Will the Reserve Bank cut in April or May?

In the March meeting the Reserve Bank of Australia (RBA) adopted a strong easing bias, suggesting it was ‘appropriate to hold interest rates steady for the time being’.

Reserve Bank of Australia
Source: Bloomberg

The question is, given the recent data flow and the Reserve Bank economic projections, is there enough data to suggest ‘the time being’ will have passed and the Reserve Bank will ease again this week, or in May?

Traditionally this degree of easing bias has resulted in action and Westpac recently detailed in a research note that ‘for the time being’ has only been used in eight statements, since January 2009. On six of those occasions the Bank moved rates at the next meeting, while it moved at the second meeting to follow on the other two occasions.

Westpac’s statistics are very interesting and it suggests a rate cut within the next two months is a done deal, which is clearly seen in market pricing. Perhaps we also need to be asking ourselves ‘what will make the RBA lower the cash rate below 2%?’

Certainly if the RBA is going to pause again it will be to get more information around the red hot Sydney property market, although the current dynamics are unlikely to alter greatly by May and housing is clearly their number one concern. The Reserve Bank will also be keen to see the March employment data (Thursday 16 April) and the Q1 2015 CPI print (Wednesday 22 April). The latter is expected to be extremely subdued with a headline print of 1.3% (although core inflation is likely to be above 2%), so this may give them further ammunition on how to act. We will also get a chance to see the May Statement on Monetary Policy, while the RBA will also be keen to see if the February cuts feed more clearly into business and consumer confidence.

On the other side of the scale Friday’s weak US payrolls report has seen the market push its date for the first hike from the Federal Reserve into December. This should keep US bond yields subdued and the USD from rallying with any real purpose. AUD/USD in this environment will struggle to break below the 75 cent handle unless we see iron ore heading towards $40. Taking the cash rate to 2% in April will help mitigate potential upside in the AUD, but ultimately many will be asking why on the current news flow would the RBA wait until May?

It is worth highlighting that the March meeting minutes detailed that ‘members saw benefits in allowing some time for the structure of interest rates and the economy to adjust to the earlier change. They also saw advantages in receiving more data to indicate whether or not the economy was on the previously forecast path’. Perhaps this throws the element of probability out to a May cut.

Market pricing

For short-term traders, understanding what is priced into markets can certainly help from a risk/reward perspective.

Looking at the swaps market, we can see the market is placing a 75% probability of an April cut and 100% of a cut in either April or May. This probability has been steadily rising, while over a 12 month period the market is pricing in a cash rate from 1.75% to 1.50%. This probability is somewhat at odds with the economist community with 13 of 30 economists calling for easing at this meeting and we have already seen two other meetings this year where there is disagreement between market pricing and economist consensus.

Market positioning

Last week’s Commitment of Traders (CoT) report highlighted that net FX futures positioning held by speculative funds showed an increased 41,800 net short contracts position on AUD/USD. This is the most short the market has been in many years and suggests the risk of short covering is real. However, we will need to see the fundamental picture alter dramatically for radical short covering to emerge, so I would not read into this too much at this juncture.

IG’s own internal data flow is much more nuanced and show 54% of all open positions held by our global client base are actually long.

Market moves since the March meeting

Perhaps the most interesting dynamic since the 3 March RBA meeting, is the 2% depreciation in the trade-weighted AUD, helped largely by a move lower in AUD/CNY. Specifically AUD/USD has fallen from $0.7780 to current levels (Friday closed at $0.7633). A large degree of falls would be down to increasing rate cut expectations, although the strongest correlation is with iron ore.

Importantly the premium in the Australian ten-year government bond commands over the US treasury has widened to 45 basis points from a multi-year low of 33 basis points on 26 March, supporting the AUD/USD to a degree. Bear in mind the premium has dropped from 274 basis points in November 2010, so a failure to cut from the RBA will continue to widen this premium, putting a better upside in AUD/USD. This is something the RBA will be fully cognisant of.

With the spot iron ore price falling 25% since the prior meeting, the AUD simply hasn’t adjusted enough to the falls in the terms of trade. To put things in perceptive the last time iron ore was below $50 a ton AUD/USD was at $0.6600. What’s more, the supply issue is not going away anytime soon and local reports suggest China is happy to sell its own production at loss making prices to reduce the reliance on foreign producers.

Turning to equities, the ASX 200 has fallen 1.2% from just before the 3 March meeting, with the consumer discretionary space having lost 0.8% in the process, despite interest rate cut expectations increasing.

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