A huge week is in prospect as markets await the RBA board’s March deliberations on Tuesday with keen interest. The week starts off with the remainder of the GDP partials ahead of the Q4 GDP release on Wednesday (Market 0.7% q/q; NAB 0.8% q/q). There are also the regular monthly building approvals and retail sales releases. And the Government releases the latest five-yearly Intergenerational Report on the forty-year outlook for Australia’s government finances, which the Government hopes to use to frame the setting of the next budget. Toss in a speech by the RBA Deputy Governor, more whispers of a leadership challenge and the important monthly ISM and non-farm payrolls releases in the US, and it’s a full dance card.

NAB continues to forecast no change in cash rates tomorrow, expecting the board to elect to monitor developments in the housing market in particular, but in the economy more generally, following the rate cut last month and as the economy also responds to the influence of the lower $A and lower oil prices. February was a very short month, it having been only four weeks since the last board meeting, which also argues for a little bit more watch-time before a further move, which NAB currently expects in May. The weekend’s auction results continued the very elevated clearance rates of recent weeks, which should also provide some cause for caution.

Standing back from the March discussion, the question most investors are asking is whether there is significant risk of rates falling a lot below 2% (implicitly below the current low point pricing of 1.75% priced for March 2016). With the market fully pricing two further interest rate cuts, it would seem to require a much weaker Australian economy and a substantially higher unemployment rate track than seems likely, to encourage the RBA to take rates significantly lower than a 2% handle. A number of points seem worth re-making:

• Monetary policy currently continues to work in Australia, with the February cut boosting consumer confidence, activity in the home sales market and improving cash flows for debtors;
• The rise in unemployment occurring in Australia is different to that which occurred elsewhere in the world in the aftermath of the GFC. Rather than there being large numbers of jobs lost, most of the unemployment is resulting from the economy not generating sufficient net new jobs growth to accommodate new entrants to the labour market (both migrants and school and university leavers). This has fewer negative effects on the economy than when unemployment is rising sharply due to large job losses;
• Monetary policy is relatively powerless to negate the downturn in mining investment or to boost non-mining investment. All that monetary policy can do is mediate second-round effects of the mining downturn into the broader economy (which the current low setting of interest rates seeks) and assist in supporting confidence and the correct conditions for a recovery in non-mining investment (which the prior reductions and the latest cut seek to do). While the first outlook for non-mining investment intentions was relatively soft for 2015-16, it is worth noting that actual non-mining investment has actually made some headway over the course of 2014-15, notwithstanding expectations commencing at a similar level to the first expectation for 2015-16. It will also take some time for consumers and the business community to respond to lower interest rates, the lower $A and lower oil prices.

So far, neither of the economics editors that were especially on the money with the RBA last month have filed stories confidently predicting what will happen tomorrow. We read this as reflecting the absence of concern by the RBA that markets are significantly mispricing monetary policy expectations over the next few months, with a further rate cut nearly fully priced by April and more than fully price by May. This month’s meeting is slightly more than 50% priced and given the short time between board meetings, the obvious momentum in auction clearance rates and the lack of fast-moving or large negative developments in the economy in recent months, we are happy to bet against the view of a very quick follow up rate cut.

This suggests the risk that the $A moves slightly higher in the very short term and interest rate markets move modestly higher also, though medium term, we continue to expect developments in US interest rate markets to be negative influences for both the $A and for Australian term yields. Friday night’s US non-farm payrolls looms large in this regard and is likely to become (if it’s possible) an even more important economic indicator for markets each month over coming months. Fed Chairman Yellen’s testimony last week, which saw many in the market conclude that tightening prospects in the US were reduced or delayed, appeared very even handed to us. As in previous cycles, the Fed’s thinking will continue to be significantly influenced by developments in the labour market. Yellen seemed to clear the decks for the possible dropping of the “patient” guidance at the upcoming March meeting, which will put the markets on alert for a possible move from the June FOMC meeting (which is when NAB expects US rates to begin to be normalised).

Historically, periods of Fed tightening have coincided with higher long bond yields, though it is true that this is the first cycle of tighter US short interest rates that is likely to occur at the same time as QE programmes continue in Europe and Japan. This leaves open the possibility that more of the adjustment might be reflected in currency adjustments than in term yields (ie perhaps the US$ could rise further, with downside risk implications for the $A). NAB FX and FI strategists forecast the $A to end 2015 at US$0.74 and for the Australian 3-year swap rate to rise around 40bps to 2.5% over the next twelve months.

The other interesting medium-term development this week will be the release of the latest 40-year peek into Australian government finances (The Intergenerational Report). The government is hoping to use this report to re-set public opinion about the need for budget reform over the medium term. The following two charts show the very interesting tale of the US and Australian budget positions. In the US, the recession impact on both outlays and receipts is apparent, but the more recent significant improvement in the US deficit has been driven by expenditure restraint in conjunction with the economic recovery of revenues. In Australia, there are two key drivers: (i) the absence of expenditure restraint (under both sides of politics, including after the election of the current government – where a number of taxes were repealed and the corresponding compensation arrangements not reversed); and (ii) the two periods of very slow revenue growth (one immediately after the GFC) and more recently as the terms of trade has fallen sharply. The scale of the Australian problem remains relatively favourable compared to the US – at its peak, the US deficit was around 40% of outlays. In Australia, even now, the deficit is only running at around 12% of outlays.

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