THE BIG PICTURE: What will trigger the next rate cut?

So the Reserve Bank has cut interest rates. Now the guessing game is on in earnest about when the next cut will occur. And that’s reasonable given the fact the Reserve Bank has never cut rates just once. In fact each rate cycle has been at least three moves in the one direction.

There are a number of factors to watch. The first is Europe. Euphoria broke out after the Euro summit agreement. But then Greece announced it would hold a referendum on the austerity package and the optimism was quickly unwound. Given that Greece is the home of democracy, it seems appropriate that the Greek people are given a say. It may turn out that there are more fair-minded Greeks than protesters, realising that there is few alternatives – they need to change their ways and take their medicine. Clearly Europe remains a powder keg.

Then there is the slowdown in China. This is far less a concern, but any economy that has been applying tighter monetary policy needs to be careful that they don’t go too far. A case in point being Australia.

And certainly domestic economic data will be watched carefully – especially the more forward-looking indicators like housing finance and building approvals. It is clear at present that very soft building activity will persist until the New Year at least.

As always, the Reserve Bank will be constantly assessing all the financial indicators: borrowing, home prices, the Aussie dollar and interest rates – both market rates and the cash rate. At the November RBA Board meeting, members had little choice but to cut rates. The Aussie had jumped US10c in the month, 3-year swap rates had lifted 40 basis points, home prices had continued to fall while borrowing remained weak.

But what level of interest rates is appropriate? Clearly this equation represents a moving feast, as the financial indicators never stay still. But if you take the view that the financial indicators are unlikely to provide much assistance in the short term, then interest rates have to get back to “normal”.

It is easy to work out what are “normal” or “neutral” rates because the RBA has made it abundantly clear. It provides charts on the variable mortgage rate with a line marking the “average” rate since 1997. The average mortgage rate is 7.30% and the new mortgage rates are near 7.55%. So there is at least one cut to come. This rate cut could come as early as December if the European situation continues to deteriorate.

Note that the “normal” or “neutral” housing rate is the level that isn’t acting to either speed up economic growth or slow it down. Now if Europe were to really implode, the Reserve Bank would need to move to an easing monetary policy stance – a cash rate of 4% or below. The Reserve Bank also looks closely at the “real” cash rate. If inflation eases further then cash rates have to fall to prevent a de-facto tightening of policy occurring. Importantly, the RBA expects inflation to stay in the target band until 2013.

The week ahead

Over the coming week there will a useful mix of indicators in Australia. Some are “leading” indicators – suggesting where the economy is likely to go. Others are “coincident” indicators – showing where the economy is. And then there are “lagging” indicators – largely showing where the economy has been.

The job advertisement data on Monday is one of the “leading” indicators. If employers are looking for staff then in 4-5 months time there should be more people on business payrolls. Clearly it takes time from when the job is first advertised to the interview stage and then to the point that the offer of employment is tendered.

Job advertisements have fallen in five of the past six months with the number of ads dropping by 2.1% in September. Employers may be looking to work existing staff for longer hours rather than take new people on board, but clearly it takes momentum out of the economy.

On Tuesday the international trade data for September is released together with figures on arrivals and departures. Largely these statistics are “coincident” indicators but there are forward and backward-looking components. If more migrants are arriving in the country, this will lead to greater spending, employment and demand for accommodation – rental or home purchase/construction. And more export income could lead to higher spending, but the dollars may also be saved. Overall we are tipping a healthy trade surplus of $3.8 billion.

Also on Tuesday NAB will release its latest business survey. One part of the survey focuses on “conditions” while the other focuses on “confidence”. If business conditions are soft then employment and spending will likely be curbed. Also if confidence levels are similarly soft, then businesses are more inclined to stick with the status quo rather than look to grow. At present business conditions and confidence are soft. And new orders have been falling for six straight months, further crimping the outlook. The October survey was probably taken in late October – at a time when the Aussie dollar had rebounded – a major negative for businesses.

On Wednesday, housing finance and consumer sentiment data are released – key “forward-looking” indicators. More confidence equals more spending. And more home loans equal more home sales and building. Consumer sentiment should have lifted sharply in response to the rate cut. And we tip a 2% increase in the value of home loans – boosted by recent falls in fixed-term rates.

On Thursday, employment data is released while Reserve Bank Assistant Governor Philip Lowe delivers a speech. Employment is largely a “lagging indicator”. That is, it reflects hiring decisions made four to five months ago. But it isn’t totally backward looking. If more people got jobs in the latest month or are working more hours, which means higher incomes and potentially higher spending. We tip a 10,000 lift in jobs with the jobless rate unchanged at 5.2%.

In the US, the economic calendar is sparsely populated. The employment index and consumer credit are released on Monday with weekly retail sales on Tuesday. On Wednesday the weekly mortgage index is issued with international trade, weekly jobless claims, the monthly federal budget and import & export prices on Thursday. On Friday government offices and the bond market are closed for Veterans Day but consumer sentiment data is released.

In China, the monthly download of economic data occurs on Wednesday and Thursday with inflation, investment, production and retail spending all released on Wednesday and trade data on Thursday.

Sharemarket

CommSec currently forecasts the ASX 200 & All Ordinaries indexes to reach 4,450 by June 2012 and 4,650 by December 2012. In late October these forecasts seemed highly pessimistic whereas in the last few days, again these seemed more like stretching projections. What a difference a week can make! Clearly the European debt situation is highly uncertain. Some countries are doing their level best to “do what it takes” to restore stability while other countries are putting politics and self-interest to the forefront.

We continue to frame conservative forecasts, assuming that economies in Europe and the US will struggle over the next few months and progress on debt reductions will be a case of two steps forward and one (or two?) steps back. In Australia, investors are spoilt for choice. Term deposits rates are around 5%. While in the property market rental yields are between 3.8-5.8% while the rate cut offers the prospect of stronger capital growth over the coming year. At the same time the Aussie dollar hasn’t eased greatly enough to attract foreign investors back into the market.

Interest rates, currencies & commodities

Is the Aussie dollar too high – and if so, is there anything we can do about it? Despite all that has happened in 2011, the Aussie dollar is almost 2% higher now than at the start of the year. However the CRB futures commodity index has fallen by just over 5%. Still, that isn’t the full picture because Australia has benefited from higher iron ore and coal prices. In SDR terms, the Reserve Bank commodity index is up 12% from last December although rural prices are down 6% and base metal prices are down 16%. Iron ore and coal producers may be less affected by the higher Aussie dollar, but for all other businesses the persistent strength of the currency has made life difficult. So if the Aussie won’t fall, cash rates have to drop.

Craig James is chief economist at CommSec.