Australian & New Zealand Weekly

Week beginning 6 October 2008

• RBA to cut by 50bps to ensure market stability.
• Fed to cut by 50bps to support bank profits.
• BoE to resume rate cutting in Oct with 25bp reduction.
• Australian data: sentiment, jobs, housing finance previewed.
• NZ data: fiscal update, business confidence and house prices.
• US Fedspeak: Evans, Bernanke and Stern take the podium.
• Key economic & financial forecasts.

Australia: RBA to cut by 50 bp's to ensure market stability

Fed to cut by 50 bp's to support bank profits.

The Reserve Bank meets next Tuesday - decision at 2:30pm.

Up until this week we had been questioning market pricing that the Bank would ease by a full 50 bp's. However, this week financial markets have turned decidedly uglier. With the collapse of Washington Mutual and the bail out of Wachovia banks are questioning the financial credentials of most of their counterparts and restricting funding to overnight funds. US dollar funding is at a premium. Official 3 month LIBOR is now at 4.2% compared 2.8% at the beginning of September. Banks are actually borrowing 3 month USD funds at even higher rates than the “official” set. Even over the last week “official” LIBOR has increased by 50 bp's and by 100 bp's over the last two weeks.

These developments in credit markets now make it necessary for the RBA to cut by 50 bp's. Markets are fully pricing in the 50 bp's and whereas in normal circumstances we do not believe that the RBA would feel obliged to frank market pricing, current conditions in financial markets are so fragile that the Bank would see it necessary to avoid further market destabilisation.

Despite a fall of 60 bp's in the market's outlook for the risk free rate over the last month the 90 day bank bill rate has fallen by only 20 bp's. If the RBA was to only cut by 25 bp's next week then the 90 day bank bill rate would probably increase by 20 bp's. The major Australian banks fund their balance sheets about 50% in retail deposits; 35% in short term wholesale deposits and 15% in wholesale term funds. Competition for retail funds has been intense and margins have contracted while the term fund market is effectively closed. That puts even more pressure on the short term wholesale market and making that bank bill rate even more important. A further rise in the bank bill rate would add more pressure to banks' funding costs.

The margin between the bank bill rate and the market's estimate of the RBA rate over the next 3 months is currently around 70 bp's. When the banks passed on the full 25 bp cut by the RBA to mortgage rates that margin was around 30 bp's - with mortgages priced off the RBA rate the banks' expected spread on mortgages has effectively narrowed by 40 bp's. A cut of only 25 bp's by the RBA would see a further increase in the bank bill rate and therefore the banks' effective funding costs.

We have consistently argued for a 25bp rate cut despite a general consensus earlier last month that rates would be on hold. That was driven by a steady stream of better than expected data (employment; retail sales; consumer sentiment; profits and business investment). However, we argued that the credit crisis had taken centre stage in the thinking of the Bank and there was more work to be done as credit growth had sunk to 16 year lows.

Even in the last week the domestic data flow has been acceptable. Business credit growth was somewhat stronger than expected; retail sales surprised on the upside for the second consecutive month and exports strengthened. These partials would make it very difficult for the RBA's forecasters to squeeze growth in the third quarter to a level consistent with their view that growth needs to slow to 1.5% through the year to the first quarter of 2009. That growth slowdown was seen to be needed to begin making inroads into inflation.

The Bank suddenly moved from discussing rate hikes at the May Board meeting to deciding to cut rates by mid July effectively delaying action to contain inflation pressures. We expect there has been a further downgrading in the urgency of the inflation task as financial conditions have tightened further. Certainly we support the general principle that a substantial widening of the output gap will contain inflation pressures.

Developments over the week in the global commodity markets would also be disturbing the Bank from the perspective of global growth and the spillover to the Australian economy. Base metal prices are now down by 13% in the last five days. That of course is before we see any impact on the real economy from the recent financial market stress.

The urgency is now about the smooth functioning of the credit process - the containment of banks' funding costs and the preservation of banks' capital so that monetary policy can be effective and credit is available to finance growth. If the bank bill rate was to rise by 20 bp's next week then there is no guarantee that banks would be able to pass on any of a 25 bp rate cut.

