BAML explains why the RBA is unlikely to cut the cash rate

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  • Financial markets, collectively, now see 25 basis point cut in the RBA cash rate as an even money bet by November this year.
  • BAML’s Australian economics team say that while the case for interest rate hikes has diminished, equally, the bar for further policy easing remains high.
  • It says a reversal of strengthening labour market conditions will likely be required for the RBA to deliver on what markets currently expect.

Expectations for the RBA cash rate have undergone a significant shift since early December with financial markets moving from pricing a 50% chance of a 25 basis point increase by November 2019 to a 50% chance of a 25 basis point cut over the same period.

The question many are now asking is whether markets, collectively, are right?

To Bank of America Merrill Lynch’s (BAML) Australian economics and rates strategy team, lead by Tony Morriss, the answer is most likely no, although it concedes the need for higher interest rates both this year and next has diminished since late last year.

“Economic risks have clearly risen at the start of the year,” BAML says.

“We continue to expect the RBA to remain on hold this year but concede the case for hikes in 2020 has weakened.

“We would expect modest changes to RBA forecasts next month, some tempering of the Bank’s mantra that the next move in rates is up, while adding some conditionality that the RBA stands ready to provide policy support if needed.”

Rather than the credit-led downturn in Australia’s housing market being the root cause of the switch in market mindset on the outlook for the cash rate, BAML says it’s uncertainty from aboard that largely explains why markets think there’s a greater probability of a cut, rather than hike, this year.

“The change in dynamics is more centered on the outlook for global growth, in our view, rather than a step change in the risks around the domestic housing slowdown,” BAML says

“The rise in global uncertainty in contrast to robust domestic conditions can be seen in the chart [below].”

BAML

While the downturn in the housing market has garnered plenty of attention, especially in Sydney and Melbourne, increasing concern about potential spillover effects into other parts of the economy beyond residential building approvals, BAML says that unless that leads to a reversal of recent labour market strength, especially in the leading indicators, the RBA is unlikely to deliver the policy easing many now expect.

“A necessary condition for a change would be a change in robust labor market dynamics,” the bank says.

“Over 250,000 jobs were created between January to November, of which more than 60% were full-time, down from the record of 410,00 in 2017 but double seen over 2016.

“While we concede the labor market lags the economy, the leading indicators of labor demand remain positive.”

It also suggests that rather than helping to support confidence, a rate cut could easily deliver the opposite effect given the RBA believes, in its opinion, that stable policy should act as “a source of stability and confidence”.

“Consumer confidence has not yet weakened with equities and the housing market, considering the strength of the labor market,” BAML says.

“Further, a cut may not be passed on by banks due to ongoing elevated funding pressures. If funding becomes more expensive then there might be case to cut to ease credit conditions, but we would expect the RBA to explore ways to improve liquidity first.”

It also notes that following a steep fall in the Australian dollar last year, and with the Federal election set to occur in May, the tailwinds for the economy — both actual from a currency perspective and potential when it comes to increased fiscal stimulus — mitigate the need to cut policy rates further at this point.

“Offsets from fiscal policy and a weaker AUD means there is a high hurdle for policy easing, but the case to hike has weakened,” BAML says.

BAML is not alone in its view that now is not the time for either policy easing or tightening from the RBA.

According to ANZ’s Australian economics team, while the prospects for Australian economic growth have weakened recently, they’re not yet at the point where policy easing is warranted.

“There are positives for the economy, such as rising commodity prices in Australian dollar terms and strong government spending, but the list of negative developments is growing,” says Felicity Emmett, Senior Economist at ANZ.

“While Australian business conditions are currently still solidly above long run average levels, we will be watching these surveys particularly closely over coming months.

“A further deterioration would challenge our view [for] further labour market improvement.”

ANZ, like BAML, sees the cash rate remaining unchanged at 1.5% throughout the entirety of 2019. Unlikely financial markets, economists at ANZ believe the next move in the cash rate will be higher, albeit not until the second half of 2020.

While most economists share a similar view, not all agree that the next move will be higher.

In late 2018, AMP’s Chief Economist Shane Oliver broke ranks from the consensus view, forecasting not one but two rate cuts will arrive in the second half of this year.

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