Australian & New Zealand Weekly

Week beginning 13 October 2008

• RBA to cut 150bp's - rates up in 2010.
• Westpac-MI Leading Index to provide update on growth outlook.
• Australian data: export & import prices, job ads, NAB business survey.
• NZ data: retail sales.
• US data: inflation, retail, housing, confidence, ind. prod'n, Beige book.
• Fed speak: Bernanke to Eco Club of NY.
• Key economic & financial forecasts.

Australia: RBA to Cut by 150bp's - Rates up in 2010

The Reserve Bank surprised markets by cutting the overnight cash rate by 100bps to 6.0% on October 7. This should not be interpreted as a panic decision. It totally surprised markets because we have not seen policy move in 100bp tranches since the 100bp rate hike in October 1994. The size of the move certainly highlights the gravity of the current global crisis but it emphasises the flexibility which Australia has to deal with the global crisis. Australian rates are still near global highs giving the authorities plenty of scope to use monetary policy to offset the contractionary pressures of the credit crisis.

As exemplified by Westpac's passing on of a 0.8% rate cut for variable mortgages Australian banks are profitable and strongly capitalised and are in the position to support monetary policy - unlike the responses we saw from the UK and US banks when their central banks cut rates last year. Those banks are now being given another chance to support monetary policy but we expect that there will be little impact on mortgage rates.

The most important reason given by the RBA is the significant deterioration in global financial markets. Furthermore, the Governor says “financing is likely to be difficult around the world for some time ahead”. The second most important reason given was a substantial revision to the Bank's view about the growth outlook for Asia - that is now being described as having seen a “significant moderation” and the terms of trade are now confidently predicted to fall, with global inflation also likely to moderate. With these two factors in place, the Bank is taking a forward looking approach to growth and inflation risks in Australia. They refer to “the risk that demand and output could be significantly weaker than earlier expected .... inflation would most likely fall faster than earlier forecast”.

The conclusion by the Bank is that a “significantly less restrictive stance of monetary policy” was required. I believe this terminology is important because one can reasonably conclude that the Bank believes that policy will still be restrictive after the October move. In previous easing cycles, which have been associated with much less threatening global and domestic economic risks, the Bank has chosen to move to a neutral/expansionary stance within one year, with cuts of 200 to 250bp in total. In those earlier periods, inflation was contained, being in the 2½% to 3% range.

However in those episodes there were no risks associated with the functioning of the financial system either domestically or globally, or the genuine prospect of a global recession. The Bank has now clearly enunciated its position that a sharp downturn in demand conditions will ensure that inflation declines. Consequently, we expect that this cycle will be more aggressive than the previous two, where it took around a year to move back to neutral. The level of the RBA cash rate that equates with neutral will be determined by the degree to which the banks pass on the RBA rate cuts. Policy is likely to be determined more by the need to get the variable mortgage rate down by 2% than a target level for the cash rate.

Westpac's bold decision to cut the variable mortgage rate by 0.8% following last month's 0.25% cut means that in terms of the mortgage rate we are more than half way there. But progress in achieving the additional 1% cut might be more difficult. Wholesale borrowing costs (about half the borrowings of the banks) are more than 1% higher than before the crisis began. Retail borrowing costs have also tightened significantly as the smaller institutions that are now denied access to funding in global markets pressure domestic funding costs. A test of whether we can expect further bold moves from the banks will be the degree to which they are able to manage down retail deposit rates. Banks are intermediaries. They can hardly be expected to aggressively cut lending rates if deposit rates do not also fall.

For a full pass-through, the neutral cash rate would be around 5.50%, but we expect that with the credit crisis almost certain to persist for the next six months at least, neutral is much more likely to be 5% for the official cash rate. The Bank is now likely to set its objective to move policy into the expansionary range which we think will be defined as 5% on the cash rate or below. That suggests to us that we can expect another 150bps in total of RBA rate cuts within the next three to six months. Recent cuts are likely to continue in November and December with 50bp moves in both months.

Rates up in 2010

These developments have also prompted us to review our core approach to the current policy cycle. Because of the need to address the inflation challenge while simultaneously dealing with the credit crisis we thought the Bank would have to adopt a very difficult and dangerous balancing act. That was to “manage” growth prospects back to a growth profile of around the 2% the Bank envisaged as necessary to gradually bring down inflation. That would entail two stages of the easing cycle. The first to deal with the credit crisis by bringing rates down but keeping them well in “contractionary territory” followed by a pause and the second to bring rates below neutral once inflation was seen to be moving towards the 2-3% range.

