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Monday, June 4, 2012

The RBA’s cash rate could go much lower than you think...

How low could the RBA’s cash rate go? Much lower than most folks, including the financial markets, think.

The global economy is schizophrenic right now. On an underlying basis, there are powerful forces shifting the centre of economic gravity away from the old world of North America and Europe towards the 2.6 billion people living in China and India.

The IMF estimates that over the next five years the euro-zone will only contribute 7.7% of total global growth. In contrast, China is expected to account for around three times that amount, or 22.6%, of the world’s total expansion. The same pattern applies when one compares the major advanced economies—or the so-called “G7”—with their emerging and developing counterparts.

Notwithstanding the media and financial market fixation with the G7, these nations only made up one-third of global growth between 2000 and 2011. The IMF believes that this share will fall further to just 28.6% between 2012 and 2016. By way of comparison, developing countries accounted for 49% of global growth over the last decade, with their contribution forecast to rise to more than 60% over the next five years.

While the industrialisation, urbanisation, and rising middle classes of Chindia are driving "decoupling" from the North Atlantic nations, the unprecedented global interconnectedness brought about by the Internet and digital communications is pulling us in the opposite direction. The 24 hour, real-time, and often sensationalist news cycle, with its bias towards the information-rich open societies in the G7, seems to be propagating even greater global synchronisation in financial market behaviour and real economic cycles.

Nothing highlights this better than the disconnect between Australia’s raw economic data and its contemporaneous financial market signals.

In May, Australia’s unemployment rate fell from 5.2% to 4.9%, blind-siding most analysts. Business investment in the first quarter also smashed consensus expectations, while plans for capital spending over the next few years were much better than pessimists anticipated. Wages and overall consumer spending are also tracking around their long-term historical trends. Finally, housing credit and, increasingly, business credit are expanding broadly in line with purchasing power.

Yet financial markets, and many asset prices, are projecting on to this ostensibly healthy picture a seemingly cataclysmic outcome. In particular, the interest rates required on Australian government bonds have plummeted to all-time historical lows. On Friday night the yield on three year Australian government bond futures fell to below 2% for the first time ever.

This is ordinarily a very worrying portent: three year government bond yields are now more than 175 basis points below the current RBA cash rate (technically called an "inversion" of the yield curve). That is, the market thinks the RBA will cut its official target cash rate to levels we’ve never seen before. Specifically, the futures market is now suggesting that the RBA’s cash rate will drop to as low as 2.15% by the end of this year. That’s more than six standard RBA rate cuts.

All commentators, economists, and policymakers have struggled to keep pace with this extreme global uncertainty. In June last year bank economists, including Westpac and yours truly, were forecasting further RBA rate hikes. In that month Westpac’s Bill Evans presciently swivelled 180 degrees and called for a 100 basis point reduction in the cash rate by the end of 2012. Bill got the direction right, but has now been compelled by evolving circumstances to dramatically adjust his view again; he's added four more RBA rate cuts, or 100 basis points worth in total, to his original 2012 expectation.

Last week the RBA was believed to be resistant to cutting rates in June. That’s understandable given the staff only recommended a 25 basis point cut in May and were pushed by the Board to double it. Since May, the RBA has seen the currency depreciate substantially—it is now about 13% below its all-time US dollar highs—the jobless rate decline, and capital spending exceed expectations. But dismal data from overseas is now likely to force the RBA to follow May with more rate relief tomorrow.

Economists at NAB, Westpac, CBA, JP Morgan, and Market Economics, amongst others, have at various points changed their June calls from no move to a cut on Tuesday. Senior commentators, such as Terry McCrann on Friday night, and David Bassanese last week, both argued the central bank would exercise the option to wait in June.

But McCrann, on Sunday, and Bassanese, in today’s paper, have embraced a cut. Bassanese puts it best: “To my mind, the facts have changed. As a result, my previous base-case view that the RBA would not cut interest rates again this month also needs to change.”

The situation in Europe is telescoping towards a binary outcome: either we get fiscal integration, which will, rather ambitiously, involve regional deposit guarantees, individual nations ceding authority over budget spending, and so-called “euro-bonds” that allow countries to raise money backed by the commitment of the entire euro-zone, or the currency union as we know it today will slowly disintegrate.

While each contingency has different ramifications for the Australian economy and the response of local policymakers, it is instructive to consider what might actually happen in a downside scenario.

In the GFC, the RBA's cash rate dropped to 3.0%, which combined with the boost to the first home owners grant helped house prices surge 13% in 2009. The cash rate is currently only 75 basis points higher at 3.75%. Of course, actual lending rates are much more important than the RBA's theoretical target. And they are, crucially, 125 basis points above the lows touched in April 2009.

If--and it is an almighty "if"--the global economy does indeed lurch into recession, I think the RBA will slash its official cash rate way below the levels seen in 2008 and 2009. In fact, I am thinking 1.9% or less.

Take home loan rates as a benchmark. After the double cut in May, the current discounted home loan rate in Australia is about 6.35%. The trough achieved during the last crisis was 5.1% in April 2009. At surface level, the RBA would need to slash its cash rate 125 basis points to 2.5% to get lending rates back to their crisis marks.

But the rub is that this supposes a 1:1 pass-through by the banks. In a best-case scenario, the RBA will only assume two-thirds pass-through. That means to get 125 basis points of lending rate reductions the RBA will have to cut its cash rate by an extra 65 basis points (or about 190 basis points in total). In turn, this implies a terminal cash rate of 1.9%. That might just get you a 5.1% mortgage rate.

There is, however, a second wrinkle, which was highlighted to me by a UBS strategist during a chat on Friday. Recall that a lot of bank funding comes from retail deposits that are transaction accounts. These deposits already earn zero per cent interest rates--it is tough (although not impossible, as the Swiss have proven), to shove them lower. Accordingly, the banks may pass on less-and-less to maintain their net interest margins. The lower pass-through would also be amplified by a blow-out in credit spreads, which would further elevate bank funding costs in the absence of taxpayer guarantees.

If you are seriously bearish on global growth prospects, as many claim, and think that the euro-zone crisis is going to push the world into recession, then you should prepare yourself for a very low RBA cash rate. Forget Westpac’s 2.75%, or the 2.15% currently pencilled in by the financial markets.

Based on the analysis above, the RBA cash rate is going to have to fall to less than 1.9% merely to replicate the lending rate lows achieved in 2009.

A final argument in favour of an ultra-low RBA cash rate is the fact that this time around fiscal policy will be hamstrung by concerns about a diminution in Australia’s prized AAA credit rating. Given the sharp increase in Australian government debt since 2007, it will be much more difficult for the Commonwealth to repeat its last cash-splash. So most of the responsibility for supporting the local economy will fall on to Martin Place’s narrow shoulders.

As the May meeting demonstrated, nobody, including the RBA governor and his staff, can know with confidence what exact decisions the RBA's board will coalesce around at 12.30pm tomorrow, or in the ensuing months. The only constant we can rely on is that heightened global uncertainty will persist for some time. And, as during the last crisis, cash will be king.