October 2015
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Are the bad times over?
ECB flags further QE
US Federal Reserve prepares for lift-off in December
RBA on the sidelines: when will rates move?
Australian banks lift residential mortgage rates
International economies
Are the bad times over?
Following two months of heightened volatility, optimism returned to global financial markets over October
with the MSCI World Index (local currency) rallying by 7.8%. All major equity markets posted solid gains
including the US market, where the S&P 500 rallied by 8.3%, the German market, which posted a 12.3% gain
and Asian markets including Japan (Nikkei +9.7%) and China (CSI +10.3%).
In addition, the VIX index, a measure of US equity market volatility fell by 38.5% over the month. What
changed during the month to cause such a reversal in investor sentiment?
Ironically, the first leg up in equity markets followed the release of disappointing labour market data in the
US. As has often been the case, bad economic news turned out to be good news for equities as markets
began to factor in an easing of monetary policy from the US Federal Reserve (Fed) in response to the weak
employment data.
And, indeed, the Fed did not disappoint. The release of the minutes of the September FOMC meeting gave
comfort to markets that the Fed was in no rush to raise rates as long as there are downside risks facing the
US and global economies. Further on in the month, the President Draghi of the European Central Bank (ECB)
indicated that the ECB were poised to expand its program of quantitative easing as early as December.
Better-than-expected Chinese economic data and ongoing recovery in the US economy boosted investor
sentiment over the month. Indeed, Fed Chair Yellen has more recently indicated that the December is a likely
month for lift off (i.e., the commencement of long awaited tightening cycle of US monetary policy), which
equity markets have largely taken in their stride.
ECB flags further QE
As the Fed contemplates its first rate hike in nine years, other central banks are increasingly under pressure
to ease monetary policy. This month, the ECB’s President Draghi flagged the potential for an expansion of its
QE program as early as December.
At the press conference following the ECB’s Governing Council’s October meeting on monetary policy,
President Draghi expressed concern over risks to global growth emanating from emerging market economies
and the persistence of low rates of inflation emanating from falls in energy prices. In particular, during the
Q&A period of the press conference, President Draghi highlighted the high correlation in the euro area
between oil prices and the region’s medium-term expected rate of inflation.
President Draghi noted that based on energy price forecasts, inflation was expected to be low “…for a
protracted period of time”. If low oil prices, in a regional economy with a large output gap, continue to push
out the time to conversion of inflation to the ECB’s target of just under 2%, President Draghi flagged that the
ECB would stand ready to respond with further monetary easing.
US Federal Reserve prepares for lift-off in December
Following the decision by the Fed to leave rates unchanged in September, citing concerns over global
economic and financial market developments, markets had become increasingly sceptical that the Fed would
start to lift rates this year. A run of poor domestic economic data, including a soft employment report, falling
retail sales in September and weaker business confidence firmed the market’s view, while cautious
comments from a raft of Fed Governors suggested the FOMC members were also shifting in this direction.
Indeed, by mid-October, market pricing fell to imply only a 1-in-4 chance that the Fed would lift rates in
December.
Over the latter part of October and into November, the Fed sought to remind the market that a move in
December was a real possibility. Following its October meeting, the FOMC statement noted that “in
determining whether it will be appropriate to raise the target range at its next meeting, the Committee will
assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent
inflation.” The statement also downgraded its global concerns, likely reflecting the recent stabilisation in
financial markets and more encouraging signals from China. More recently, Fed Chair Yellen re-iterated the
case for feds fund rate lift off in December in her comments to the US House of Representatives’ Financial
Services Committee. Chair Yellen noted that the current pace of growth was consistent with continued
improvement in the labour market and the achievement of the Fed’s inflation target of 2% over the medium
term and that lift off in December “…would be a live possibility”.
Market pricing has reacted to recent Fed guidance, with the federal funds futures now implying around a 60%
chance of a rate hike in December. Shifting monetary policy expectations has resulted in an increase in the US
10-year government bond yield of 10.5bps over the month of October and a similar increase has been seen in
the first five days of November.
