The RBA’s 50/50 Conundrum

Posted on February 7, 2019

The Reserve Bank of Australia’s overnight cash rate has been unchanged at a record low of 1.50% for a record 28-months (Fig 1a). Throughout 2018, the central bank’s meeting minutes and speeches suggested that rates remained appropriate – implying a broadly neutral policy stance – while hinting that the next rate movement would be higher, albeit with “no strong case for a near term adjustment in monetary policy”[1].

For the majority of 2018, forwards markets agreed with the central bank and were firmly pricing in future RBA rate hikes – but this has abruptly changed (Fig 1b) with the market now indicating a 50/50 chance of a rate cut in 2019. This rapid reversal could exert substantial influence on the central banks thinking with significant implications for money market and fixed income investors.

Stuttering growth engines:

Historically, Australia twin engine economy has been a source of strength, with the combination of commodity exports and domestic demand helping the country avoid recession for a record breaking 27-years. In the past half-decade, as mining infrastructure investment waned, a booming housing market – with prices jumping by 45% between 2012 and 2017 – replaced it as the key driver of economic growth.

However, the factors that triggered the housing surge – low interest rates, easy bank financing, limited supply and strong foreign demand have recently faded due to a combination of new macro prudential measures, higher commercial bank mortgage rates and tighter restrictions on foreign buyers. House prices (Fig 2a), building permits and new home sales have all fallen sharply, with negative repercussions for retail sales and consumer confidence.

Meanwhile, the well-publicized slowdown in Chinese economic growth and rising global trade tensions have raised the specter of lower demand for key Australian commodity exports including coal, gas and iron ore.

Consequences and conundrums:

Throughout 2018, solid business sentiment, an improvement in capital expenditure intentions and a tight labor market – with strong hiring momentum and up-tick in wage price pressures – encouraged the central bank’s belief that inflation would move higher – implying the need for future rate hikes.

But weaker housing, sharply lower business sentiment and softer domestic demand are already impacting growth and are challenging the viability of the RBA’s optimistic 3.5% 2019 GDP forecast[2]. The hawkish bias is also being questioned as the RBA has never hiked interest rates during a housing market downturn (fig 2b).

The path of least resistance:

Economic growth will likely slow in 2019, albeit from a previously robust level. However, fears of a property price crash are likely overdone: Low unemployment and low interest rates suggest mortgage payments remain affordable and most homeowners still enjoy positive equity. Little mortgage borrowing was completed at the peak which was perceived by many as unsustainable.

Finally, even if the economy slowed faster than expected, the RBA has capacity to cut base rates if necessary and the government’s improved fiscal position has given it the ability to cut taxes or boost spending if required.

Given this backdrop, the RBA is likely to strike a more neutral tone in meeting minutes and revise down its 2019 GDP forecast while keeping base rates unchanged for the foreseeable future – further extending its record breaking period of inertia.

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[1] RBA’s December monetary policy meeting minutes as at 18^th Dec 2018

[2] Source: RBA Statement On Monetary Policy, 9^th Nov 2018

Posted in Australia,General.Tags: Australia, rates, RBA, Shevlin.

New02/07

Ed Fitzpatrick, CFA

Head of US Rates

Kelsey Berro, CFA

Associate, US Rates & Inflation Strategies

FOMC Statement & Potential Impact on Fixed Income

Posted on January 31, 2019

Following the Fed’s announcement, please see below for market views from the Global Fixed Income, Currency & Commodities Team (GFICC):

Consistent with our and the market’s expectations, the Federal Open Market Committee (FOMC) maintained the Fed Funds rate target range of 2.25% ‐ 2.50%.

The January FOMC statement was notably altered in order to reflect the Committee’s commitment toward data-dependence and bias towards patience in regards to additional rate hikes. Despite viewing a strong labor market and sustained economic expansion as the most likely outcome, the Committee removed the balance of risks to the outlook from the statement given the reduced visibility around the US and global economy due to “cross-current” described in detail below.

Although the official statement did not reference the balance sheet normalization process, the Committee released an additional document on balance sheet normalization which indicated the Committee’s desire to continue to use interest rate policy as their primary tool but with flexibility available to adjust balance sheet policy in the future within the context of maintaining the current floor system of ample reserves. For now, the decline in the Fed’s asset holdings will continue in the background at the max run-down rate (30bln Treasuries / 20bln MBS).

Overall, this was a decidedly more dovish statement than market participants had expected.

