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Putting the puzzle together for second rate cut

So, with Governor Stevens’ speech in New York now digested, the more important part of the May rate cut puzzle is released today - the CPI read.

RBA
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I need to revisit what was covered by Governor Stevens plus what has been stated in the previous two minutes and the previous two statements.

This line from the speech has been getting plenty of air: ‘The Board has, moreover, clearly signalled a willingness to lower it even further, should that be helpful in securing sustainable economic growth.’ Couple with this line: ’So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table.’

Some have taken these two lines as something new and a clear sign the board will move in May. However, from what I have read in the statements and minutes of the previous two meetings - it is not.

This line has been in the statement preceding the last two rate decisions: ‘Further easing of policy may be appropriate over the period ahead, in order to foster sustainable growth in demand and inflation consistent with the target.’

So yes, we know that Stevens’ and co. have been looking at cutting rates further, however, it’s how many cuts the bank will make before it reaches terminal velocity. That is the main question. If it’s only one more, it will need to be sure that the economy needs it, as once it runs out of monetary ammunition and the market figures that out – all bets are off.

So, what are we expecting form the May 5 meeting? All 26 economist surveyed by Bloomberg on April 10 expect the cash rate to be 2% from 2.30pm on May 5 – the interbank market however is not that confident. Having priced in a certainty just before the April decision (as high as 114%) its belief of a further cut in May has wavered greatly falling as low as 49.5% after the stellar jobs numbers last week.

That is why todays CPI print is so important from a strategy point of view – equities, currencies and bonds will be effected by the print in some shape or form as inflation is a key pillar of Stevens’ reasoning for moving rates if they are in line there will be feverish trading here.

I personally believe they need to lower rates further - the employment read appears to still have ‘seasonality issues’ inside it. The rate of jobs added in February and March seems very high considering the data from the CAPEX estimates, business confidence, consumer confidence, the very public end of the mining boom and the fact China is slowing at a faster rate than expected are negatives for employment. Australia needs a further boost to the real economy – Sydney’s housing market aside in my opinion.

However, if the CPI comes in line with estimates – we may have to wait another month. Expectations are for a trimmed-mean year-on-year figure of 2.2% - that is still well inside the comfort band of 2% to 3%.

The AUD will be interesting on the drop as it is likely to gyrate initially on the headline CPI print which is estimated to be 1.3% year-on-year as the oil price and food have continued to slide in the first quarter of 2015. However the RBA watches core inflation which is the trimmed-mean figure – and the AUD may return to currently levels after the fact once the initial reactions settle down.

Employment, inflation and the fact the May budget is expected on May 12 could be enough for one more month of rates at 2.25%. At the close of business yesterday the interbank market settle back to where it was post the Stevens’ speech last night at 57% - its reaction to the CPI print I think will be telling to what is likely to transpire on May 5.

From an equity perspective, no cut will bring further downside risk to bank and defensive equities. I have been concerned the banks have run away from fair value on little or no news. As we approach first half earnings season for the banks fundamental analysts are asking the same question.

The dips in the banks are becoming stronger and they are now unable to recoup losses as strongly as they did at the start of the year when cuts were more certain – this suggests to me investors are also nervous that premium price in the banks for such a skinny yield that isn’t going to expand on falling cash rates is no longer justified. Considering the banks make up over 25% of the ASX – downside risk in equities is mounting and the breakdown in the index over the past week shows that further consolidation may be on the cards if a no move eventuates.

Ahead of Australian open

We are calling the ASX 200 down a few points to 5869 – it should be fairly flat trading ahead of 11:30 am. Iron ore slipped yesterday having crossed over US$50 a tonne last week and BHP is due to release its quarterly numbers which will also have a bearing on trade. However, I can’t help but think portfolio managers will view the CPI read as a short term mover of rate expectations and will therefore position themselves accordingly.

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