News

The December quarter CPI was released this week showing a headline quarterly rate of inflation of +0.4% (seasonally adjusted) or 1.7% for the year to the end of December. This surprised markets which were expecting 0.3% for the headline rate and an annual inflation of 1.6 per cent.

The “core” or underlying rate, the RBA’s preferred measure of inflation that strips out volatile food and energy prices, recorded an average 0.5% for the quarter (0.5% expected) and 2.0% over the year (2.1% expected).

The underlying inflation rate of 2.0% is at the very bottom of the RBA’s target range of 2.0% to 3.0%, as shown in the chart below, reinforcing the RBA’s easing bias but not being seen as the smoking gun required to immediately cut rates.

*average of trimmed mean & weighted median CPI measures

Economists agreed the RBA was unlikely to change their rate setting in the short term and the cash markets reacted by dialling back expectations of rate cuts this year, although pricing still indicates an official rate reduction by August is still a very high probability. Pricing for a RBA rate cut in February fell from 19% to 6% and for a May cut the odds fell from 82% to 62%. Bond markets were largely unaffected but yields in the futures markets for 90 day banks bills rose sharply, rising between 5bps and 7bps for 2016 contracts, while the Aussie dollar jumped against the greenback.

Here’s what the economists thought:

Michael Workman, CBA

Inflation is not dead. It is just resting. Today’s 0.4% rise in the headline inflation rate was slightly above market, and our, expectations of 0.3%. The underlying measures averaged out at 0.5% which was in line with expectations. The annual inflation rates of 1.7% for headline and 2.0% for the underlying measures show that inflation is well under control. The RBA’s first 2016 meeting is next Tuesday. We believe the low inflation outcomes will give them room to maintain their conditional easing bias. But they are unlikely to act on it unless there are signs of deterioration in the jobs market. And the improvement in the jobs data is remarkable. There have been an extraordinary 300k extra jobs added over the past year and the unemployment rate is at 5.8%.

Jo Masters, ANZ

The low inflation environment is unlikely to be a catalyst for policy action given our expectation that underlying inflation will move back within the RBA’s 2%-3% band in early 2017. However, it not a constraint on policy action should demand need a boost. We continue to closely watch demand indicators, including the December partials next week.

Tapas Strickland, NAB

The underlying inflation rate for Q4 is exactly in line with the RBA’s November Statement on Monetary policy which was for underlying inflation at 2.0% year-on year. NAB’s view remains that the RBA will continue to hold interest rates at current levels on continuing signs that the domestic economy is performing somewhat better in recent months – evidenced by above average business conditions and solid employment growth.

Paul Bloxham, HSBC Australia

Importantly, for the moment, the RBA can afford to tolerate low inflation because the jobs and activity indicators have been lifting. The unemployment rate fell to a two-year low of 5.8% in December and a key survey also shows that business conditions have been around 7-year highs recently (albeit falling back a little in the December print). While the labour market and activity surveys are still holding up, the RBA is unlikely to cut rates. This pretty much rules out a cut next week.

Scott Haslem, UBS

Today’s CPI was broadly in line with market & RBA expectations, with the headline of 1.7% continuing to drift up toward the bottom of the target, while core measures…have converged on a 2% pace. Pleasingly, the areas we’ve been highlighting as possibly flagging an era of lower inflation due to more competition in telecoms & food, rents & slowing administered prices (health & utilities), continue to moderate. While today’s CPI is no impediment to a rate cut, nor is it a smoking gun compelling the RBA to cut, given the economy’s ongoing moderate growth.

Shane Oliver, AMP Capital

As December quarter inflation was in line with RBA forecasts it is probably not low enough to bring on another rate cut from the RBA on its own. But with inflation running at the bottom of the 2-3% inflation target it leaves plenty of room for another rate cut and helps reinforce the RBA’s easing bias. While the RBA may not be ready to cut the cash rate again next week our assessment remains that the ongoing downside risks to growth, further falls in commodity prices and global growth uncertainties along with low inflation will see the RBA cut rates again at some point in the next few months. Market pricing continues to allow for at least one more rate cut over the year ahead.

