Thursday, December 17, 2015

NZ GDP - September 2015 quarter

NZ GDP came in at a better-than-expected 0.9% in the September quarter (market consensus +0.8%, RBNZ +0.6%).  Annual growth came in at +2.3% with annual average holding up at a still impressive +2.9%.

The strong quarterly growth rate is part solid underlying growth (which we think is running at around +0.6-0.7% per quarter), part pay-back for the weak start to the calendar year and part higher meat processing reflecting low dairy/high meat prices and impending drought.  With all that going on its important not to take the strength in the result, especially when compared to the RBNZ’s forecast, at face value.

History has been revised up with annual average growth for calendar 2014 revised up from +3.3% to +3.7%.  That makes the lack of inflation over that period even more surprising than it already was!!

The outlook remains for solid growth of around 2.5-2.7% per annum over the next couple of years.  But with likely continued benign inflationary pressures reflecting a near-term rise in the unemployment rate and soft increases in unit labour costs, this result won’t change the RBNZ’s comfort with interest rates now back to 2.5%.

The RBNZ has flagged they are now more than likely on hold.  The key risk to that view is a period of drought in early 2016 that hits production hard.  That makes the risk to interest rates still biased to the downside but that will remain dependent on the data…and the weather.

Fed lift-off - finally

Following much anticipation the US Federal Reserve raised interest rates this morning, taking the Fed funds rate from a range of 0.0 - 0.25% to 0.25 - 0.50%.  This ends 7-years of zero interest rates and is the first increase in US interest rates since mid-2006. 

The anticipation of the end of the Feds zero interest rate policy has caused considerable angst and volatility in markets.  In the end markets have taken it in their stride with equities up a touch and little change in bond yields.  In fact this is all somewhat reminiscent of the taper tantrums where markets were volatile on the anticipation of tapering, only to deliver a massive yawn when it actually happened.

As we have stated repeatedly, the important story is the likely path of interest rates from here and the terminal rate (i.e. the peak).  On that there were soothing words from the Committee this morning:

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”   

To reinforce the point there was a further small downward movement in the interest rate projections contained within the Summary of Economic Projections (SEP).  The central tendency estimate of the neutral rate came down a touch further to range of 3.3 – 3.5%.  We think there is scope for this to move lower towards our estimate of 3.0% over time.   

At their September meeting the Committee provided a number of reasons why they decided not to tighten at that time.  Chief amongst them was concerns about market volatility reflecting concerns about the extent to which the US and global economies could withstand a period of higher US interest rates.  Today’s move reflects a vote of confidence in the ability of the domestic and global economy to cope with higher US interest rates.

A critical factor for the Committee is getting the right balance between going too early and going too late.  In that respect we think the Fed has made the right move today.  In a domestic environment in which GDP growth is running above trend, the unemployment rate is either at or close to full employment, productivity is low  and core inflation is at 2% (although the breakdown still falls short of what could be described as generalised inflationary pressures), moving interest rates off zero is a prudent move.  In doing so they start to mitigate a potential risk for 2016 in which that combination of factors leads to a stronger rise in inflationary pressures and fears the Fed is behind the curve.

History shows (see post below) that the USD does most of its work in anticipation of rate hikes rather than while interest rates are rising.  But this time the Fed is going it alone as the other major central banks continue to ease including in Europe, Japan and China. 

Various central banks have tried to go it alone and failed over the last few years, including our own.  We think the Fed is probably the only central bank that will be able to get away with that, but it will certainly limit how much they can do given the likely impact on the USD of too great a degree of monetary policy divergence.  That’s good news for asset classes such as emerging markets and commodities that are most sensitive to increases in the USD. 

In the meantime a combination of low core inflationary pressures and the recent strength in the USD has us believing the Committee’s gradual rate rise story.  We expect the federal funds rate will still only be around 1.0 - 1.25% by this time next year.  As the Committee notes, this will of course be dependent on the incoming data.  Watch this space.

Thursday, December 10, 2015

RBNZ cuts again

The RBNZ cut the Official Cash Rate a further 0.25% this morning, taking it back to the historical low of 2.5%. 

Projections for the 90-day bill rate suggest we are now at the bottom of the interest rate cycle and that there may be some reluctance to cut interest rates further.   However the RBNZ retained a mild easing bias in the news release stating that while they expect to achieve their inflation target with current interest rate settings “…the Bank will reduce rates if circumstances warrant.”

To emphasise the uncertain outlook the Bank discusses four alternative scenarios including some that could lead to stronger growth and higher inflation along with others that could lead to lower growth and inflationary pressure.  

The trajectory of the Bank’s (central case) growth forecasts are the same as ours in that after a weak patch in the first half of this year growth is expected to improve from the second half of this year, however the Bank’s forecasts are higher than ours.  They see GDP growth of 2.9% in the year to March 2017 (AMP Capital 2.5%) followed by 3.4% in March 2018 (2.8%).