Stability of the bank bill rate would be delivered with a 50 bp cut giving the banks flexibility to pass on some of the proposed rate cut. This stability is based on the assumption that the US Rescue Package is passed and we therefore do not get a repeat of the markets' response to the failure to pass the Package earlier in the week when the bank bill rate increased to 95 bp's above the expected RBA rate.

THE NEXT MOVES IN THIS CYCLE

The market is currently pricing in a quick move to neutral from the current 7% to 5.5% by March next year. That will certainly happen if the current financial stress persists for the next 6 months. While the US Rescue package will not have any immediate impact markets are accomplished at anticipating events well before actuality. It seems unlikely that the current gridlock could continue for the whole period.

Undoubtedly the US economy will start printing recession style data. There will be further pressure on bank balance sheets but official efforts to force mergers; remove problem assets; encourage private capital into the banking system and subscribe government capital should see a gradual thawing of current conditions. At that point the RBA will be able to refocus on the inflation challenge in an economy which will be getting some support from the current easing process.

Unlike market pricing we still see a pause in the easing cycle from the first quarter of 2009 probably when rates have hit around 5.75- 6.00%. The unknown is how much of that expected additional 100- 125 bp cut will find its way into the mortgage rate - a factor that is directly related to the time required to thaw the financial markets.

When this market thaw takes hold the RBA will once again be very confident to refocus on real data and the inflation challenge. The need to “frank” market pricing will have gone and the markets' current forward pricing will prove to be a little ambitious.

WE EXPECT THE FED TO CUT BY 50 BP'S BY THE OCTOBER FED MEETING WITH A DECENT CHANCE OF AN EVENTUAL MOVE TO 1%

While market pricing has now moved to anticipate a 50 bp cut over the next few months we make no apologies in franking that pricing with our forecast. Readers will recall that we successfully resisted following market pricing in June when markets were pricing in up to four rate hikes during 2008.

The case for a 50 bp cut from the Fed is very strong. The US is in recession. Lower rates will assist recovery by lowering floating borrowing costs for credit worthy corporates. However the real benefit of a lower Fed funds rate will be its role in indirectly assisting with the recapitalisation of the banking system The Rescue Plan will assist in that objective but is not the definitive solution to recapitalising the banking system. An adequately capitalised banking system is required to finance economic recovery by allowing banks to raise their lending to risk worthy borrowers.

The Plan is designed to eliminate uncertainty about banks' balance sheet quality so they can resume lending to each other and so that mergers are attractive and private/sovereign wealth funds are encouraged to subscribe new capital. Alternatively, under the Plan, the government could purchase assets at above book value in exchange for equity. Another way to rebuild capital is to raise the profitability of the banking system. That can be enhanced with a steeper yield curve at the short end as the margin between borrowing and lending rates increases. That policy was used with some success during the Japanese banking crisis in the 1990's.

While the US is in a classic liquidity trap, with the constraint on credit growth being supply rather than demand, a Fed rate cut will still help by assisting the rebuilding of bank profits. A 50 bp cut in the near future (at the very least at the next FOMC meeting on October 28) with a possible further 50 bp over subsequent months would assist banks to rebuild profits.

The Greenspan error of creating the property bubble with 1% rates in 2003 can be avoided by tightening much more quickly as the economy starts to recover. Greenspan left rates at 1% for almost 12 months between July 2003 and June 2004. The current crisis is much more severe but we would envisage the Fed taking back the stimulus in the first half of 2010.

The Fed is already operating in the market with an effective rate of 0.5% to 1%. With commodity prices falling and the inflation threat almost non existent the Fed can justify cuts in the official rate pointing partly to the current market rate and the implication behind the need to support liquidity by formalising current market rates.

Consistent with this Fed view, the ECB and Bank of England are also expected to follow suit with rate reductions in coming months (BoE on Oct 9 and ECB in Nov/Dec).