Chris Caton, BT Financial Group

We continue to think that the cash rate is on hold for several months yet, and that the next move is just as likely to be up as to be down. The RBA will hold its first monetary policy meeting for 2016 on February 2. Cash rate futures put the probability of a 25bps interest rate cut at just 6%, down from 21% before the CPI report was released. Despite the diminished expectations for a near-term interest rate cut, markets are still fully priced for a reduction in the cash rate to 1.75% by September this year.

The breakdown of figures are as follows:

December quarter CPI: +0.4% (headline figure)
September quarter CPI: +0.2%
CPI to December year end: +1.7%

Underlying December quarter CPI: +0.5% Avg
Underlying September quarter CPI: +0.5% Avg
Underlying CPI to December year end: +2.0%

Analysis of the CPI by CBA showed that the impact of petrol prices is less that most people’s assumptions and that the greatest impact on the CPI was, in fact, tobacco prices. For the quarter petrol subtracted 0.18% from the CPI while tobacco added 0.26%. This is interesting for several reasons: the CPI is low but would be lower if not for tobacco; tobacco tax is large and controlled by the federal government. A chart of the CPI excluding tobacco and petrol is included below.

S&P has slashed commodity price forecasts as a result of sharply falling commodity prices. On the back of this assessment it has also flagged possible downgrades to many mining and energy companies. It has also indicated there may be cuts to credit ratings of oil and energy producing countries reflecting the ‘new reality’ of lower commodity prices.

One of the world’s biggest mining companies, BHP, has come under increased focus with its stated desire to maintain its ‘solid A’ balance sheet (the company currently has a long-term A+ rating from S&P and an A1 rating from Moody’s). The company’s commitment to a ‘progressive’ dividend policy of sustaining or raising its annual dividend is seen as increasingly vulnerable and will be watched closely when the company reports its half-year earnings in February.

S&P cut its 2016 and 2017 iron ore prices to USD$40 a tonne (or around 20%) as well as lowering its price forecasts for a range of other commodities including zinc, copper, nickel and aluminium. It’s oil price forecast had previously been cut to USD$45 a barrel.

Santos has had its credit rating cut to BBB- from BBB by Standard & Poor’s. The rating is the lowest investment grade rating and one notch above junk bond status.

The move has been expected for some time as Santos battles with a plunging oil price and revenues that have fallen by around 20%. The company revealed late last year that the Brent oil price assumptions it was using for asset valuations was USD$90 per barrel. It also disclosed in November, when it raised $2.5 billion in additional capital, that a USD$15 reduction in its long term oil price assumption would impair its assets values by $USD3.4 billion before tax. With the oil price trading around $30 a barrel, the pain could be around for some time to come.

Falling European inflation has seen ECB president Mario Draghi indicate the ECB will look at further adding economic stimulus when it next meets in March. The tone of the comments were very ‘dovish’ and the USDEUR immediately dropped 140pips. Euro bond yields all fell in response.

The ECB has got itself into an awkward position whereby inflation is below target but markets are sceptical the ECB is fully committed to tackling the problem. The minutes of the 3 December ECB meeting show some discord in the way the problem is tackled and whether the problem needs tackling at all. One governor suggested he would only be in favour of further bond buying if deflation was present while another said that the effects of QE diminished over time. Both comments would suggest there is a lack of commitment to the inflation target of 2.0%.

Central bank credibility is increasingly in the spotlight since the Swiss central bank reneged on its commitment to maintain the Swiss franc/Euro peg in January 2015. Markets are increasingly less convinced about central bank ability to alter market outcomes and less inclined to rely on the words of central bankers. This is a problem for Draghi who is seen as jawboning about QE but often lacking action.

CPI figures in the US have been persistently low since falling significantly in 2011. The US Fed is keen to get the figures higher but the oil price has reached multi-year lows at under US$30 per barrel and inflation is remaining difficult to budge. In the days before the release of the latest inflation figures, local analysts thought the headline result was likely to remain unchanged.

The U.S Bureau of Labor Statistics released December CPI figures and the headline inflation rate came in at -0.1% for the month, a drop from November’s 0.0%, as energy and food prices fell. The year-to-date figure rose to +0.7%, up from November’s comparable figure of 0.5% but below market expectations of +0.8%. Core inflation, which strips out the more volatile food and energy components, rose 0.3% for the month and 2.1% over the last 12 months, up from November’s figure of 2.0%.

