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Home Loan Interest Rates May Drop

Markets are now pricing in about a 20% probability of a rate cut in Australia by September. That of course is in response to the huge volatility in financial markets in response to the European crisis.

They are harking back to the surprise 100bp rate cuts we saw in October and November 2008 in the aftermath of the Lehmann collapse. There are many things that are different and are likely to stay different between the current period and 2008.

Financial markets are not “frozen”. The biggest single factor behind the carnage in 2008 was the lack of preparedness by banks to lend to each other for fear of the actual state of the counterparty's balance sheet – the key circuit breaker was the authorities' stress tests where the top 19 banks in the US submitted themselves to rigorous external analysis of their balance sheets. Over that period the 3 month TED spread (gap between risk free and bank borrowing rates) blew out to 450 basis points and subsequently settled around 200bps. It is currently around 30bps and not too far from normal levels.

There will be some concern in the European banking community about the state of the balance sheets of European banks. RBA data (see Figure 1) shows that European banks hold around 4–5% of assets in liabilities issued by either Greece, Portugal, Spain, or Ireland, including the government. This could represent around 30–40% of capital and therefore represents an issue for European banks. (Only around 1% of these assets is held in liabilities to Greek or Portugese entities).

We accept that the only credible solution for Greece and, probably, Portugal is to move back to drachmas and escudos. If the liabilities of Greece and Portugal are also denominated in these currencies then the European bank investors will certainly take a “hair cut”. In an extreme case there may be a need for the German and French governments to “top up” some capital especially for future repayments of existing liabilities once the drachma and escudos adjust to levels which will allow Greece and Portugal to embrace economic recovery.

In the mean time we can only hope that the European authorities adopt a realistic approach and timetable to allow this to happen..

From the perspective of Australia, Europe's woes should have minimal impact on the economy. This is on the assumption that bank counterparty fears are eased as a result of a measured, sensible, predictable outcome. The biggest risk for Australia would be some bank liquidity crisis which affected Asian trade. The 30% collapse in trade in the Asian region in 2008 was the real cause of Australia's (relatively mild) woes in 2008. It is unthinkable that policy makers would dither sufficiently long to allow a repeat of the liquidity inspired collapse in global trade which we witnessed in 2008.

Another key factor for Australia is its reliance on offshore capital markets for funding of its banking sector. Recent developments in global markets associated with the European crisis have widened borrowing spreads by 30–0bps for term funding. However banks are under no pressure to access these markets at this time since the fall in the AUD has freed up considerable cash at each roll of the currency swaps. The USD's which these banks have borrowed are now worth more AUD giving the banks access to increased volumes of AUD for no new borrowing.

In the mean time the RBA is still focussed on tight capacity; rising inflation pressures; and the “locked in” boost to incomes in Australia through the surge in our terms of trade.

Readers will recall that until the release of the surprisingly strong inflation data for the March quarter, Westpac was the only forecaster predicting rates on hold once the May rate hike was delivered. (April 30 Bloomberg poll – 24 forecasters; Westpac only forecaster with rates at 4.5% by year's end). That was because we had already seen a slowing in the interest rate sensitive parts of the economy (retail; housing finance; employment growth) and we expected a big negative response from Consumer Sentiment to the May rate hike. However we did not expect to see a revival of inflation pressures as early as was apparent in the March report.

The Bank's concern with limited capacity and building inflation pressures was apparent from the May Board meeting minutes. The minutes of the May Board meeting of the Reserve Bank have provided us with strong support for our view that the Bank will not be raising rates at either the June or July Board meetings. The key quote is: “Members felt that this would leave monetary policy well placed for the present”.

The Board is now clearly dealing with a range of conflicting influences. On the positive side they have revised up their global growth forecast for 2010 from 4% to 4¼%. The commentary on the US economy is also more positive, describing conditions as “now clearly improving” with household consumption being described as “growing solidly”. On the other hand, the turmoil in Europe attracts considerable discussion. With these minutes referring to a meeting on May 4, they cannot give the Bank's current assessment of these developments. For instance, “problems in debt markets had been predominantly confined to Europe” – whereas in the last two weeks, credit markets globally have deteriorated markedly. Clearly the underlying concern for the Bank today would be if these developments damaged the global economic recovery. And that was noted: “there was a risk that the situation could worsen further, damaging the global economic recovery”.

Westpac has been arguing for some time that interest rate sensitive parts of the economy are being affected by the rate hikes. These minutes provide the strongest evidence that the Bank is also detecting those factors: “consumption spending had been quite subdued … perhaps reflecting some impact from rising interest rates”. On employment, “growth appeared to have slowed a little from the rapid pace seen in late 2009”. In summing up: “there were some early signs that they [interest rates] were beginning to affect behaviour, with retail sales subdued and housing loan approvals falling noticeably.”

However, the dominant themes which the Bank has consistently promoted are still very evident: “the stimulatory effects of the resources boom would be building over the year ahead”, “with the terms of trade now expected to rise by close to 20% over 2010, boosting nominal incomes by around 4%”. As we saw in the Statement on Monetary Policy, prospects for inflation have deteriorated. The Bank is now recognising that “over the next couple of years it was likely that inflation would not be much below the top of the target range.” Their biggest concern is that prices of many services are rising strongly, indicating limited spare capacity.

We believe there is sufficient caution in these minutes to preclude further rate hikes for the next two months. Indeed, the further deterioration in financial markets, particularly credit markets, raises a higher risk than assessed in these minutes that the global economic recovery may be damaged. With rates back to normal levels, the opportunity to pause to assess these impacts as well as the ample evidence that the recent rate hikes are now biting seems very attractive.

However as discussed above, we are not expecting a GFC Mark II from the European developments. Policymakers will be too alert to the risks associated with unmanaged sovereign defaults to allow such uncertainty to prevail. On the other hand, the boost from the mining sector and the clear upward pressure on inflation makes it reasonable to expect that following the next CPI release on July 28, evidence of upward inflation pressures will be enough to prompt another 25bp move following the Board meeting on August 3.

The behaviour of underlying inflation through 2008, when the Reserve Bank's preferred core measure printed around 1.2%qtr for the first three quarters as the mining boom Mark I tightened capacity and pressured demand, will be a clear warning that the inflation target is unlikely to be taken for granted when rates are still not even in the contractionary zone. Bill Evans, Chief Economist Westpac weekly