Australia: Data Wrap

Aug private credit

• Credit increased by 0.5% in August.
• Credit growth has been weak over the last five months, expanding by an average of 0.48%, significantly slower than the 1.3% monthly average last year. The RBA's aggressive tightening of monetary policy and the credit crisis have had a substantial impact.
• While the weakening of credit growth from 2007 is evident across the board, divergent trends have emerged of late. Housing credit growth is on a slowing trend, while business credit growth has rebounded over the last two months. By contrast, personal credit is contracting.
• Business credit resilience over the last two months is more consistent with a picture of rising business investment. • The RBA's policy u-turn will provide some support to credit growth, most notably for housing. However, a return to the pace of 2007 is unlikely. The credit crunch will continue to impact and, for the RBA, the aim is to cushion the slowdown rather than reflate the economy.

Aug dwelling approvals

• Dwelling approvals fell 3.7%mth in August, below market expectations of a 0.5% decline and our more bearish forecast of a 2% fall.
• Private sector house approvals - which usually give a better feel for underlying trends - saw a milder 0.8%mth fall in August. In contrast, private sector unit approvals were down 7.8%mth. Both segments are down 9 to 10% from their late 2007 peaks in trend terms with the pace of decline quickening to double-digit rates in both cases.
• Conditions remain very mixed across the states with Aug seeing more weakness in NSW (approvals down a sharp -8.5%mth), Vic (-4.2%mth) and SA (down -1.9% after a 9.8% drop in July), but a 6.2%mth bounce in Qld (albeit after three hefty declines) and a 2.3%mth rise in WA.
• The value of renovation approvals continues to hold up reasonably well in trend terms but the value of non-residential building approvals fell sharply in Aug, led by a sharp drop in office approvals.
• Overall, the data points to weaker building construction activity over 2008H2, both residential and non-res.

Aug retail sales

• Retail sales rose +0.3%mth in August in trend terms, with the gains for the previous two months revised up from +0.1%mth to +0.3%mth. In seasonally adjusted terms, sales rose 0.6%mth following a 1.4%mth jump in July. The result was well above market expectations of a flat result.
• Survey changes have increased the volatility or monthly retail sales data making them a much less reliable guide to spending.
• In contrast to July's broad-based rise, sales were more mixed across categories in August, rebounding sharply for cafes & restaurants (+9.7%mth!), and up solidly for clothing and food retailers but down for 'other' retail, dept stores and household goods. Indeed, the detail generally reinforces the need to treat the latest monthly data with extra caution. For instance, large retailers - a segment unaffected by survey changes - recorded flat sales in August.
• Overall, retail sales continue to track much better than expected. Interest rate rises may still be dampening demand (mortgage rates rose another 15bps in mid-July), but tax cuts and lower fuel prices are giving a bigger offsetting lift. The RBA's 25bp interest rate cut will add more momentum in Sept. However, we remain wary that the survey redesign may be exaggerating recent strength and more generally of the degree to which sales momentum will be sustained. We continue to see a patchy period ahead for Australian consumers.

Aug trade balance

• The trade balance was much better than expected in August at a surplus of $1364mn, a $2061mn improvement from a $697mn deficit previously. The consensus forecast was a $200mn surplus and Westpac forecast a $900mn surplus. The surplus was the highest since June 1997 and the second highest since data commenced in July 1971.
• Exports were strong benefiting from a valuation boost from an 8% AUD/USD fall, and further non-rural volume gains led by coal. Rural exports remain in a mild downtrend despite a 3.6% rise this month, but a 8.6% surge in non-rural and other goods (with non-rural up 10.5%) has seen a significant upward revision to their trend growth to 3.0%mth. Total export trend growth is now 2.3%mth.
• Despite the valuation boost from the currency fall, imports fell 2.4%, driven by a pullback in fuels. Trend growth eased to 0.9%mth from 1.1%, the lowest since September 2007.
• Abstracting from fuels, consumer goods imports fell further taking their trend negative, indicative of particularly weak volumes given the currency move. Capital goods imports saw an aircraft-led 5.9% rise, but trend growth ex-aircraft still remained solid at 1.2%mth, indicative of the resilience of business investment spending relative to depressed consumer spending.

