Bulletin

8 May 2013

Reserve Bank easing cycle to trough at 2%
We expect the Reserve Bank will complement its May rate cut of 25 bp's with a follow up move of 25 bp's in June. Rates are expected to eventually bottom out at 2% by the first quarter of 2014. In May last year Westpac forecast that the low point in the cash rate cycle would be 2.75%. At the time the Consensus view was around 3.25–3.5%. We have held that view consistently since then while emphasising clear downside risks over the last six months. With the Reserve Bank cutting the rate to our target level yesterday it is appropriate to quantify those downside risks. The Governor gives us clear encouragement that a further move in the near term is likely. The final paragraph of the statement makes the following point: "The Board has previously noted that the inflation outlook would afford scope to ease further, should that be necessary to support demand. At today's meeting the Board decided to use some of that scope. It judged that a further decline in the cash rate was appropriate to encourage sustainable growth in the economy, consistent with achieving the inflation target". It was also significant that the Governor did not choose to use the term: "The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the target over time". Our interpretation of this wording is that the Governor has left the door open for another move as early as June. Certainly we expect that over the course of the next month it will become clear that business investment intentions are soft, both business and consumer confidence are fragile and credit growth continues to remain subdued. There are ample precedents for a May/June move. Over the last 10 years the Bank has moved rates on four occasions in May with two of those occasions being followed up in June. There was other evidence in the Governor's Statement to support further cuts. The description of the domestic economy has taken a step down from previous statements. Growth in the second half of 2012 is now described as "a bit below trend" and 2013 to date is described similarly. Employment is assessed as not being strong enough to absorb the labour force implying an expectation of a rising unemployment rate. The peak in mining investment is assessed as being in 2013 while the demand for credit remains relatively subdued. Our own forecasts accord with these views. We expect growth in Australia to be stuck at a below trend 2.5% in both 2013 and 2014 while we expect the unemployment rate to exceed 6% by year's end. On the positive side, consumption is described as "strengthening" and there are prospects for some increase in non-mining investment. Some recent strength in retail sales is supporting a strong recovery in household spending in the March quarter although much of this may reflect a rebound from the dour spending pace of the second half of 2012. The survey of Capital Expenditure which prints on May 30 will provide more information on business investment. Suffice to observe that

Core inflation: pulse receding
9 8 7 6 5 4 3 2 1 0 -1 Dec-96
Sources: ABS, RBA, Westpac Economics

%yr
Core CPI, avg RBA %qtr (rhs) Core CPI, avg RBA %yr (lhs) Headline CPI %yr (lhs)

%qtr

3.6 3.2 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0 -0.4

Dec-00

Dec-04

Dec-08

Dec-12

confidence and credit growth are not indicating much evidence to support an improving investment environment. Of course the recent unexpectedly low print on inflation is assessed as "a little lower than expected" while labour costs have moderated slightly and productivity growth appears to be improving. We expect that core inflation is likely to hold around 2.0–2.25% in 2013. The Bank's own forecasts which will print on May 10 are likely to show a marked reduction in the current forecast of 2–3% in 2013 to 2.0–2.5%. It is significant that while the cash rate has now been reduced to 2.75%, below the 2009 lows, borrowing rates are described as "approaching previous lows". This is somewhat of an overstatement given that official RBA statistics nominate the low point on the standard variable rate at 5.75% in May 2009 compared to 6.45% before yesterday's decision. (Of course these headline rates are complicated by special discounts which Banks consistently offer). Finally, the Governor once again points out the unusual elevated level of the exchange rate given that export prices and interest rates have fallen markedly over the last 18 months with the exchange rate remaining relatively steady. Unease around the Australian dollar is undoubtedly a key factor behind the decisions to move Australian rates more into line with global markets. The outlook – interest rates and the Australian Dollar Yesterday's decision was very significant because it indicates that the Bank sees a new urgency to use interest rates to support demand. The commentary suggests that success in boosting demand so far has been mixed and there is no clear indication that the Bank expects a quick resolution. It is pointed out that private sector interest rates are still above the lows we saw in 2009. Recall that at that time fiscal policy both domestically and offshore; the exchange rate; and the upswing in the mining sector were complementing monetary policy to restore demand in the aftermath of the global financial crisis. In the current environment, monetary policy is effectively acting alone and yet private sector interest rates are still above those that operated in 2009.