Committee Statement

We can break the statement into two parts:

Economic Assessment – The Committee had less visibility into current economic conditions as a result of the government shutdown, delaying a number of major data releases. Unlike in the December meeting, in the January meeting there was newfound recognition of the decline in market based measures of inflation compensation. US inflation breakevens actually moved higher in January during the intra-meeting period after moving lower in Q4.
Outlook – The Committee continued to soften its language and perceived certainty around “some further gradual increases” by removing it all together and replacing it with a line that the Committee can be “patient in adjusting policy” given muted inflation pressures and global economic uncertainty. The Committee continues to expect the most likely outcome to be sustained growth accompanied by a strong labor market and inflation matching their objective.

There were no dissenters.

Chair’s Press Conference

Chair Powell remained somewhat upbeat on the US economy, specifically the labor market, but recognized the continued “cross-currents” which included policy uncertainty (trade and Brexit), the weakening global growth backdrop and the impacts of the government shutdown. He recognized the contradiction between the still robust economic data in the US and the cross currents described below and stated the best way to manage risk in this situation was to be patient and take a “wait and see” approach. Chair Powell also described the case for raising rates to have diminished due to muted inflation risks.

On the balance sheet, Powell stated that the Fed is actively working towards a decision on when to conclude the balance sheet run-off given that the balance sheet will need to be larger than it was pre-crisis. In addition, he reiterated the details of a separate document released with the statement which emphasized that interest rate policy would remain a primary tool but balance sheet policy was not on a pre-set course and ultimately the run-down in the balance sheet will be within the context of an abundant reserve regime.

The chairman struggled to explain the rather abrupt shift in the tone of communication that appeared to move even further beyond the assurance he provided the market during his January 4^th comments at the American Economic Association (AEA). Powell cited persistently tighter financial conditions and a continuing narrative around weaker global growth as reasons for the shift. However, it was challenging to view the cumulative changes in the communication post at the December FOMC meeting as being anything other than reactive to financial markets. It remains to be seen whether today’s press conference performance represents a material shift away from the current hiking cycle or indeed a true pause before the cycle continues.

All eight FOMC meetings will be followed by a Press Conference this year.

Our View

The Committee has fully shifted away from pre-set quarterly rate hikes towards data dependence. The recent tightening in financial conditions in Q4 and more uncertain global economic backdrop has been reflected in a more patient stance from the Federal Reserve as it relates to further interest rate hikes. A precedent to pause before adjusting policy further has now been completely established after Fed speak has been trending in this direction since the start of the New Year.
Meanwhile getting back to the economic fundaments, the Committee will continue to be watching for evidence that inflation is trending near the 2% objective, job growth remains robust, wages continue to gradually rise and GDP remains above-trend. In addition, more clarity on the balance of risks will be needed. This will take time and more data to determine the trajectory for the global and US economy. If this backdrop does materialize after a period of patience, the FOMC will be able to tighten policy again later in 2019 and move the Fed Funds rate closer to the median estimate of neutral.
The FOMC’s balance sheet rundown has been widely publicized and well telegraphed and ran in a predictable fashion for all of 2018. Despite getting closer to the end of this process, we anticipate the run-off will continue into 2019. The Fed will attempt to continue to keep the balance sheet run off decision separate from interest rate policy which they view as their primary policy tool. We expect the debate around the composition and weighted average maturity of their balance sheet as well as an end date for normalization to continue and a decision to be made at coming meetings. In the meantime, the Fed will avoid giving too much information in the near term while continuing to re-assure markets that policy is not on a pre-set course.
We expect the Fed will be able to raise rates two more times in 2019 after a pause to assess the landscape. During this time we expect the labor market to continue to tighten, inflation to move gradually higher, fiscal stimulus impacts to linger positively in the first half of the year and regulatory reform proceeds. Some resolution or de-escalation on US-China trade policy will likely also be a necessary ingredient. All of this will allow 10-year Treasury yields to trend higher in 2019. However given today’s new information, questions now linger whether the Fed is willing to tighten policy consistent with their previous reaction functions of growth and inflation. While not explicit, the comments at the press conference did suggest the Fed was going to allow the economy to run hot assuming inflation risks remain low which should minimize risk-asset volatility.
We expect the reduction in global central bank liquidity to continue through 2019, led by the Fed’s balance sheet reduction and followed by the conclusion of the ECBs purchase program at the end of 2018. While this negative liquidity impulse should result in higher asset-price volatility, the commitment by the Fed today to adopt a patient stance should serve as an important offset.