The Bank expects inflation to rise but notes this is largely due to prior falls in petrol prices dropping out of the annual calculation and the flow through of the lower exchange rate into retail prices, the quantum of which remains highly uncertain given the level of competitiveness and lack of pricing power in the retail sector.  They expect inflation to be at the midpoint of their 1-3% target band by late 2017.

Given our expectation that growth will be lower than the RBNZ is currently forecasting, we concur with the sentiment in the Bank’s news release that interest rates may need to be lowered further from here.  It's certainly the case that if the RBNZ is going to do anything further soon, its more likely to be lower than higher interest rates.  The tenor of the data flow from here will be critical.  Watch this space. 

Monday, December 7, 2015

RBNZ: To cut or not to cut

The RBNZ releases its December Monetary Policy Statement (MPS) this Thursday with the big question being whether there is another interest rate cut in the bag.  Our view is that having signalled another cut at the last MPS, there is no compelling reason not to deliver.

Sure some of the growth indicators are looking better.  In particular both business and consumer confidence appear to be on the mend after a mid-year slump on over-inflated concern and hyperbole around the imminent demise of the Chinese economy.  At the same time dairy prices have waxed and waned but appear to be trying to form a base at a level that suggest the RBNZ will be able to revise up its forecast for the terms of trade.  And net migration inflows continue to hit new record highs.

But it’s the labour market that I think should still see the RBNZ deliver on an interest rate cut this week.  Our views on monetary policy have evolved with the labour market.  As I’ve said many time before the big surprise for me this cycle has been the extent to which increased labour supply via net migration and a high participation rate have conspired to keep wage increases and therefore domestic inflationary pressures in check.   Non-tradeables inflation was 1.5% in the year to September, a 14-year low.  At the same time unit labour costs (as measured by the private sector Labour Cost Index) are again ticking lower. 

Headline inflation will rise over the next few quarters as big declines in fuel prices drop out of the annual calculation and as (at least some of) the recent decline in the exchange rate feeds through into retail prices.  But importantly, while some of the growth indicators are looking better, we still expect the unemployment rate to rise over the next few quarters.  Outside some notable sectors (e.g. construction in Auckland) we expect this to keep wages and underlying inflationary pressures in check. 

So in short – we see no compelling reason for the RBNZ to back away from or even delay its already flagged interest rate cut this week.

Tuesday, December 1, 2015

Fed and ECB on divergent paths

Interest rate markets are now pricing in a 74% probability the US Federal Reserve starts the interest rate normalisation process at its 15/16th December meeting. But before then the European Central Bank is widely expected to step up its easing efforts in the face of low growth and weak inflation expectations when it meets later this week.

In comments reminiscent of his game-changing 2012 do “whatever it takes” to save the Euro, ECB President  Mario Draghi has committed the central bank to do “what we must” to achieve its inflation target in the face of low inflation expectations and growth that remains too low to put any significant upward pressure on inflation. 

Further action therefore appears more than likely when the Governing Council meets on December 3rd.  That could include one, some or all of: cutting the already negative deposit rate, increasing the quantum of the current asset purchase program or extending the duration of the program beyond its scheduled finish of September next year.

The Euro is currently trading at its lowest level in eight-months, indicative of market expectations of meaningful action from the ECB this week.  The risk then is the Council reads too much into recent better data and under-delivers.  Our read of the data is that it appears consistent with trend GDP growth, which we put at around 1.5% per annum.  The problem is the Euro zone needs a decent burst of above trend growth to absorb the still significant spare capacity across the region, the most obvious example of which is the still-high unemployment rate of 10.8%.  Monetary policy can’t do that by itself.

 After delaying the start of the interest rate normalisation process in September, markets are now pricing in a 74% chance of the Fed lifting interest rates off zero at their December meeting.  Only an atrociously bad payrolls report this weekend appears likely to derail the Fed from what will be their first interest rate hike in 9-years.

Markets seem more comfortable with the prospects of higher interest rates now than they were prior to the September meeting.  This is likely a combination of factors including the growing understanding that interest rate increase are likely to be only gradual and fears of a hard landing in China (and global growth) have receded.  So the fact the Fed didn’t hike in September for all the reasons they stated to some extent turns a December hike into a good news story!

As we have consistently argued it’s the pace of interest rate increase and the peak (terminal rate) in rates that are more critical for markets than the timing of the start of the process.  Assuming the Fed start to raise rates in December, we expect the Fed funds rate to be around 1.00-1.25% by December 2016.  Furthermore we expect the Fed will continue to lower its estimate of the neutral rate from the current 3.75% towards our estimate of 3.0%.

The path of the USD will be a critical part of the outlook for interest rates.  History shows us that the exchange rate does most of its work in anticipation of higher interest rates – the classic case of “buy the rumour, sell the fact”.  That said the fact that the Fed and the ECB (along with the BoJ and the PBoC, amongst others) are on divergent monetary policy paths will limit the extent to which the Fed can tighten.