances,". Here the RBA clearly states the conditions for cutting the cash rate – inflation remains lower than expected and that the trend in unemployment starting to rise.
Whilst the first part of this condition has been met, with inflation remaining below the central bank's 2-3% target band, the second condition is yet to materialise. The deterioration in core inflation is alarming, especially given that the underlying is trending in the wrong direction, but core inflation has not met the bottom end of the 2-3% target range since late 2015 so this one particularly weak inflation print is unlikely to force the RBA’s hand in such an erratic fashion.
Until very recently, the RBA has maintained a stubborn optimism that the labour market will strengthen and inflation will return to its target range, allowing it to lift interest rates, despite continuously missing its 2%-3% inflation target range over the past three years, tepid wage growth and heavily overleveraged Australian households struggling under the weight of a slumping property market.
It was only in February of this year that Governor Lowe even opened the possibility of a more symmetric outlook for the cash rate, and the central bank is still yet to adopt a formal easing bias. This would be another reason the central bank may hold off on cutting the official cash rate tomorrow as its preferred modus operandi would be to prepare financial markets for a drop later this year by making its easing bias explicit. In 2016 a weak CPI report prompted the RBA to cut the cash rate from 1.75% to 1.5%, but during that time the central bank had a formal easing bias under the stewardship of Governor Stevens.
The second condition which the RBA have stipulated would force its hand towards cutting the cash rate is that the trend in unemployment starting to rise. Governor Lowe has remained confident to date, pointing to the positive momentum in the labour market as a bright spot despite other softening data. On that basis the labour market is crucial to the RBAs outlook, something we have pointed out before.
Australian households are under pressure to maintain spending habits as the property market continues to deteriorate given that most are significantly overleveraged and have whittled down their savings down to around decade lows. Private consumption is a big driver behind the Australian economy and historically represents around 60% of GDP, so in order to maintain economic growth and prosperity, consumption must be maintained.
The RBA is banking on employment strengthening and subsequent wage growth pressures offsetting the negative wealth effect and consequent hit to consumption due to the slump in property prices. We have long forecast that the RBA will eventually have to cut the cash rate, as pervasive stagnant wage growth means income growth for the average person is not enough to produce significant inflationary pressures or to offset the negative wealth effect felt as house prices continue to deteriorate.
But so long as unemployment is trending lower, the RBA will not fully capitulate on policy guidance. Unemployment is now sitting close to cycle lows at 5% and in March the economy added 25,700 jobs, a beat on the median forecast of 15,000 and most of the beat was for full-time jobs, which rose by 48,300. Whilst we recognise that unemployment is a lagging indicator and several leading indicators are pointing to a slowdown in hiring ahead, given that the RBA has maintained such a positive outlook and the most recent jobs numbers illustrate positive momentum remains in the labour market, the RBA is unlikely to move to cut the cash rate tomorrow.
Construction is one of the largest employment sectors, making up nearly one in 10 jobs in Victoria and New South Wales. As residential construction activity deteriorates over the coming months, this will hit jobs. Employment will not continue to hold up as confidence is eroded and growth continues to lose momentum. The labour market remains resilient, but unemployment is a lagging indicator so the data only give us a rear-mirror view. At that point once evidence of softness creeps into the labour market the RBA will move to cut the cash rate fairly quickly.
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