US bond yields were lower on the day as markets took little notice of the data and focussed on safe places in which to invest as equity markets were sold off and oil finished below $US27 per barrel. The yield on 2 year bonds fell 2bps to 0.82% and 10 year bond yields also fell 2bps to finish the day at 1.98%. In the US cash markets, the odds for an increase in the Fed rate at the January meeting are only at 10% while the odds of an increase at the March meeting have come down from 53% to 27% over the last month.

Just before Christmas the AOFM published its 2015/2016 borrowing programme and its intention to issue a new benchmark 2.75% November 2027 bond in mid-January. Initial price guidance for the issue was 13.5bps to 17.5 bps over the implied yield for the primary 10 year Treasury bond futures contract. The $4.6 billion (face value) offer was sold at a yield to maturity of 2.865% which, given the guidance, was much as expected. The March 10 year futures contract was at 2.655% at the end of the business day.

The new bond provides additional liquidity for investors around the important 10 year benchmark.

Falling share markets and an oil price which has not translated into lower petrol prices seems to have had an effect on consumer confidence according to the latest consumer sentiment index reading. The Westpac-Melbourne Institute Index of Consumer Sentiment fell to 97.3 in November from the December recording of 100.8. The fall in the index indicates a decrease in the ratio of optimistic consumers to pessimistic consumers and it is a continuation December’s fall. A reading above 100 means there are more positive responses from people in the survey than negative ones.

The domestic bond market took the report in its stride and yields continued their intraday upward trend. The 3 year bond futures yield rose 3bps to 1.90% while the 10 year bond futures yield also rose 3bps higher in afternoon trading.

Bill Evans, Westpac’s chief economist said, “With limited domestic news during the holiday season consumers appear to have been mainly impacted by the spate of negative news on the international front and the spill over effect on financial markets.” Westpac is still of the view the RBA will keep the official rate at 2.00% through 2016. The lower exchange rate has provided an “important ongoing boost to Australia’s competitiveness which is now assisting the economy’s adjustment as the mining sector slows.”

The Province of Manitoba is one of several Canadian states which is a regular issuer of bonds into the Kangaroo market, issuing bonds every two or three months. The latest deal is for the sale of $50 million of June 2026s at ACGB + 79.75bps, which is noticeably lower than the ACGB + 90.75bps on the $70 million of the same line sold in early December.

Wesfarmer’s proposed debt-funded purchase of the UK’s Homebase hardware chain has seen its credit outlook revised to negative by S&P. The current S&P rating is A-. Fitch has affirmed its rating and stable outlook as BBB+.

China’s National Bureau of Statistics released Q4 2015 GDP figures that indicated a quarterly increase of 1.6%, 0.2% lower than market expectations. The annual growth rate was 6.8% and slightly lower than the expected 6.9%. It was the lowest growth level in 25 years.

That, of course, is if you believe the numbers. There is a fair degree of scepticism regarding the validity of Chinese economic data and a look at the quarterly GDP figures from the start of 2014 indicates some of the reasons for suspicion. Given the volatility in the GDP data prior to 2014, the smooth decline of GDP figures afterward is either a remarkable fluke, a display of unprecedented economic policy skill or “data smoothing”.

Nonetheless, the release of the GDP numbers saw local bond market 10 year yields initially move up a point to 2.65% but then fall away to 2.61%. In the foreign exchange market the AUD sold off by US 0.5 cent before recovering back to close to the pre-announcement level.

China’s transition from a reliance on exports to domestic consumption and service provision needs more time and government support according to AMP Capital’s Shane Oliver. “Growth is still soft but it’s not collapsing…policy stimulus measures are helping but more is needed.”

Three months ago, Westpac focussed on the nominal GDP figure which the bank sees as a more reliable gauge of underlying demand conditions. This time the bank said, “Overall, the loss of momentum evident in the nominal series is a disappointing result…in through the year terms, that (the latest data) equates to a 5.8%yr pace in Q4, from 6.2% in Q3 and 7.1%.”