Can the RBA hold out against the rising tide of global interest rates


Matthew Peter, Chief Economist 

At its Board meeting of last Tuesday, the Reserve Bank of Australia (RBA) kept the official cash rate on hold at 1.5% and maintained a neutral bias. This is in stark contrast with developments elsewhere in the world, where central banks are either in the process of tightening monetary policy or are signalling to the market their intention to tighten policy.

Despite weak inflation reports over the last three months, the US Federal Reserve (Fed) raised the federal funds rate target range by 25 basis points in June to 1.0-1.25 per cent, in response to solid underlying momentum in economic activity and further tightening in the US labour market. The Fed has also indicated that the reduction in policy accommodation will, in time, include a shrinking balance sheet; a move that could be considered a reversal of quantitative easing.

Sustained economic recovery and receding political risks have also seen the European Central Bank (ECB) shift its direction on monetary policy. In recent comments, ECB President Mario Draghi stepped up the hawkish tone, stating that deflationary pressures in the euro zone had been replaced with reflationary ones. Elsewhere, the Bank of Canada (BoC) is set to implement its first rate hike since 2010. According to Bloomberg, the overnight-index swaps data are indicating traders expect an 80% chance of a 25 basis point (bp) rate hike by the BoC at their monetary policy meeting next Tuesday.

Even in Japan and the UK, where the Banks of Japan (BOJ) and England (BoE) have been the laggards in the tightening cycle, the potential for ongoing easing of monetary policy is being questioned. The BoE’s Monetary Policy Committee came close to raising Bank Rate at their June meeting in response to rising inflation after a split vote of 5-3 in favour of no change.

In Japan, the 10-year JGB has been trading at +10 bps, at the upper end of tolerance that market expects the BOJ to tolerate on its target of 0%. This has led some commentators to expect that the BOJ may review its target upwards from 0% to a positive number closer to current market pricing.

Driving the move among the world’s largest central banks towards monetary tightening has been improving economic conditions. The June quarter of 2017 has shown signs of solid economic activity across the major economies with broad-based strength in surveys of consumer and business sentiment, industrial production and merchandise trade.

It could be argued that it is only the lack of a sharper lift in inflation rates that is preventing central banks from adopting an even more hawkish stance towards monetary policy. Fluctuations in oil prices are still impacting headline inflation rates, while wage growth remains tepid, despite falling unemployment rates. A stabilisation of oil prices around US$50/bbl and signs of rising wage growth will certainly tilt market expectations towards higher interest rates.

Where does Australia and the RBA fit into the global picture? Unfortunately, the Australian economy and monetary policy is out of synch with the rest of the world.

An unsustainably high level of household debt, the need for fiscal constraint by the government to preserve its AAA credit rating and a slowdown in dwelling investment are dampening growth in domestic demand. However, the risk of fuelling even higher levels of household debt and stoking an already overheated housing market prohibits the RBA from contemplating rate cuts.

Some commentators have been arguing that as growth in the Australian economy picks up over the second half of 2017, the RBA can afford to lift the cash rate. Some have even pointed to the RBA’s own growth forecasts as evidence that a rate hike is due before too long. However, it must be remembered that the RBA’s forecasts are conditioned on current market pricing for cash rates. Current market pricing is for the RBA to keep the cash rate on hold until at least the September quarter of 2018.

Early cash rate hikes by the RBA are inappropriate in the current environment, where the lack of domestic demand requires a more competitive Australian dollar to improve competitiveness of our internationally traded goods and services sectors, and where household and government balance sheets require breathing space to ensure an orderly deleveraging. With the RBA on hold, higher interest rates in the rest of the world will drive the Australian dollar lower and deliver improved international competitiveness, which will help drive growth in the Australian economy. However, the key point is that the direction of causation is from low RBA cash rates to a lower AUD to stronger growth, not from stronger growth to higher RBA cash rates.

Table 1: Financial market movements, 29 June 2016 - 6 July 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,409.8

-0.4%

US

2.37%

9.9 bps

US Dollar Index (DXY)

95.80

0.2%

Nikkei 225

19,994.1

-1.1%

Japan

0.10%

4.1 bps

USD-JPY

113.22

0.95%

FTSE 100

7,337.3

-0.2%

UK

1.32%

6.6 bps

GBP-USD

1.297

-0.3%

DAX

12,381.3

-0.3%

Germany

0.56%

11.0 bps

EUR-USD

1.142

-0.2%

S&P/ASX 200

5,758.8

-1.0%

Australia

2.64%

14.0 bps

AUD-USD

0.759

-1.3%

Source: Bloomberg 


Economic Update

United States

US business sentiment surges
  • The ISM Manufacturing PMI jumped to 57.8 in June, from 54.9 in May. This was the highest reading since August 2014, with the expansion broad-based across industries. New orders (including export orders) and production measures increased in May, and the employment gauge climbed to 57.2 (from 53.5 in April), its second highest level since 2011. In addition, the ISM non-manufacturing ISM also rose to 57.4. Combined, the ISM surveys point to US annual GDP growth in excess of 3%; around a percentage point higher than our current estimate of trend. The lift in business sentiment came despite a slight pull back in factory orders in May.
  • Consumer spending rose 0.1% in May, following 0.4% gains in April and March. This was in line with expectations, and came alongside a fall in the year-ended core inflation rate to 1.4% (from 1.5% in April) as measured by the PCE price index (ex. food and energy). Headline PCE inflation fell to 1.4% in year-ended terms, down from 1.7% in April.


Euro area / United Kingdom

Conditions in the euro area continue to tighten as core inflation picks up
  • Flash estimates suggested that inflation in the euro area was 1.3% over the month from June, down from 1.4% in May. Core inflation, which excludes volatile items such as energy and food, was 1.1% in June, up from 0.9% in May.
  • Retail sales within the euro area accelerated in May, growing 0.4%, down from 0.1% in April. This print was largely driven by a spike in automotive fuel sales and to a lesser extent, non-food items.
  • The unemployment rate remained steady at 9.3% throughout the month of June. 

China / Japan

Business confidence in China’s manufacturing sector lifts
  • The Caixin-Markit manufacturing PMI rose to 50.4 in June after falling into contractionary territory in May. The reading suggests ongoing resilience in China’s manufacturing sector as reported by the more positive official manufacturing PMI, which also rose in June.
  • Wage growth firmed a little in Japan in preliminary estimates for May. Nominal wages per worker increased 0.7% from a year earlier, up from 0.5% annual growth in April. Real wages growth increased to 0.1% in year-ended terms, from 0% in April.



Australia / New Zealand

Retail sales pick up while dwelling approvals continue to decline
  • The RBA kept its cash rate target unchanged at 1.5% during the July meeting earlier in the week.
  • After a sluggish start to the year, retail sales have picked up over the past two months, rising by 0.6% over the month of May, slowing slightly from 1.0% growth in April.
  • Dwelling approvals fell moderately in May (-5.6%) after remaining surprisingly resilient in the first two months of the year. The fall over the month was driven primarily by a reduction in non-house approvals (-12.6%), while approvals of houses were relatively flat (0.4%) over the month. Looking ahead, we expect approvals to continue to trend lower given the large supply emerging in most housing markets across the country.





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