Developments in global credit and equity markets which are now destroying confidence (Westpac Consumer Sentiment Index down by 11%) and wealth (Australian share index now at its lowest level since June 2005) will prompt a decision by the Bank to aim to move quickly into expansionary range. We expect rates to be there by early 2009.

That profile will change our rate outlook during the second half of 2009 and 2010. Yield curves are likely to steepen from the middle of 2009 as markets anticipate economic recovery and the eventual beginning of a new tightening cycle. Whereas we expected 2010 to be a year featuring the second round of this extended rate cuts it will now likely see both RBA and US Federal Reserve moving to tighten rates.

US rates will be moving from a much lower base than Australia. Just as we saw Japanese authorities reduce their cash rates to zero in the Japanese banking crisis of the 1990's so the Federal Reserve will move to 0.5% in the first half of 2009. Both the RBA and Fed will be taking back their accommodation during 2010.

Australia: Data Wrap

Oct Westpac-MI Consumer Sentiment

• The Westpac-Melbourne Institute Index of Consumer Sentiment fell by 11% in October from 92.2 in September to 82 in October.
• The survey was conducted prior to Tuesday's announcement by the Reserve Bank that the overnight cash rate is to be cut by an extraordinary 100bp's. The survey results are therefore relevant for assessing the confidence of consumers prior to this stunning good news. As indicated by the double digit fall in the Index a strong positive message was required from the Reserve Bank.

Aug housing finance

• Total housing finance to owner-occupiers fell by 2.2% in the month and by 2.0% after excluding refinancing. Since January new lending has slumped by 28%.
• Lending for the established market, down 29% since January, showed less weakness over the last two months, falling by only 1.5% in August. Finance for the construction of new dwellings declined more significantly over the last four months, falling by 4% in August and by 18% since January.
• The debate now is the likely bounce in housing finance in response to the RBA lowering rates by 1.25% over September and October and any further rate cuts.

Sep employment and unemployment

• Employment rose 2.2k in September (consensus and Westpac forecast flat) after a downwardly revised 10.2k gain previously (was 14.6k). The participation rate was below consensus as we expected at 65.1%, but was also revised down to this level previously, providing a lesser constraint on labour force growth than we expected. Consequently, the unemployment rate was higher than we expected but in line with consensus, rebounding to 4.3% from 4.1%.
• Our preferred leading indicator, the Westpac-ACCI labour market composite index, implies a continuation of this gradual jobs growth slowdown for the remainder of 2008, with a greater slowing in 2009H1. In line with this signal, we expect jobs growth to slow to around 1½%yr at end 2008, lifting the unemployment rate towards 4¾%, with a greater slowing in 2009H1 to 0.9%yr lifting unemployment to 5.0%.

Oct MI consumer inflation expectations

• Consumers' inflationary expectations were steady in October at a median of 4.4% after falling sharply in August and September. The 4.4% consumer median expectation is the lowest since April and well down from the peak in July of 5.9%. The stability in October expectations has confirmed the recent downtrend since peaking in June, with the trend level falling to 4.68% in October versus 5.30% in June, the lowest since March.
• The median expectation of managers and professionals (collected since 1995) fell to 4.2% from 4.3% previously, the lowest since February and well below their July peak of 6.6%. This confirmed their downtrend since peaking in June also.

Oct Westpac-MI unemployment expectations

• Accompanying the sharp plunge in October consumer sentiment was a further large deterioration in already pessimistic consumers' unemployment expectations.
• The unemployment expectations index jumped 11.6% to 153.30 after a 0.7% rise previously, allowing their trend deterioration since August 2007 to continue at a rapid pace. This took their deviation from long run average levels further into positive territory at 16.7% (highest since Feb-02). Their level is consistent with a more severe slowing in annual full-time jobs growth into negative territory late 2008/early 2009, suggesting downside risk to our forecast of total jobs growth of 1.4%yr at end 2008, with a greater slowing to around 1%yr mid-2009.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Kaboom!

The outlook for the world economy has deteriorated at a frightening pace. The freeze in credit markets makes it clear that this is not a 'financial' issue, and some real damage to the economy seems unavoidable. Authorities around the world are scrambling to shore up balance sheets and confidence, but the situation remains extremely fluid and fragile.

The timing of these developments is particularly unfortunate for New Zealand, as there were signs that consumers and businesses were starting to feel chirpier after enduring a rough patch. The Q2 GDP figures confirmed a recession in the first half of the year, and timing issues around primary production suggest that GDP will probably contract again in the September quarter. But with the drought well and truly over, fuel prices down, interest rates falling, and personal tax cuts kicking in from October, the outlook for growth in 2009 and beyond looked encouraging. But that was then!