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

1

Based on current official data, private sector rates are still up to 50 bp's above the lows of 2009. That suggests to us that there is scope for further cuts in official rates. The really key new developments over the last few weeks have been evidence of an even lower than expected trajectory for inflation and, as pointed out in this note, a Reserve Bank that is clearly open to further action. Given this scenario we think that the most likely policy option is a follow up rate cut in June of 25bps which will be implemented for the same reasons as we have seen today complemented by further evidence of softening confidence and weak business investment. We have also always argued that our assessment of the global economy is more subdued than the consensus. The IMF is expecting 4% world growth in 2014 – we are closer to 3%. For Australia's terms of trade, the peak to trough decline in the 2011–12 period was 17%, while we forecast a 2013–14 decline in the region of 10%. We have long maintained that from a world growth perspective, 2014 will feel like 2012. The threat of a disruptive event in Europe remains ever present. The US story does not convince us. We confidently expect that the US Federal Reserve will persist with its quantitative easing policy through most of 2014. China has already begun the process of recalibrating its monetary and real estate policy settings and the support it received from the export sector in Q1 is already receding. Indian domestic demand is flagging badly and the required policy support has not been adequate. Japan is something of a bright spot, but its gross acceleration will far exceed the net from a global growth perspective as it takes back market share. From June we expect the Bank will be patient to assess the impact on domestic demand of the low rates. However by year's end it will become clear that further stimulus will be required to offset the impact of a softening world economy while the response to the low rates in the domestic economy will be disappointing. We anticipate two further rate cuts will be required in the December quarter of this year and March quarter of next year. That would see the cash rate bottom out at 2% from its current 2.75%. Having driven rates down to that level we expect rates to remain on hold through the remainder of 2014. The global backdrop will continue to be characterised by aggressive monetary policy easing of the unconventional variety in the G4 economies. There is clear evidence that this policy framework leads to higher exchange rates for those countries where conventional policy settings are still in place. The Australian dollar has lost a

little ground in recent days. Post the decision, there is every reason to believe that the 8–10 cents over-valuation relative to fair value that has opened up since the Fed embarked on QE 2, will remain substantially in place for now. Our forecasts for the currency envisage the gap between spot and fair value closing only gradually through the remainder of 2013 and 2014. The RBA can contribute to the lowering of fair value by delivering on the rate cuts we envisage. Our specific profile for the Australian dollar, which had incorporated a steady cash rate of 2.75% (with downside risks) and a softening world economy, saw AUD back at USD 0.97 by June next year, partially due to a gradual narrowing of the overvaluation premium. With our lower RBA rate profile there is some modest room for further moderation in the fair value of AUD with our June 2014 target being lowered to USD 0.96. However, the key to a more significant fall in AUD is a more marked reduction in that over valuation premium – something that lies essentially outside the RBA's influence. Bill Evans, Chief Economist

The Australian dollar: actual versus fitted
1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50
Includes WCFI+BI commodities index, 2 year swap spread, and NFD to GDP.

USD
Fair value band AUD/USD actual & forecast
Sources: RBA, Westpac Economics

USD

1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 0.40

0.40 Jan-91

Jan-95

Jan-99

Jan-03

Jan-07

Jan-11

The Australian dollar & 2yr swap spreads
1.20 1.10 1.00 0.90 0.80 0.70 0.60 0.50 0.40 Jan 90 Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08 Jan 11
Sources: Bloomberg, Westpac

USD
AUD/USD (lhs) AU-US 2yr swap spread (rhs)

%pa

6 5 4 3 2 1 0 -1 -2

Interest rate forecasts
Latest (8 May) Cash 90 Day Bill 3 Year Swap 10 Year Bond 10 Year Spread to US (bps) AUD/USD 2.75 2.79 2.85 3.12 134 1.0183 Jun 13 2.50 2.55 2.80 3.05 125 1.01 Sep 13 2.50 2.55 2.80 3.05 125 1.00 Dec 13 2.25 2.30 2.75 3.05 120 0.99 Mar 14 2.00 2.10 2.65 2.90 110 0.97 Jun 14 2.00 2.10 2.75 3.10 105 0.96

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

2

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