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Why The RBA Has To Cut Interest Rates

The Bank of International Settlements (BIS), the central bank for central banks, came out and told the market yesterday what every Aussie property investor already knows: Property produces incredible returns.

Using data dating back to the 1960s, the BIS said Aussie house prices have increased an incredible 6,556% since then, averaging 8.1% per annum for five decades.

Now, the BIS admitted that this worldwide study shouldn’t be taken as gospel. They admitted that, while they compared long-term house prices across the world, the data periods weren’t consistent for every country.

An important take-away from the report, however, is that even though housing is a good long-term investment, interest rates were a ‘surprisingly important’ factor determining house prices.

Which leads us to today’s conundrum: What the Reserve Bank of Australia will do next.

Since the RBA dropped rates to a record low of 1.5% in August 2016 — the latest policy change — most analysts have suspected the next move will be up.

National Australia Bank Ltd [ASX:NAB] and Australia and New Zealand Banking Group [ASX:ANZ] said in September that they expect the RBA to raise rates twice in 2018. The head of Australian economics at ANZ David Plank noted:

In sum our outlook for 2018 is a touch more positive than before, reflecting a stronger outlook for non-mining business investment, the strength in public sector spending [not only in the infrastructure space] and a shallower dip in residential construction than previously expected.

If these moves occur, the Aussie market would end up with cash rate of 2%, assuming two moves of 25 basis points each.

Meanwhile, the Commonwealth Bank of Australia [ASX:CBA] expects a single rate rise at the end of 2018, leaving the cash rate at 1.75%.

I suspect the commercial banks will be left to control the Aussie housing market. They’ve already done this by raising the base rate on investor and interest-only loans over the past few months. These rate rises have come from increased capital requirements and the banks lowering the percentage of investor loans on their balance sheet under the direction from APRA.

I can’t see the RBA raising the cash rate next year. In fact, I think they’ll have to cut rates, regardless of concerns about high house prices.

One of the only dissenters on rates, comes from Westpac Banking Corp [ASX:WBC] chief economist Bill Evans doesn’t think the RBA will be raising rates next year. Evans has said the Aussie labour market isn’t as rosy as everyone wants to think, and that weakness in retail and services will halt any plans the RBA has to bump up the base rate.

Joining in on the ‘everything is not OK’ rhetoric is Sally Auld, the chief economist and head of Australia and New Zealand fixed income and FX strategy at JPMorgan. Going a step further, Auld said in a note that the RBA will have to cut rates over the coming months.

She argues that weak retail sales data for August, which followed horrible results in July, proves that consumption isn’t growing.

Source: Business Insider
[Click to enlarge]

Without consumption growth, it’s nearly impossible for GDP to nudge towards the RBA’s 3% forecast. That said, the RBA is confident that, by 2019, the GDP figure will rise to 3.5%. Both targets are well above 2.75%, which is considered to be Australia’s long-term trend. And way above the current GDP year-on-year figure of 1.8%.

As Auld explains:

The weak August retail print casts a shadow over Q3 consumption, with volumes likely to slump relative to the first-half average.

Any further sense that the consumer is wavering under the burden of slowing house price growth, rising utility prices, tighter lending conditions, and near-flat real wages would reduce the RBA’s confidence that the current policy settings are consistent with a return to above-trend growth by mid-2018.

‘We were somewhat surprised by the strength of retail sales in Q2, with temporary factors such as replacement buying following damaging storms and some one-off fiscal transfers supporting spending.

The drop in retail spending in Q3 is consistent with our view that these boosts would fade, as well as further evidence that upbeat tone of the labour data does not accurately reflect how the household sector is positioned.

Why the RBA won’t raise interest rates in 2018

For the better part of a year, I’ve argued that the RBA will be cutting rates before they get around to raising them.

Most analysts keep looking at falling unemployment and population growth as factors that will boost consumption. But the fact is that household costs are rising via utilities, education, insurance, energy and, to some extent, basic food items. Yet discretionary items, such as clothing, footwear and electronics, are falling in price.

Part of the price decline here can be attributed to price deflation — these items are cheaper today than they were a year ago. Also, with the cost of necessities rising, any other purchases typically get shelved.

In other words, weak income growth and higher costs of living — is likely to lead to a fall in discretionary spending.

For the majority of last year, the RBA suggested via their meeting minutes that inflation was a key focus for the economy. The consumer price index (CPI) is rising, albeit slowly, with prices mostly rising for basic items.

Furthermore, we are spending less and less money outside the home, if the performance of services index (PSI) is anything to go by. The index tracks activity across Australia’s hospitality sector. Measuring accommodation, cafes and restaurants, the PSI dropped 0.9 points for the month of September, to 52.1. That represents the fastest decrease on record.

The services sector is the largest employer in the Aussie economy. But it further backs up the view that we are spending less outside the home.

In other words, without consumption signalling that everything is OK, I don’t believe there’s any way the RBA will be raising rates.

But, if we aren’t buying and gobbling up more of everything, you can bet your house that there’ll be no rate rise in 2018 either.

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