Interest rate forecasts (%)
Australia
US
Canada
Europe
UK
Japan
Level at
6-Nov-15
2.00
0.00 - 0.25
0.50
0.05
0.50
0.00 - 0.10
Dec-15
2.00
0.25 - 0.50
0.50
0.05
0.50
0.00 - 0.10
QIC Forecasts
Mar-16
1.75
0.50 - 0.75
0.50
0.05
0.50
0.00 - 0.10
Sep-16
1.75
0.75 - 1.00
0.50
0.05
1.00
0.00 - 0.10
Source: Central Banks, QIC.
Australian economy
RBA on the sidelines: when will rates move?
In its November Board meeting, the Reserve Bank of Australia (RBA) left the official cash rate on hold at
2.00%, in line with market expectations and the consensus view of economic commentators. Governor
Stevens’ Statement following the Board decision provided little by the way of new guidance on the RBA’s
thinking.
We thought the rise in mortgage rates by the Big Four Australian banks, the extremely weak September
quarter CPI outcome and the currency remaining stubbornly elevated, would provide the RBA with the
backdrop to lower the cash rate and provide a boost to business confidence. In particular, we thought that
with the actions of commercial banks and regulatory restrictions working to cool the housing market, a
significant impediment to an RBA rate cut had abated.
In addition, we thought the RBA could deliver a rate cut within an upbeat economic context, thereby
maximising the impact on business and consumer confidence. In fact, in his Statement, Governor Stevens’
alluded to the improvement in the European economy and in Australian business confidence; both
references missing from the October Statement.
We also thought that by lowering the cash rate now, the RBA could provide a hedge against a failure by the
US Federal Reserve (Fed) to raise the fed funds rate in December. By lowering the cash rate, the RBA could
mitigate upward pressure on the currency that could occur if the Fed delayed lift-off.
Having baulked at cutting the cash rate at its November meeting, we see little chance of an RBA move until
February, when the Board reconvenes for the first time in the New Year. Our view is that the RBA will lower
the cash rate by 25 basis points in February. However, unlike the possibility of delivering a rate cut within a
positive narrative, a February rate cut will be delivered within the context of renewed fiscal consolidation,
weaker commodity prices, a further slowing in housing activity and pass through of mortgage rate hikes.
Without policy support, these factors will temper consumer confidence, result in below average growth in
domestic activity and a further gradual rise in the unemployment rate.
Australian banks lift residential mortgage rates
In July, the Australian Prudential Regulation Authority’s (APRA) announced that the “Big Four” and Macquarie
Bank would have to increase their average mortgage risk weights from 16 per cent to 25 per cent from 1 July
2016. Increasing banks’ ‘resilience’ was the motivation for this move and follows a recommendation from the
Financial System Inquiry (FSI).
The change to the risk weighting of mortgages amounts to around 90 basis points (bps) of capital for the four
majors, to which they’ve responded by raising around $19 billion of common equity.
To help preserve their return on equity (ROE) and share prices, the banks have decided to bolster earnings by
increasing mortgage rates, initially for investors, but also for owner-occupiers in more recent months. Taking
into account moves by major banks as well as smaller players, and market shares, we estimate that moves to
date amount to an across-the-board 25bp rise in the variable mortgage lending rate.
However, the change to risk weights represents only an ‘interim measure.’ The FSI also recommended banks’
capital levels be raised to make them ‘unquestionably strong’ and targeted the top quartile of internationally
active banks as the benchmark.
What constitutes ‘top quartile’ will depend on global capital raising efforts in response to BASEL III
regulations that will most likely play out over 2016. In its July 2015 International Capital Comparison Study,
APRA argued that to be comfortably positioned in the top quartile of their international peers ‘Australian
major banks would need to increase their capital adequacy ratios by at least 200 basis points.’
The upshot is that APRA may require the major banks to increase their common equity tier one capital ratios
by another 100 basis points (on average) to join the top quartile club.
Should this happen, we estimate banks may lift variable mortgage lending rates by another 25 basis points to
preserve their ROEs.
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