Tuesday, 7 October 2008

We've Seen this Movie Before

Well the RBA certainly didn't waffle on about inflation today, dropping the cash rate 100 bps. The last time the RBA cut the cash rate by 100 bps was April 1992. Naturally the market rallied on the news of a bigger rate cut than expected. However what does it really mean that the RBA has departed from its policy of incremental moves in the cash rate?

Quite simply there are serious problems. You only need to take a look at the statement accompanying today's rate decision.

Conditions in international financial markets took a significant turn for the worse in September. Large-scale financial failures in several major countries were accompanied by serious dislocation in interbank markets and heightened instability in other markets, including sharp falls in share prices. Official actions in a number of countries have been aimed at restoring stability, by adding to short-term liquidity and laying a foundation for longer-term recovery in the health of balance sheets. Nonetheless, financing is likely to be difficult around the world for some time ahead. This is also affecting Australia, albeit by less than in many other countries, given the
relative strength of the local banking system.

translation - the shit has well and truly hit the fan.

Economic activity in the major countries is also weakening, and evidence is accumulating of a significant moderation in growth in Australia’s trading partners in Asia. The expansionary effects of the recent surge in Australia’s terms of trade are still coming through, but some decline in the terms of trade now looks likely over the coming year, with many commodity prices having declined from their peaks.

translation - the decoupling theory was bogus, China will not save us.

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

translation - forget inflation, we're now just trying to prevent a recession. That's the real message here, with credit markets frozen and the deleveraging process underway across all asset classes, the global economy is essentially grinding to a halt. I've been saying for a while that I think the RBA will go much lower in this cycle on the cash rate than most think and that we will end up under 5%. After today the futures market is now expecting the cash rate to be at 4.5% by March 2009.

During the last cycle the cash rate got as low as 4.25% in the first half of 2002. This cycle is looking much worse and I wouldn't be surprised to see rates end up around 3%. The inflationistas have had it wrong, as predicted months ago, deflation would become the over-riding issue and that is finally becoming clear.

We've Seen this Movie Before

But won't rate cuts save the day? Well lets take a look at what happened in the US. Starting in September last year the Fed cut the federal funds rate 7 times taking it down 325 bps from 5.25% to 2.00%. What was the result? As you can see below, the Fed's medicine simply has not worked.

So be wary of the dead cat bounces that inevitably follow rate cuts in this type of environment - one in which the economy is deteriorating and earnings expectations are being cut.