A consistent theme in our research over the past month has been that the November rate cut is best viewed as the start of an easing cycle rather than a ‘fine tune’. The Reserve Bank of Australia’s (RBA’s) willingness ease with full employment and underlying inflation at the midpoint of its target band, in our opinion, reflected its belief that the terms of trade have peaked and are expected to decline further. The likely significance of the terms of trade to RBA thinking and policy setting can easily be seen by viewing the direction of policy when the RBA’s non-rural index of commodity prices is rising or falling on a 6m change basis. As highlighted in Figure 1, declining commodity prices tend to be associated with easing cycles while rising commodity prices tend to be tied to policy tightening. Despite the better than expected outturn in November, the 6m change in the non-rural index of commodity prices remains in negative territory.
Figure 1: RBA cash rate vs 6m change in RBA’s non-rural index of commodity prices
Source: Bloomberg, Barclays Capital
With the market fully priced for a 25bp rate cut at the December board meeting, however, the question we should be asking is whether there is a chance the RBA decides to defer action until early next year? The answer in our opinion is yes. For instance, Governor Stevens during Q&A following his Australian Business Economist (ABE) speech appeared to be at pains to point out the RBA had effectively delivered 50bp of easing (25bp ease in November plus the 25bp of tightening that wasn’t delivered in August) so far. This argument for RBA inaction, at least until February, is also supported by the fact that:
- Resilient domestic data provides the RBA with time to better assess the global backdrop;
- RBA appears to have pre-empted its usual terms-of-trade adjustment process with the November rate cut (see RBA’s terms-of-trade forecast holds the key, 23 November 2011);
- RBA’s index of commodity prices stabilised in November, after a small upward revision in October;
- Despite weakness in Asian PMI data, export data has yet to show a material softening; and
- Euro area summit is on 9 December, three days after the RBA board meeting.
As compelling as any discussion about the outcome of December meeting is, it is important not to lose sight of the fact that 3y yields are around 125bp below cash and the market expects a 3.0% cash rate by June-12. As discussed in Expected RBA easing cycle is aggressive, but not that aggressive – receive AU 18m1y vs pay Jun 12 OIS, 11 November 2011, a nominal cash rate expectation of 3.0% should not be seen as accommodative as policy settings at the depths of the global financial crisis. Nonetheless, the key question for the market is whether current pricing is appropriate?
Figure 2: 6m change in AU 3y vs 6m change in global PMI
Source: Bloomberg, Barclays Capital
In an attempt to answer this question we have called upon two strong market relationships relating to our global PMI measure, the first of which is displayed in Figure 2. The linkage between the global PMI and Australia comes via industrial production and hence, commodity prices. Utilising the relationship in Figure 2 we can model the appropriate level for AU 3y yields given the global PMI. To get a sense of the sensitivity of our modeling we have assumed three scenarios for the global PMI for the next six months (Figure 3). The scenarios should not to be interpreted as a range of forecasts, but rather three possible outcomes, namely the global PMI stabilising, recovering or deteriorating further over the next 6m.
Figure 3: Global PMI, three scenarios
Source: Bloomberg, Barclays Capital
The results of our modeling are presented in Figure 4. In short, the AU 3y at 3.25% currently appears consistent with the global PMI stabilising around current levels. Interestingly, even the positive global PMI scenario fails to push AU 3y to the 4.0% level.
Figure 4: AU 3y yield (%) under three global PMI scenarios
Source: Bloomberg, Barclays Capital
The other useful relationship, namely between AU 3y less cash spread and the 6m change in global PMI, in assessing the appropriateness of market pricing is captured in Figure 5. Assuming the three scenarios for the global PMI, our modeling delivers three outcomes for the spread between the AU 3y yield and cash (not shown). Given that and the AU 3y outcomes above (Figure 4), we in turn back out a profile for the cash rate under the three global PMI scenarios (Figure 6).
Figure 5: AU 3y less cash spread vs 6m change in global PMI
Source: Bloomberg, Barclays Capital
A few key points can be made from this analysis:
- First, an easing cycle from the RBA of some magnitude appears to be already baked into the cake;
- Secondly, the market currently appears to be pricing in a stabilisation in the global PMI over the next 6m;
- Finally, the RBA easing cycle is likely to pick-up momentum over coming months under all three scenarios.
Figure 6: Cash rate (%) outlook under three global PMI scenarios
Source: Bloomberg, Barclays Capital
Bottom line:
Whether or not the RBA eases again in December appears to be a fairly close call based on recent RBA commentary despite market pricing. Historical precedent supports the notion that further easing is likely, notwithstanding the uncertainty with respect to timing. In line with that, the bigger question is whether market pricing of AU 3y (125bp below cash) and a 3.0% cash rate by June-12 are appropriate. While understanding the limitations of PMI measures, namely its tendency to overshoot actual IP outcomes at the top and bottom of the cycle, the analysis above suggests that market pricing is consistent with the global PMI around current levels. Moreover, a gradual rebound in the global PMI over coming months only marginally reduces the degree of RBA easing that appears to be warranted. In other words, an RBA easing cycle of some magnitude is already seemingly baked into the cake with only a rapid rebound in the global PMI truncating it.
BARCLAYS CAPITAL
INTEREST RATES RESEARCH | ASIA-PACIFIC INSTANT INSIGHTS