Why Soc Gen sees an interest rate cut coming today

Aerialist Nik Wallenda at Niagara falls. Photo: Getty / File

Good morning! It’s RBA interest rate decision day.

A 25 basis point cut to a record low of 2.00% is in play for today’s announcement, but the market is split on whether it will happen. A Bloomberg survey has 17 out of 30 economists expecting the RBA to hold in today’s meeting.

Many analysts have been pulling forward their predictions for another interest rate cut in recent weeks, but there remains a question over how effective it could be, and this could be the decisive factor if the RBA decides not to move. Over the weekend, I heard a friend saying that “all the people in the newspapers” were talking about another rate cut this week. She was already working that into her household budget.

Tightrope time. A survey of one mate proves nothing, of course, but it illustrates a broader point about the power of monetary policy: if savers are factoring rate cuts into their budgets, we have a problem, because it shows the RBA is running out of ways to free up money in the economy.

There’s some urgent context for today’s RBA meeting. A really strong US jobs report last Friday would have pulled the Aussie dollar lower (just by a US dollar rally all over the board).

That US jobs number – the mother of all leading global economic indicators – came in weak. This is among a string of data points in recent weeks that have arrested the Aussie dollar’s slide.

This morning it was trading just below US76c, but the RBA would probably like to see it at around US70c. There are all sorts of reasons for this but what’s important to remember is even at 2%, Australian interest rates still offer a solid yield in a world where markets are desperate for it — and those rates are on a AAA rated security from a government standing over a growth rate of around 2.5%.

Fundamentally, Australia remains attractive on global markets because the economy – despite what many people would like to have you believe – is strong. It’s just a little less robust in terms of growth than it has been for a long time.

The RBA has been hating on the dollar’s resistance to all the forces dragging it down for a long time, talking repeatedly last year about how the exchange rate remains “high by historical standards” and “above most measures of its fundamental value”.

Translating this from central bank speak, it means the RBA thinks the currency should be lower. One way to shove it down is to cut the official interest rate. We saw the power of it in February when the surprise rate cut drove the Aussie from just above US78c to US76.6c in seconds.

Now some might see it as a bit of a sport to cheer on a strong Australian dollar, but that loses its lustre when you consider the effect it’s having on the country, by keeping exports expensive.

Last week we noted the iron ore price slide is becoming a gathering storm for Australia in terms of the fiscal position and company profits. Klaus Baader, Soc Gen’s Asia-Pacific chief economist, points out in a note to clients that the problem is compounded by the dollar’s seeming insistence on staying where it is, even while the country’s key commodity export is getting smoked.

Baader does the maths:

Looking at monthly averages, iron ore priced declined by 7% in February and a further 9% in March, leaving them down 49% yoy in March 2015. Meanwhile, the exchange rate has also declined, but by a far lesser margin. This means that even in Australian dollar terms iron ore prices were down 39% yoy in March 2015, and declined by 4% mom and 7% mom in February and March respectively.

So on global markets iron ore prices are falling, but with the Aussie high, if you’re going to buy Australian, you have to pay a hefty premium.

This is a problem for Australian competitiveness in a period of falling demand and high supply. (And, briefly, the government should start talking about this too. Treasurer Joe Hockey only seems to get the point of the fall in the terms of trade, but won’t – or can’t – engage on the more difficult issue of the currency strength. It’s not complicated, it’s just new.)

Baader, who predicted an outlier GDP growth number last year against the market, puts the chances of a rate cut from the RBA today at 80%. (He also completely missed the February rate cut, along with everyone else.) He thinks there are a bunch of reasons that the RBA should cut, and paints a blunt picture of what could happen if the board decides not to move.

… the most pressing factor in the RBA’s rate deliberations with respect to the exchange rate will be the weight of rate expectations, or more precisely what an upward adjustment in rate expectations could do to the Australian dollar. Currently, the swaps market is priced for some 65bp of rate reductions by March 2016 from the 2.25% level at present (i.e. to 1.6%). Although this is an extreme expectation in our view, the RBA will be weary of causing a sharp upward adjustment here – and hence another argument for a rate cut in April. Indeed, it also makes the case for the RBA to retain some form of easing bias, albeit in our view likely to be less explicit than the current wording and contain less conviction.

In other words, the absence of a cut, or something in the statement that suggests the next move down might be months away, could send the Aussie dollar through the roof.

It would build a potentially huge spike into the Australian dollar’s price, which nobody wants. The lower dollar right now makes Australian steak, wheat, university degrees, bauxite, iron ore, and holidays to the Gold Coast or Melbourne or Broome cheaper and more appealing.

On the off-chance there’s no cut, expect a very severe statement that another cut is immediately available. Baader also said that “external developments” including the US and China were “an argument for an early move”. The prospect of a US rate hike at some point, probably late in this year, is a reminder that increasingly, global forces and institutions – especially the US Fed these days – have great say over Australia’s future.

There are still many powerful levers Australia can pull, however, and central bank interest rates is one of the biggest. (The other is confidence, which is down to Canberra.) We’ll have LIVE coverage here this afternoon.


P.S. Many will wonder what Baader had to say about Sydney house prices. So here it is:

There are … any number of reasons for the further easing of monetary policy in Australia, but there are also arguments on the other side. One is that monetary policy appears to be working perfectly well with respect to the credit channel, and overall credit growth to the private sector is running at the highest rate in six years of 6.2% yoy, well above nominal GDP or domestic demand growth. However, the RBA continues to portray this as ‘moderate’ growth.

More central to the discussion is what is happening to residential house prices. Nationwide house price appreciation had moderated to 6.4% yoy by Q4 2014 according to the ABS, but over the past two years the gain was 17.5%. More recently, private sector data suggest some reacceleration in house prices, especially in the country’s largest housing market, Sydney, where prices in March were up some 14% yoy. All this is stoking fears of a housing bubble which could burst and thus pose a serious risk to financial stability. The RBA must be weary of adding too much fuel to the fire, which is one reason why our low point for policy rates is still considerably higher than the current market pricing. But as regards the near-term outlook, it appears that the RBA is putting more weight on macroprudential measures (in cooperation with the banking regulator APRA) to contain upward pressure on real estate prices.

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