Sep TD-MI inflation gauge

• The TD-Melbourne Institute inflation gauge rose 0.4%, 4.5%yr in September, confirming that inflation remains well above the RBA's target band. Monthly volatility saw the annual rate rise from 4.2% in August, but it remains below the 4.8% peak in June.
• The quarterly headline inflation pulse appears to have eased in Q3, as petrol prices come off their peak and, we suspect, because of the impact of weaker domestic demand conditions. The index is up 1.0% on three months ago, as it was in August. That is a moderation from the 1.24% rise over the three months to May.
• The biggest price increases in the September month came from fruit & vegetable, petrol (although as noted above, petrol is down for the quarter). These gains were partially offset by cheaper bread and cereal products, books and domestic holiday travel.
• Adding to the view that the inflation pulse eased in the quarter the trimmed mean measure of the Inflation gauge stepped lower over recent months. The three month annualised rate slowed to 2.7% in Sep down from over 4% in May and June. Also, price rises became somewhat less widespread in Sep. The net balance of classes showing an increase moderated to 20 from 33 in Aug and 26 in Jul, but that is still above the 2007/08 average of 17.
• Against this backdrop, we are forecasting the official data to confirm a moderation in the quarterly inflation pulse. At this stage, our Q3 CPI forecast is 0.7%, 4.5%yr, compared with the Q2 outcome of 1.5%, 4.5% and for the average RBA core, we are forecasting 0.9%, 4.4%yr, compared with 1.1%, 4.4%yr in Q2

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Rollercoaster ride

The progress of the US financial bailout package understandably garnered most of the attention this week, sending financial markets on a wild ride. Beyond this, the local economic news has been blowing hot and cold as well, and is likely to do so again next week.

The week began with a 7.9% drop in residential building consents in August, tracking the slump in home sales through the first half of this year. We were already expecting residential investment to contract by 20% this year, and the consents figures suggest that this weakness will continue into next year as well. Non-residential consents continued to trend higher, due to a shortage of prime office space in the major centres, but they remain below the levels of a year ago.

On the plus side, monthly business confidence rose sharply again in September, with the headline measure returning to positive territory - remarkably, it hasn't been there since May 2002. The details of the survey were more restrained, with some forward-looking measures such as profit expectations and employment intentions still negative on balance. Inflation expectations finally responded to the fall in fuel prices, but remain at historically high levels. At face value, the recent improvement in confidence is consistent with a healthy 0.5% rise in Q3 GDP. But other indicators suggest otherwise, and in particular the details of Q2 GDP suggest that there is still some weakness in dairy production, and a reversal in meat production after an earlier slaughter, due to come through.

The Westpac-McDermott Miller employment confidence index also rose in the September quarter, albeit only slightly. Current conditions in the jobs market have worsened, but confidence about the future increased. The survey accords with our outlook for the labour market: the downturn to date has been mild, but employment is very much a lagging indicator, and is expected to deteriorate further well into 2009. Even so, some industries are still desperately short-staffed, and those workers with the right skills will be able to demand compensation for the rising cost of living.

Arguably, both of these surveys are already a little dated, as the responses were collected in the first half of September, before the worst of the turmoil in world financial markets. At this stage it's difficult to judge the impact that this renewed credit crisis will have on the New Zealand economy, though we have noted that the most immediate and direct effects will come through fear and reduced confidence.

Finally, world prices for New Zealand's commodity exports fell 4.9% in September, the largest one-month fall in 21 years. This was led by a 7.9% fall in dairy prices, as increasing supply from NZ and Australia collided with softening world demand. Fonterra's most recent online auction saw whole milk powder prices down 10% from month ago. Fonterra's announcement that lower world prices will be passed on to the NZ consumer is perhaps some cold comfort.

Next week sees the Treasury open its books for the Pre-election Economic and Fiscal Update, ahead of the election on November 8. The central outlook is now more likely to resemble the 'downside' scenario that Treasury envisaged in May: domestic and global growth is significantly weaker, causing a hit to tax revenue and a return to operating deficits by 2010. The implications for the incoming government are clear - there will be less room to move when it comes to spending promises and/or tax cuts in the years ahead.

The other major release is the Quarterly Survey of Business Opinion on Tuesday. Headline confidence is likely to improve, though perhaps less emphatically than other recent confidence surveys (responses were accepted up to the end of September). We'll be interested in the extent to which capacity constraints and cost pressures have eased since June, though it's unlikely to influence the outlook for monetary policy in the near term. The RBNZ is focused on bringing down the borrowing rates faced by households and businesses, and with wholesale interest rates now fully anticipating a 50bp rate cut at the 23 October OCR review, the RBNZ will need to deliver at least this much to avoid a potential rise in mortgage rates.

