Reserve Bank outlook points north for interest rates

The Australian dollar is being overvalued at current levels and the strong dollar hinders domestic growth and reduces inflationary pressure, Simson Sanaphay writes.

Reserve Bank of Australia (RBA) governor Philip Lowe would likely have a growing sense of confidence toward the Australian economy, as improving employment conditions, steady trade volumes, and continued accommodative policy settings, nudge the economy’s growth trajectory higher.

This constructive macro-economic backdrop creates fertile conditions for the next rate move to be upwards, and it’s pertinent to note the US has already entered an upward trajectory, with Europe currently pondering when to follow.

But despite the positive signposts we don’t expect the current record low cash rate of 1.5 per cent to shift anytime soon, and likely not until late next year.

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Our reasoning is that the economy continues to transition towards growth from infrastructure building and non-mining business investment in areas like education and tourism.

But while ongoing transition in the economy takes place, we continue to be challenged by highly indebted households, a slowing contribution from housing investment, and at times an overly strong currency – although the latter does create opportunities for investors looking offshore.

Even the RBA’s own assessment that core inflation (that excludes energy and food) will struggle to get back to two per cent until 2019, implies the RBA won’t be rushing to lift the cash rate, even if it is more confident about the economic outlook.

Despite concerns for higher utility prices like electricity, inflation continues to be anchored by low wage growth and the creation of new jobs in below average wage occupations.

Quarterly labour data released in June showed that 86 per cent of strong employment gains in the previous three months had come from four sectors – healthcare and social assistance, accommodation and food services, professional services and transport – or to put it another way, hospital workers, baristas, app developers, and Uber drivers.

The issue is that these sectors tend to offer lower wages, and so it also partially answers the question on why Australia is experiencing such low wage growth. The exception is professional services, but most of those jobs are concentrated in NSW.

Additionally, the three highest paid sectors, mining, utilities, and finance are still shedding jobs.

July data did show strong employment growth of 27,900 jobs, and the unemployment rate fell slightly from 5.7 per cent to 5.6 per cent. However, the numbers came with a loss of 20,000 full-time positions and a 0.8 per cent decline in aggregate hours worked.

Full employment still looks some way-off. At his testimony recently Lowe said it could be another two years before the economy reaches full-employment. With the unemployment rate seemingly welded to a rate around 5.5 per cent despite strong headline employment gains, his comments deserve attention.

As such, we don’t expect significant pick-up in wage growth in the near-term. Our forecast for the Wage Cost Index, which is used in formulating industrial relations, wages policies, and economic analysis, is an increase of two per cent in 2017, and 2.2 per cent next year, which will maintain the trend established since June quarter 2014.

And that lack-lustre wage growth is reflected in consumer spending, which has risen only 2.3 per cent in the past 12 months, and has been below average so far this decade.

As the RBA has noted on many occasions, households are also highly indebted, and when combined with low income growth, it creates a trend of households lowering their saving ratio to support spending. This cannot continue indefinitely. 

Not surprisingly, views about family finances, which lead consumption, are subdued. It is hard to see how consumer spending growth can pick up materially given these headwinds.

The other challenge for the Australian economy is that currency investors have latched onto the RBA’s confident view. Add in improved commodity prices and diminishing US dollar strength on the back of a legislative log jam and lower expectations for rate hikes, and theobstacles are diminishing for the Aussie dollar to revisit recent two-year highs.

Despite traders’ optimism, we view the Aussie dollar as being overvalued at current levels, and note that a strong dollar hinders domestic growth and reduces inflationary pressure. We forecast US$0.75 on a six to 12-month time horizon. 

Until then it’s unlikely for the RBA to undertake a rate cut to drive down the dollar, as this may intensify borrowing into a housing market that is already a source of systemic concern, given the high level of household housing debt.

Instead, we believe the RBA will be hoping that the US Fed sticks to its guidance and continues to gradually raise interest rates, despite a more dovish consensus market view. That could force a repricing of the US dollar and put downward pressure on the Aussie dollar. But this could be a protracted process, so the RBA will need to be patient.

Citi believes the next interest rate movement will be higher, but patience and time are the keys for the local economy to be in a position to better absorb less monetary accommodation.

But as that scenario plays out, the period of strength that remains for the Aussie dollar does provide an opening for investors to consider expanding offshore asset holdings.

The best time to buy offshore assets is when the local currency is strong, and the currency you are buying into is weak, as you get more for your outlay. Despite good economic signals the US economy has been hit by a number of uncertainties, meaning the greenback is not as strong as market consensus expected. 

If you buy income producing assets, like dividend-paying US equities or bonds, and the local dollar falls, the translation from US to Aussie dollars puts more money in your pocket, and the same result is achieved if you sell offshore assets. 

Simson Sanaphay is Citi’s wealth management investment strategist.