Why the RBA Will Keep Rates on Hold

Today sees the release of Australia’s economic growth numbers for the fourth quarter. Given growth in the third quarter contracted, another fall in the three months to December would mean an official ‘recession’ for Australia.

But don’t worry. That’s not going to happen. While I’m writing this before the data release, my guess is that you’ll see a healthy growth number for the fourth quarter.

Consumer spending (which makes up the bulk of economic growth) will remain decent, while exports should contribute strongly to growth too.

Thanks to a strong iron ore price and the start-up of Queensland’s massive LNG export industry, Australia’s trade balance has shifted markedly over the past year.

It’s shifted so much that investment bank UBS predicts Australia’s current account deficit (which includes the balance of trade and net income flows from investments) will turn positive this year for the first time since the 1970s.

Given our income deficit is hefty (thanks to the interest we pay on $1 trillion of foreign debt) the trade situation has moved strongly in our favour.

And while commodity prices remain robust, the momentum will continue.

This has important implications for next week’s interest rate decision by the RBA.

Will the RBA raise rates next week?

A stronger rate of economic growth increases the chances that the RBA will raise rates, right?

Maybe. But my view is that the RBA will keep a close eye on the reaction of the Aussie dollar. A rising dollar acts as a brake on demand. As the dollar rises, it translates into less export income.

An interest rate rise would only push the dollar higher. This would impact domestic demand as well as export income. Given that the economy still isn’t growing that strongly, I expect the RBA to err on the side of caution and keep rates stable for some time.

As Australia continues to push into record economic growth territory, the reality is that the growth is becoming more and more dependent on low interest rates. As Bloomberg reports:

Inner districts of Sydney drove almost a quarter of Australia’s expansion last fiscal year, underscoring the city’s pre-eminent position in the nation’s economy.

The area stretching from Sydney’s central business district to Macquarie Park north of the center made up 24 percent of GDP growth in the financial year through June 2016, according to consultancy SGS Economics & Planning. Inner Melbourne contributed 11.4 percent as Australia’s east coast cities perform in a similar fashion to their impact on the property market.

I’m not sure how they worked this out. But it certainly doesn’t scream ‘balanced economic growth’, does it?

In fact, according to SGS Economics and Planning, Sydney and Melbourne accounted for around two thirds of Australia’s economic growth in 2016.

Source: Bloomberg
Click to enlarge

It makes sense that Australia’s two largest cities account for a decent chunk of economic growth. But it’s growth that is largely driven by debt, and that’s largely driven by low interest rates.

I think the RBA will be happy to sit back and see whether the commodity boom eventually translates into higher growth in the resource states of WA, QLD, and to a lesser extent SA, before moving rates higher.

In the meantime, they will keep rates on hold, in the knowledge that debt-addled Sydney and Melbourne are keeping the economy afloat.

All eyes on the Aussie dollar

But the dollar will be in focus. As you can see in the chart below, after falling sharply at the end of last year, to below 72 US cents, the dollar has rallied back to around 77 cents.

It’s not far off the 2016 high at just over 78 US cents, but it still has a bit of work to do to get there. If it does though, you can bet that interest rate rises will be off the table for a while. That’s because the currency will be doing the work of a rate rise.

Source: Optuma
Click to enlarge

Meanwhile, the Aussie stock market continues to perform well during the reporting season. Sure, during the past week or so, the market has pulled back. But looking at the bigger picture, things look strong.

To see what I mean, check out the chart of the ASX 200 index. As the name suggests, this is an index of the largest 200 stocks in Australia. It’s dominated by financials (banks) and to a lesser extent resource stocks.

Note how the index bottomed in early 2016 and has been trending nicely higher ever since? That marked the bottom of the commodity bear market. When commodity prices fall, that puts pressure on Australia’s debt dependent economy. When commodity prices rise, the leverage effect works the other way.

And as you can see, the commodity price rise throughout 2016 is benefitting the market…

Source: Optuma
Click to enlarge

The index has pulled back slightly. But positively, it’s consolidating at higher levels. The key points to watch for now are support at around 5,600 points, and resistance at just over 5,800 points.

The odds favour an eventual move higher. But we could be in a sideways movement for some time. As long as the index holds above 5,600 points, the short term outlook is bullish.


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Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

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