The most immediate and direct effects for New Zealand will be felt through reduced confidence and lower equity prices. But the more enduring impact of this crisis is likely to come through two channels:

Weaker export prices and volumes: World prices for New Zealand's commodity exports have already fallen in response to concerns about weaker demand. The key question now is the extent to which the financial turmoil spills over into real economic activity in our major trading partners, especially in Asia. Export prices can certainly fall further from here, and recent anecdotes of export orders drying up are also a worrying sign.

Access to funding: Credit markets remain tight around the world, as firms look to shore up their own balance sheets by hoarding cash. The problem is compounded when it comes to persuading firms to lend in a peripheral currency such as the New Zealand dollar. While New Zealand banks' balance sheets are among the strongest in the world on the asset side of the ledger, around a third of funding has traditionally come from offshore. The longer that global credit markets remain frozen, the greater the impact will be on credit creation.

However, it's important to remember the role that the exchange rate plays in absorbing the impact of external shocks. Lower commodity prices in world terms can be countered by a weaker currency - as has been the case in recent months. Lack of access to credit is not something that can be directly addressed through the currency, but as part of the adjustment process, the currency can undershoot its long-run 'fair' value, to the point where lenders can be lured back by the prospect of an exchange rate re-appreciation as well as the usual yield pickup.

We expect a further decline in the New Zealand dollar over coming months. However, trying to pick the bottom is a futile task in this environment - the currency will do whatever it needs to do, to buffer the economy against the worst of the global turmoil. The only thing we can confidently forecast is more volatility.

The other channel for softening the blow to the economy is, of course, interest rates. The RBNZ made it clear in the September Monetary Policy Statement that they intend to front-load the easing cycle, in order to offset the rising cost of funding and deliver some immediate relief to homeowners and businesses. As a result, a sizeable cut to the OCR was already on the cards for the 23 October review.

Recent developments make it even more likely that the RBNZ will match the RBA's 100bp rate cut earlier this month - not because they are in any way obliged to follow their neighbour, but because they are likely to share their thinking. The RBA stated that, given the rise in funding costs, “an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers” - essentially the same reason the RBNZ gave for their 50bp cut in September. Wholesale interest rates are already factoring in 100bp of easing for the October meeting, and the risk is that a smaller move could leave retail rates unchanged or even higher.

The RBA also noted evidence of “a significant moderation in growth in Australia's trading partners in Asia”, and that “some decline in the [Australian] terms of trade now looks likely over the coming year”. The RBNZ has put a particular emphasis on the performance of these economies, and they are likely to respect the RBA's judgement on this matter.

Round-up of local data released last week

Data Previews

Aus Aug Westpac-MI Leading Index

Oct 15, Last: 3.7% annualised

• The annualised growth rate of the Westpac-Melbourne Institute Leading Index, which indicates the likely pace of economic activity three to nine months into the future, was 3.7% in July, well below its long term trend of 4.2%.
• Monthly components were mostly weaker in August: dwelling approvals fell 3.7%, money supply growth slowed from 2.0%mth in July to 1.1%mth in August and US industrial production contracted sharply, down 1.1%mth in August after a 0.1% rise in July. Against this, the sharemarket actually rebounded through August with the ASX200 up 3.2% after a 5.3% drop in July. However, it has since crashed an astonishing 15.9% lower pointing to some very weak reads for the leading index in the months ahead.

Aus Q3 international trade price indexes

Oct 17, Export: Last: 13.5%, WBC f/c: 7.5%

Import: Last: 1.4%, WBC f/c: 2.8%

• Q2 export prices surged 13.5% led by sharply higher prices for bulks and petroleum. With the AUD import TWI up 3%, core import prices fell 1.4% and food prices were subdued with a 0.2% rise, but with petroleum up 15.9%, the MPI rose 1.4%.
• While the ToT boost from sharply higher bulk commodity contract prices hit largely in Q2, further gains were seen on a quarterly average basis in Q3 for coal and iron ore. This saw the USD RBA commodity price index rise 5.4% in Q3, and with a reinforcing 5.8% AUD/USD fall (lifting the commodity price gain in AUD terms and boosting non-commodity export prices), we expect a further 7.5%qtr jump in the XPI. With the import weighted TWI down 4.2%, we expect a 3.5% rise in core import prices, but with petroleum prices flat, the total MPI rises 2.8%. This gives a further rise in the Q3 terms of trade of 4.6%qtr (vs +12.0%qtr prev) and 17.1%yr (vs 9.5%yr).

