Third quarter 2016 commentary

24 Oct 2016

By Shadforth Financial Group

RBA cuts the cash rate again
The Reserve Bank of Australia (RBA) cut the official cash rate by 25 basis points to 1.50 per cent in the September quarter. The rate cut was widely anticipated and thus shrugged off by equity markets and the Australian dollar, which hit over US77c during the quarter. Consumer price index data was an important catalyst for the rate cut, with June quarter headline inflation recording 0.4 per cent in the three months through June and the annual rate falling to 1.0 per cent, well below the RBA’s target of two to three per cent. The big four banks upset consumers by only passing on part of the 25 basis point rate cut. Commonwealth Bank reduced its standard variable mortgage rate by 13 basis points, National Australia Bank by 10 basis points, ANZ by 12 basis points and Westpac by 14 basis points. However, the big banks surprised the market by increasing term deposit rates by between 50-85 basis points, which will make them more competitive against the smaller players more reliant on the deposit market.

Japan’s failed attempt at reaching two per cent inflation
The Bank of Japan (BOJ) brought into focus the challenge central banks face reviving growth and inflation despite the use of quantitative easing and, in Japan’s case, negative interest rates. Inflation in Japan recorded -0.4 per cent in July, nowhere near the target of two per cent. As a consequence, the BOJ has announced an innovative approach to reaching its inflation target. The BOJ is moving from focusing on quantity under its quantitative easing program to yield curve targeting. The focus will be on steepening the yield curve by buying more short dated bonds rather than long dated bonds in order to anchor 10-year government bond yields at around zero per cent. This approach should positively impact bank profitability since banks borrow short term and lend long term, as well as insurance companies and pension funds buying longer dated bonds.

Monetary policy divergence continues to be diluted
The U.S. Federal Reserve (U.S. Fed) went another quarter without raising interest rates, but was at times more cautious in its press releases in an attempt to restore some credibility with the market. The world’s central bankers descended on Jackson Hole, Wyoming in August for their annual economic symposium, this year titled ‘Designing Resilient Monetary Policy Frameworks for the Future’. However, markets were more focused on Janet Yellen’s speech for guidance on future U.S. interest rate hikes and she delivered, indicating that ‘the case for an increase in the federal funds rate has strengthened in recent months’. This sent the probability of a September rate hike soaring to 52 per cent, but the U.S. Fed maintained the federal funds rate in the target range of 0.25-0.50 per cent due to mixed labour market data and inflation continuing to run well below the target of two per cent. This helped U.S. equities hit an all-time high, with the S&P 500 climbing to just below 2,200 points. Federal Reserve members were divided in the meeting though, with three of the ten voting members preferring an immediate 25 basis point hike, adding to our view that the U.S. Fed is on track for monetary policy tightening in December.

OPEC – Close to reaching a deal on a crude oil production cut?
The price of crude oil soared to just below US$48 in September after OPEC surprised the market, indicating that a production cut is necessary to lift prices. OPEC proposed a cut to 32.5-33 million barrels a day, a reduction of up to 700 thousand barrels a day on August production levels. This sent crude oil soaring five per cent despite indications that output quotas won’t be finalised until the official OPEC meeting in November. We remain sceptical of the market reaction because a formal agreement has not yet been reached, only a thought out market announcement that keeps the carrot in front of the donkey. It is, however, a move in the right direction for OPEC, and one that is needed for countries like Saudi Arabia whose fiscal deficit is 13.5 per cent of GDP.

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