Round-up of local data released last week

Data previews

Aus RBA policy announcement (2:30pm)

Oct 7, Last: 7.00%, WBC f/c: 6.50%

Mkt f/c: 6.50%, Range: 6.50% to 7.25%

• We expect the RBA to follow its September rate cut with a 50bp reduction at its October meeting. The rhetoric in its accompanying statement is also likely to be more bearish.
• Domestic data continue to point to a slowdown in demand consistent with inflation coming back to the 2 to 3% band over time. However, disarray in global financial markets, weakening world growth prospects and sharp falls in commodity prices are clearly intensifying downside risks to the outlook.
• The impact of the global credit crunch on local funding costs presents a significant tactical challenge for the Bank. A move of 25bps would likely have no impact on mortgage rates and other retail lending rates. Hence we expect the Bank to move more aggressively, cutting rates by 50bps. The cash rate is forecast to fall a further 75bps to 5.75% by early 2009 contingent on financial conditions and retail rates (see main article p2).

Aus Sep Westpac-MI Consumer Sentiment

Oct 8, Last: 92.2

• The Westpac-Melbourne Institute Index of Consumer Sentiment rose by 7% in September from 86.2 in August to 92.2 in September. Although still firmly in pessimistic territory, the 16.7% rebound in sentiment through July-Sep was the 3rd largest two month increase in the last 10 years and the 6th largest since the index began in 1975. A 25bp cut in interest rates and 8% fall in petrol prices have been key drivers.
• The October survey is in the field from Sep 30 to Oct 5. Sentiment is likely to be impacted by: severe global financial turmoil (ASX down 4% since last survey) and extreme market volatility in both equities and currencies; expectations of a follow-up interest rate cut from the RBA but doubts over the extent to which it will be passed on to mortgage rates; continued falls in world oil prices but a muted impact on local pump prices (largely unchanged since the previous survey).

Aus Aug housing finance

Oct 8, Last: -0.2%, WBC f/c: -1.5% (no.)

Mkt f/c: -1.3%, Range: -2.0% to 0.8%

• Housing finance slumped over the five months to June, under the weight of sharply higher interest rates and the credit crisis. More recently, lending is showing signs of stabilising.
• Following a broadly flat result in July (with a fall of just 0.2%), we are forecasting a small decline of 1.5% in August. The 'independent' interest rate rise in July by the commercial banks has had some negative impact.
• The mix of finance in the month will be of interest - eg new lending (ie ex-refinancing) may be weaker than the headline.
• The RBA's policy u-turn, with rates cut in September and a likely follow-up rate cut in October, will provide a boost to demand for housing finance before years end. The improvement in housing affordability will provide some much needed respite for the established market.

Aus Sep employment chg

Oct 9, Last: 14.6k, WBC f/c: flat

Mkt f/c: flat, Range: -12.6k to +18.0k

• While jobs growth beat consensus again in August with a 14.6k rise, the underlying trends continued their gradual 2008 slowdown in line with our prognosis. Monthly trend jobs growth slowed to a still positive 8.1k, and annual trend growth eased to 2.21%yr from 2.33%, above labour force growth of 2.14%yr, limiting pressure on the unemployment rate.
• Our preferred leading indicators of labour demand are now pointing to a steepening of the jobs growth slowdown into 2009H1, with risks building on the downside for our 1.5%yr end-2008 forecast. Our Westpac-ACCI Labour Market Composite implies 2008H2 resilience with a greater 2009H1 slowing, but job ads and consumers' unemployment expectations imply a more rapid slowing. For now we expect the gradual slowdown to continue, with a forecast flat result for September slowing trend growth to 2.09%yr.

