July 10, 2016
Earlier this week, the Reserve Bank left the cash rate unchanged at 1.75% and reinstated an explicit easing bias in its post-meeting press release. The Bank noted, “over the period ahead, further information should allow the Board to refine its assessment of the outlook for growth and inflation and to make any adjustment to the stance of policy that may be appropriate”.
Although this stopped short of the language previously used by the Bank when signalling a rate cut at the next meeting, we still expect a 25bp rate cut to 1.5% on 2 August.This is when Bank staff will present an updated economic outlook to the Board in the wake of the Q2
CPI on 27 July (the outlook will then be published in the Statement on Monetary Policy on 5 August). Notwithstanding stronger-than-expected growth in GDP in Q1, we think that the updated outlook will continue to show underlying inflation remaining below the 2-3% target band for an extended period.
With inflation remaining persistently low, we think that the recent spike in uncertainty will push the RBA over the line to cut rates in August. Uncertainty has spiked, both globally and locally. Higher global uncertainty reflects the shock decision by the UK to leave the European Union, although the initial surge in market volatility has eased somewhat, except in the case of the UK and some European assets.
The increase in local uncertainty reflects the extremely close Federal election, where at the time of writing it is not clear whether the Liberal/National Coalition will be able to govern in its own right or whether it will have to rely on the support of the minor parties/independents. The close election was a factor behind the decision by Standard & Poor’s to change the outlook for the
Commonwealth of Australia’s AAA credit rating for local and foreign currency from stable to negative.Standard and Poor’s has said that it will “continue to monitor, over the next six to 12 months, the success or otherwise, of the new government’s ability to pass revenue and expenditure measures through both houses of parliament”.
This suggests to us that the rating agency wants to see tough budget measures in the mid-year review of the budget later this year and for those measures to be passed through the parliament by early next year. This seems a tall order considering that there is already a substantial backlog of savings measures from last year’s budget that have been blocked by the senate.
Moreover, there are early indications that the Senate will be more fragmented, which suggests that more compromises may be required to pass legislation through the parliament. If the new government is unable to take the remedial action required by Standard and Poor’s, then we think a rating downgrade would trigger a downgrade to the major banks.
Following the downgraded outlook for Australia, Standard & Poor’s has already changed the outlook for the larger banks from stable to negative. The ratings are linked because Standard and Poor’s takes into account the implicit support provided by the government to the banks, where the major banks’ ratings are two notches higher than would otherwise be the case.
A lower rating for the major banks could place pressure on bank funding costs, which have historically been reflected in lending rates. With the Reserve Bank taking wider bank spreads into account when setting policy, this suggests to us that a rating downgrade for Australia could ultimately see the Bank cut the cash rate further. Wider bank spreads would also point to a lower neutral cash rate, where we think that a 175bp increase in the spread of lending rates over the cash rate since the global financial crisis has already reduced the range for neutral to 2.25-3.25%.