NZ Aug retail sales

Oct 13, Last: -0.8%, WBC f/c: 0.5%

• Total retail sales in the month of August are expected to recoup some of the fall in July. Consumer confidence bounced off its lows in August thanks to a 6% fall in petrol prices and the RBNZ OCR cut in late July. Lower petrol prices and a 4% fall in car registrations is expected to see the auto sectors a large drag on overall sales.
• Lower expenditure on petrol frees up cash to spend on other things. We expect a strong lift in core sales. Supermarket sales are expected to rebound from their 2% fall in July. A hefty lift in food prices is likely to boost supermarket sales. The strong core sales and more moderate total sales growth in the month is consistent with the electronic transaction data for the month.

US Sep PPI & CPI - inflation now falling

Oct 15, core PPI Last: 0.2%, WBC f/c: 0.1%

Oct 16, core CPI Last: 0.3%, WBC f/c: 0.2%

• The collapse in commodity prices since mid July, even allowing for the temporary spike in the oil price in mid Sep back to $120 per barrel, should deliver further negative PPI and CPI headlines in Sep (see calendar for details) and contribute to sharply lower annual inflation rates (8.7% yr for PPI; 4.9% yr for CPI).
• Core inflation rates will be slower to respond, but should be relatively muted in Sep. The Aug core PPI was up 0.2% on top of a 0.7% Jul jump, but some payback for that Jul spike and continued constrained new vehicle prices in the face of weak sales should hold the Sep core PPI to 0.1%.
• The core CPI eased back to 0.2% in Aug after 0.3% gains in June and July, thanks to softer auto prices and subdued pressures elsewhere - likely to be repeated in Sep.

US Sep retail sales weighed down by autos

Oct 15, Last: -0.3%%, WBC f/c: -1.0%

• Retail sales fell 0.3% in Aug despite a 10% surge in auto unit sales which translated into less than a 2% jump after price discounts were taken into account. Falling gasoline prices and a 0.4% fall in core retailing also weighed on the result.
• In Sep, auto unit sales fell 9% despite discounts still being offered. Gasoline prices levelled off somewhat but constrained household income showed up in very soft weekly retailer reports.
• This combination of mostly weak clues points to a headline retail sales decline of 1% or higher. Core retail sales likely fell again too.
• Retail and auto sales developments through Q3 point to the first quarterly contraction in real consumer spending since the early 1990s. Talk of global recession won't have helped either.

US Oct regional Fed factory surveys

Oct 15, NY Fed index Last: -7.4, WBC f/c: -12.0

Oct 16, Philly Fed index Last: 3.8, WBC f/c: -10.0

• These neighbouring regional Fed surveys have been quite volatile of late, holding below 0 for much of the year then popping into positive territory in Aug (NY) or Sep (Philly). This was in contrast to the national factory ISM which hovered close to the neutral 50 level for much of the year before plunging sharply in Sep from 49.9 to 43.5.
• Realistically, forecasting these small surveys of 100 or so regional factory bosses is an impossible task without agents on the ground. But over time they tend to converge towards the national ISM unless significant local factors are at play. Given the weak Sep ISM, already partially matched by the NY Fed, and the doom and gloom peddled (rightly!) by US policymakers to get the $700bn Paulson plan passed, we would expect both these regional surveys to be very weak in Oct.

US Sep industrial production to slump again

Oct 16, Last: -1.1%, WBC f/c: -0.8%

• Industrial production fell 1.1% in Aug, its steepest decline since the aftermath of hurricane Katrina. The main reason for the fall was slumping auto output, but even excluding that sector, factory production posted its fourth fall in five months.
• Indications ahead of the Sep report point to another weak result. Factory hours worked posted a steeper decline in Sep than in Aug, though it was not as concentrated in the auto sector last month. The factory ISM plunged to recessionary levels in Sep, led by a 12pt fall in the production index, and factory orders were down 4% in the month. There were anecdotal reports of hurricane and Boeing strike disruption as well. The only positive could be a utilities rebound after two monthly declines.
• Given these factors we expect a 0.8% IP fall, with downside risk (depending on the utilities component).

US Sep housing starts & permits

Oct 17, starts Last: -6.2%, WBC f/c: -4.0%

Oct 17, permits Last: -8.5%, WBC f/c: -2.0%

• Housing starts and permits in Aug continued to be weighed down by the unwind of the June spike in multiples activity in NY to beat the July 1 building code change. But even accounting for that, the report still showed underlying weakness, with single family starts and permits down 2% and 5% respectively (both to new cycle lows, and both unaffected by the NY issue).
• The NY distortion should be mostly worked out of the figures by now but we expect it to continue to exert a modest downward influence until the end of the year. But the new housing market has no friends at the moment, particularly with so many cheap existing homes now for sale, and mortgage lending drying up.
• Hence we expect both starts and permits to record further declines, though less steep than in July/August.

Westpac Institutional Bank
http://www.westpac.com.au

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