New historic low for RBA cash rate?

Only a few months ago the market was split on the expected path for Australian interest rates. Many felt keeping the cash rate on hold for the bulk of 2015 made sense, while others thought we were likely to see a cut of 25 to 50 basis points. 

Source: Bloomberg

Now it seems the doves calling for the RBA to cut in response to rapid declines in terms of trade, falling inflation, growth and an elevated unemployment rate may have the upper hand, with the RBA expected to ease again after keeping policy unchanged since August 2013.

14 central banks having already eased policy in 2015, which in the period of one month is quite amazing in itself! Some of the moves have been completely unexpected (for example the Bank of Canada on 21 January) and others (like Denmark) have eased multiple times. For the RBA to not follow suit would cause a strong reaction in Australian assets; the central bank would need to feel the Australian economy is far more resilient.

What the markets expect

If you look at market pricing (with the swaps market currently suggesting a 66% probability of a move lower), it suggests this will certainly be a ‘live’ meeting. Six of 27 economists surveyed by Bloomberg are calling for a cut; while the market seems fairly certain, economists are still a little hesitant. Bear in mind that a number of economists believe that if the RBA doesn’t cut then a March move is very much on the cards.

This last view is in-line with the recent article from Terry McCrann. Although he hedged his bets on Friday in a TV interview with Sky Business about a rate cut on Tuesday, he was of the same view. If we don’t see a cut in February, he believes it will be March. Perhaps the contraction in China’s manufacturing PMI on Sunday (the first in two years) has now sealed the deal.

Traders’ expectations can be seen in the FX market, with AUD/NZD struggling to find upside momentum above NZ$1.0700, while the EUR has recently outperformed. On the bond market side, Aussie bond yields (up to ten-year maturities) are below the current 2.5% RBA cash rate, while the 15-year bond is only 14 basis points above 2.5%.

The Fed spoke about watching global developments, should the RBA?

China is the big question here for the Reserve Bank, especially after the weak manufacturing PMI data. We saw the IMF cut its forecast to 6.8% for 2015 and 6.3% for 2016, although it has held a bearish view on China for the last couple of years. We have also seen changes to the World Bank’s growth figures, so we may get a more concerned picture from the RBA, though it’s unlikely to be dire.

Domestic conditions are key; while we should always listen for narrative around the currency, watch out for views around housing if the statement indicates cuts are on the cards.

Warning signs

RBA governor Glenn Stevens stated in an interview in the AFR that AUD/USD should be closer to $0.7500; while the pair is over 500 pips higher, Brent prices are also much higher than the current front month contract. Unlike the Fed or ECB, we don’t get to hear from individual members as often, so there have been few clues of easing and therefore the market has had to make up its own mind.

It is clear the Board would like to see the AUD lower;  the three biggest currencies in the trade-weighted basket (CNY, JPY and USD) all have attractive qualities in a volatile environment. Given current market pricing, the RBA has to deliver or traders will cover shorts aggressively and the market would lose an element of trust in the RBA, because it should have been guided more convincingly.

It’s also worth pointing out that in July 2014 (when there was increased talk of rates rising), the RBA Governor detailed in Tasmania that ‘long before any thought were to be given to an increase in rates, it would probably be sensible for the Board to cease references to a future ‘period of stability’ and revert to the more normal formulation that the stable policy settings "remained appropriate” or something like that.’

So, if the RBA was going to give a clear point of reference for hiking rates, should it do the same for cuts? Perhaps, but the market has clearly run with its own view, as iron ore, coal, steel and energy prices have been decimated.

Market positioning

The Commitment of Traders (CoT) report on Saturday (which looks at reported positioning from leveraged and speculative accounts) showed that the market has been running with the biggest net short position in the AUD for over a year. This won’t surprise anyone given the strong downtrend in AUD/USD, but there is just under $5 billion in net short positions in the futures market alone.

IG’s clients are less convinced, with 57% of all open positions held long and looking for a move higher*. Many will be speculating that the RBA will leave rates on hold, although some just feel the pair is oversold.

The RBA Playbook

Tuesday’s meeting will be an exercise in positioning, expectations and algorithmic trading, with systems set to react to word flow and key technical levels. Being nimble is incredibly important if you are trading around the announcement and the first move might not be the right move.

Here are the three key likely outcomes and the potential reaction at a very high level:

The RBA cuts rates and gives an indication it could cut again – The swaps market is pricing in a 65% chance of a cut, so expect AUD/USD to break the recent lows, although the RBA will have to strike a very dovish tone to cause the pair to break $0.7500 over the next 24 hours. The ASX 200 should continue to find support as well, with banks at the heart of the rout.

The RBA leaves rates on hold but indicates a cut is coming – This is my base case and we could see the RBA amend the last (and most important) paragraph from ‘on present indications’, that the most prudent course is ‘likely’ to be a ‘period of stability’ in interest rates (narrative it has had in place since February 2014). The bank could look to give a clear indication of an impending cut by adopting a view that it has ‘some scope to ease’, or words to that effect. In this situation we could see an initial pop in the AUD, before traders have the chance to read the statement, with a vicious reversal likely taking place in the currency. Watch the Aussie bond market (especially yields/priced up to five years) as the best guide for direction in the currency market.

Potential moves of AUD/USD

Look for AUD/USD to undergo some whippy price action, with price settling down and trending lower into the London open. Look to potentially buy EUR/AUD for a move to A$1.4824, with the pair starting to look quite compelling on a technical basis.

The RBA leave rates at 2.5% and give no indication of easing - There is a low probability of this given the actions of every other central bank and prospects for a weak Q1 inflation, with growth and key terms of trade falling heavily. In this case a sharp move through $0.7900 would be on the cards, with London traders pushing the move further higher. The RBA will issue its Statement on Monetary Policy on Friday and I would be fading moves into the $0.8000  to $0.8025 area and the 28 January high.


*IG client account view at 8:00am 02/02/2015

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