Where to for Interest Rates?

Contrary to market expectations, on 7 Feb 2012 the Reserve Bank of Australia (RBA) kept the official cash rate at 4.25%, the rate remained on hold this month, following the most recent announcement made on 6 March 2012. The RBA appears satisfied for the time being that the cuts implemented in November have been sufficiently supportive to lending rates without driving a strong increase in consumer spending that might fuel inflation.

The key considerations driving interest rates continue to be; 

• Risks and volatility posed by the Eurozone Crisis, funding tightness and higher associated wholesale borrowing costs for the banks and lending institutions
• Increasing deposit vs. wholesale funding mix for major Australian banks
• The two–speed economy with commodities driving investment, inflation and the high Australian dollar which is negatively impacting manufacturing and other industrial sectors
• Fairly full employment rates which could lead in the long term to the inflationary pressures the RBA is charged with avoiding
• RBA Official Rates set based on their view of growth and inflation risks 

Separately the major banks have implemented “out of cycle” increases in mortgage rates independently of the RBA. The justification for these increases is to offset the increase in cost of “wholesale funding” sourced from overseas markets. Despite an increase in the deposit base of banks since the GFC in 2008 the Australian banks still have a relatively low proportion of deposit funding vs. offshore wholesale funding compared to international peers. Hence the increased borrowing costs for wholesale component of their funding as bond markets have tightened have been a net drag on bank interest margins. The banks seek to maintain profitability by increasing the value of their assets (i.e. increasing mortgage interest rates) and cutting cost (i.e. retrenching staff).

Towards the end of 2011 the uncertainty in Europe led to significantly higher in wholesale funding costs for Australian Banks even though they benefited from a “flight to quality” by fund providers. There was a marked reduction in successful bond issuance across Europe and bond spreads expanded dramatically.  Behind the US and Japan, Italy operates the third biggest bond in the world and has to refinance ~$300 billion of debt maturing during 2012. Recently with the increasing confidence in the markets there have been successful auctions of Italian bond at lower rates than those at the end of 2011. 

Overall Australian banks seem well placed to cope with a greater funding tightness in the global market as the “flight to quality” of money market funds shifts funds from the European market to Australian banks and deposit demand growth continues to outstrip loan demand growth as Australian households deleverage.

Looking forward the market has expectations of a rate cut with an implied official cash rate of ~3.75% by calendar year end. The RBA’s expectation is for GDP growth at trend despite deterioration in global outlook as expectations for our Asian trading partners remains strong with an average of 4.4% growth for our main trading partners. In addition the RBA points to unemployment at 5% and with inflation in the middle of their target range the likelihood of a further imminent cut in the official rate seems low.

The risks tend to support that the next official rate move will be down as European outlook remains volatile, global growth expectations are softening and during the recent company results reporting season a number of companies outlined significant job cuts. A structural shift in Australian investment is occurring whereby investment growth is largely associated with the booming resources sector in WA and QLD coincident with very little investment in the Eastern States. This is the “two-speed economy” with commodity induced high Australian dollar and low domestic consumer demand as households deleverage negatively impacting manufacturing and other industrial sectors.

As the government has committed to a surplus in 2013 there is very little room for targeted fiscal stimulus and hence monetary policy will need to be brought to bear if the expectations for global growth or the local employment market deteriorates below the RBA’s current expectations.

Sources:

1. Minutes of the February 2012 Monetary Policy Meeting of the Reserve Bank Board
2. RBA Statement on Monetary Policy Feb 2012