Aus Sep unemployment rate

Oct 9, Last: 4.1%, WBC f/c: 4.2%

Mkt f/c: 4.3%, Range: 4.2% to 4.4%

• An unexpected pullback in the participation rate in August to 65.2% (65.15% to two decimals) from 65.3% was sufficient to see the labour force contract by 8.3k in the month. This combined with the solid jobs gain saw the unemployment rate fall to 4.1% (4.08% to two decimals) from 4.3%. This saw the trend unemployment rate stabilise at 4.23% for the last three months, not far above its cycle low of 4.13% in February.
• With a below-trend forecast for September jobs growth, we expect the participation rate to nudge lower again (-0.04ppts) to round to 65.1%.
• This smaller participation rate fall though would still allow a small increase in the labour force. When combined with zero jobs growth in the month, this lifts the unemployment rate back to 4.2% in September from 4.1%

NZ Pre-election Economic and Fiscal Update

Oct 6

• We expect the Treasury to shave at least 1% off their nearterm real GDP forecasts, and possibly more off the mediumterm forecasts.
• Lower GDP forecasts will create operating deficits for the first time in 14 years. Government debt will be forecast to rise, and be outside of the 20% target band by the end of the forecast period.
• Bond issuance will be higher than the $3.4bn/year average forecast in the Budget. We now expect the bond issuance forecast to average around $4.5bn/year.

NZ Q3 NZIER business confidence

Oct 7, Last: -64%

• Headline business confidence held at levels consistent with recession in Q2. The latest measure is likely to bounce in line with other recent confidence surveys, though in this case some returns may capture the worst of the financial market turmoil seen in late September.
• The details of the survey are likely to be more subdued than the headline measure, and key indicators of inflation pressures, such as capacity utilisation and difficulty finding labour, may ease further.
• Lower fuel prices will help to ease cost expectations from a 21-year high.

NZ Sep REINZ house prices

Oct 10, Last: -5.7% yr

• We expect the annual rate of house price growth to ease further as prices now are being compared to the 2007 peak period of September to November. It is probably too early but we will be watching for any immediate impacts from the midmonth surprises of a 50bp cut in the OCR (with mortgage rates following a week later) and the extreme volatility in financial markets later in the month.
• House sales (seasonally adjusted) fell in August after what now looks like a 'dead cat bounce' in July. Outside the monthly volatility, house sales appear to have found a floor over the past five months, but at an extremely low level. We expect September figures to remain subdued. The very weak activity is reflected in the number of days to sell a house trending sharply higher through 2008, although it did dip slightly in August.

Bank of England to resume rate-cutting in Oct

Oct 9, Last: 5.0%, WBC f/c: 4.75%

• The BoE cut rates by 75bp between Dec-April, but sharply higher inflation saw further cuts shelved, despite the economy slipping towards recession. Inflation is yet to peak, but should hit 5% yr in the next month or so. After that, it will fall sharply, reflecting favourable base effects, the impact of falling commodity prices on the retail price of energy and food, and weak economic activity. We assess the UK economy to now be in recession.
• In its Aug inflation report, the Bank's central tendency forecast for the CPI in 2010 was a touch below the 2% target. Since then, risks to the downside have increased; the economy has stalled, another two major local banks are in trouble, the lone MPC voter for a rate hike has dropped it, the lone MPC rate cutter is now arguing for a 50bp cut, and markets have fully prices an Oct move. It hasn't been the consensus view among UK economists until recently, but we see no credible reason for the BoE to delay any longer.

Bank of England to resume rate-cutting in Oct

Oct 9, Last: 5.0%, WBC f/c: 4.75%

• The BoE cut rates by 75bp between Dec-April, but sharply higher inflation saw further cuts shelved, despite the economy slipping towards recession. Inflation is yet to peak, but should hit 5% yr in the next month or so. After that, it will fall sharply, reflecting favourable base effects, the impact of falling commodity prices on the retail price of energy and food, and weak economic activity. We assess the UK economy to now be in recession.
• In its Aug inflation report, the Bank's central tendency forecast for the CPI in 2010 was a touch below the 2% target. Since then, risks to the downside have increased; the economy has stalled, another two major local banks are in trouble, the lone MPC voter for a rate hike has dropped it, the lone MPC rate cutter is now arguing for a 50bp cut, and markets have fully prices an Oct move. It hasn't been the consensus view among UK economists until recently, but we see no credible reason for the BoE to delay any longer.

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

Disclaimer

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