It's not out of the realms of possibility that the RBA could cut rates in May

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  • Recent economic data in Australia has been far stronger than in prior months. There’s also tentative evidence that China’s economy is gathering momentum.
  • Despite those trends, financial markets still expect the RBA will cuts rates in the coming months.
  • In April the RBA made a small yet significant tweak to its commentary that has, in the past, signalled that it’s moving towards cutting rates. Many suspect the bank will adopt an easing bias in May, implying that rates are likely to be lowered again.
  • The RBA has nominated a sustained lift in Australia’s unemployment rate or lack of progress in returning inflation to its target range as two catalysts that could warrant easier monetary policy settings.
  • Markets will receive updated data on both fronts later this month. If both are very weak, it’s not out of the realms of possibility that the RBA could cut rates in May.

Something strange happened in the Australian economy in February, at least according to data released so far.

After being almost universally weak, outside of the official jobs number, economic data is suddenly starting to look alright.

Retail sales rose by the most in over a year, more than doubling the increase expected by markets, while Australia’s trade surplus surged to $4.8 billion, the highest level on record, helping to deliver income to the government’s coffers.

Building approvals also staged an apartment-led comeback, surging by the most in years, albeit from depressed levels.

Coupled with growing evidence from abroad, especially China, Australia’s largest trading partner, that suggests the global economy may not be as crook as many were fearing just a few days ago, it’s not the kind of backdrop one would normally associate with the need for RBA rate cuts.

However, that’s not the case.

As things currently stand, financial markets are still fully priced for one 25 basis point reduction to the cash rate to arrive by the end of the September quarter this year. Another cut, taking the cash rate to just 1%, is also nearly priced to occur by the middle of 2020.

Even with tentative evidence that both the Australian and global economies may be starting to improve after a fairly weak end to 2018, markets, collectively, are clearly not convinced, holding onto the view the cash rate will be cut at some point in the coming months.

That’s despite Australia’s labour market continuing to chug along nicely, with unemployment sitting at an eight-year low of 4.9%, seemingly removing one of the two catalysts RBA Governor Philip Lowe nominated in February that could warrant a rate cut, a sustained lift in unemployment.

So why are markets still backing in a near-term rate cut?

Like many others out there, the Commonwealth Bank’s rates strategy team was listening, or should that be reading, what the RBA said in its April monetary policy statement earlier this week, especially the tweak in the RBA’s commentary in the key final paragraph of the release.

For the first time in two years, the RBA changed its wording, something that often signals that a change in policy direction may be coming, in this case, a cut.

“The RBA has, in previous easing cycles, usually displayed an explicit easing bias before cutting rates,” the CBA team said.

“They have also almost always signalled a form of ‘heightened vigilance’ two or three months before cutting rates. The comment in the April statement about ‘monitor developments’ clearly fits the mould.”

Strategists at the bank say the whenever the RBA has included a heightened vigilance-type comment in the past, it has usually come two months before it has cut rates, with an explicit easing bias usually inserted in the month in between.

So if prior form is any guide, the RBA may shift to an easing bias, implying the cash rate could be cut again, when it next meets in May.

Bill Evans, Chief Economist at Westpac Bank, was another who took interest in the RBA’s change in commentary, calling it both “significant” and “surprising”,

He believes the tweak points to the likelihood that the RBA will adopt an easing bias when it next meets on May 7, paving the way for two 25 basis point rate cuts to be delivered in August and November.

“This is consistent with our general view that the RBA is on track to adopt an easing bias in May and cut the overnight cash rate in August and November,” he said in a note released following the bank’s April monetary policy decision.

“This change appears to be a very clear intention to signal that policy is much more ‘live’ than has been the case since [Philip Lowe was first appointed as RBA Governor].”

Adding extra spice to the RBA’s May 7 policy decision, it will come two weeks after Australia’s March quarter consumer price inflation (CPI) report is released on April 24.

Core CPI — far more influential on the outlook for monetary policy settings than the headline CPI rate — has remained under the RBA’s 2-3% medium-term target for three years, and actually moved further away in the December quarter last year.

Along with a sustained lift in the unemployment rate, Philip Lowe nominated a lack of progress in returning inflation towards its inflation target as a second catalyst that would warrant a further easing in monetary policy settings.

To this point the vast majority of market attention has been on the first catalyst — a lift in unemployment. This likely reflects that Australia’s jobs report is released monthly whereas the CPI report, frustratingly, is only produced on a quarterly basis.

However, that focus is now likely to shift more towards the March quarter CPI release, particularly after Australia’s March jobs report is released on April 18.

If the next inflation report is weak, even with unemployment sitting at an eight-year low, it could be enough to prompt a near-term policy response from the RBA.

While not its base case — the CBA’s economics team still believe the next move in Australia’s cash rate will be higher — the bank’s strategy team say the combination of a weak jobs and CPI report later this month could lead to the RBA to actually cut rates in May, even before introducing an easing basis.

“We still feel that it is a big stretch to get from here to a rate cut in May,” they said.

“[However], if at any point the RBA finds itself with a rate cut priced in the market, GDP clearly below trend and inflation clearly below the target it will be hard for them to resist the urge to cut rates.

“They are, after all, an inflation-targeting Central Bank.”

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