Monday, 6 October 2008

How Low Will the RBA Go?

As of Friday the SFE cash rate futures contract was pricing in a 96% chance of a 50 bps cut by the RBA at tomorrow's meeting. Back in August I posed the question: Just how far will the RBA go? At the time I said they will go they will go much further than most expect. At that time the futures were pricing in a rate of 6.5% by March 2009.

Just two months later and the futures market as shown above is expecting the RBA to lower the cash rate a full 100 bps lower than that to 5.5%. That's pretty aggressive but I think it's close to the mark. From March the futures are looking flat at 5.5% out until early 2010. I actually think we could get under 5% before the RBA is done in this easing cycle.

Whilst the RBA will still talk about inflation the game has clearly changed. Credit markets are freezing up and the RBA needs to act to prevent a strong slowdown. At least that is what they will be thinking. My view is that at times like these, monetary policy is of little use as we have seen in the US.

As highlighted before, Fed easings did not bring down market rates for mortgages in the US. I think we will see the same result in Australia. Banks will pass on what they can but they won't be able to follow fully every RBA cut with such onerous funding costs.

Households and small businesses will continue to suffer as the Australian economy slows into 2009 and RBA cuts will provide little relief. I haven't called a recession in Australia previously but looking at the data I am fairly confident in calling Australia's first recession since 1991 in 2009. Expect unemployment to rise to 6% or higher by the end of next year.

Data out in the last week showed that the Australian manufacturing industry contracted for the 4th straight month while the services sector contracted for the six straight month. That can't be good news, also I caught a smh article last week that showed small business bankrupticies are on the rise. Combined with higher funding costs that is one reason why I cannot see bank stocks as attractive at current prices.

The market will be hoping for a 50 bps cut tomorrow, anything less will probably be a disappointment. However any rally will be shortlived, the market has a way to go before lower earnings outlooks and recession are priced in.