Tuesday, 5 August 2008

Get Ready For Rate Cuts

Back in mid-June I posed the question, Is the RBA Done? Today I think we got an answer. Whilst the RBA left the cash rate unchanged at 7.25%, the accompanying statement gave a hint of what was to come. Here is the money quote:

Weighing up the available domestic and international information, the Board judged that the cash rate should remain unchanged this month. Nonetheless, with demand slowing, the Board’s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing.

As can seen below the cash rate futures market got very excited. They are now pricing in 50 bps of rate cuts by November. Back in June they were pricing in another 25 bp rise.

The markets could be jumping the gun, the RBA may take its time to cut but the direction of the next move is no longer in question, we are now entering an interest rate cutting cycle.

Just how far will the RBA go? I believe they will go much further than most expect. The problem is that a significant amount of damage to the Australian economy has already been done and just as we saw in the US, slashing interest rates will not stop a significant slowdown in the economy.

Take the Performance of Services Index (PSI) released today. Like the PMI reported last week, the Australian services sector saw its second straight month of contraction in July and was the worst result in the series since it was started back in February 2003. Of particular note the Employment component plunged 6 points to 42.2, well below the 50 mark that differentiates expansion from contraction.

Numbers like this coupled with other recent data showing sluggish spending numbers and a sharp slowdown in credit growth point to a rapidly slowing Australian economy.

Of course, rate cuts are generally good news for the stockmarket however I believe we will see that same course of events that played out in US. The markets rallied after each rate cut only to move lower as the market came to grips with the reality of a deteriorating economy and the knock effects to corporate profits.