THE WEEK AHEAD: The great rates balancing act

There are still only two certainties in life – death and taxes. Some thought that an interest rate hike in February was also a certainty, but the Reserve Bank showed that wasn’t the case.

Of course, as we pointed out last week, a rate hike was far from a certainty: “Some analysts believe that another rate increase is a lay down misère, but as News Limited’s Terry McCrann rightfully points out, that is far from the case. While interest rates remain low, the Reserve Bank has already lifted interest rates three months in a row at a time when almost every other central bank is still sitting on their hands. Certainly our economy is in far better shape than most but the IMF is continuing to warn of the dangers of removing stimulus too quickly.”

In the end we did go along with the other economic literati in expecting a rate hike but we noted: “If the RBA Board opts to leave rates alone, it will be merely seeking to gather more information before continuing the process of ‘normalising’ rates.”

Of course, at some point the Reserve Bank did have to sit back and assess – not only the impact of three rate hikes – but also the withdrawal of government stimulus from the economy. And it does have time on its hands with underlying inflation easing as expected. If inflation hadn’t been on track, the Reserve Bank wouldn’t have had any hesitation in lifting rates again.

The interest rate equation is always predicated on two variables – economic growth and inflation. You can always throw other factors into the ring, but those elements are always front-and-centre. Inflation is tracking as the Reserve Bank had expected, with the underlying rate “to be consistent with the target in 2010”. While the economy remains in good shape, the Reserve Bank indicated that it had limited information about how the lift in mortgage rates had affected activity. The Board thought it was “appropriate” to get more information before continuing with its process of ‘normalising’ rates.

Looking ahead, the indicators to watch are housing finance (February 10), employment (February 11), the Reserve Bank Governor’s testimony (February 19) and job advertisements (March 1). We don’t include the data on business investment in the list as companies are only likely to firm up spending plans over the next few months after sizing up the removal of government stimulus. Unfortunately, there is also a gamut of information we don’t see, as the Reserve Bank is constantly making its own inquiries about how businesses are faring. If it concludes that the economy has hit a flat spot following the ending of government grants and tax breaks then it will stay on the interest rate sidelines in March.

It’s a constant balancing act. The Reserve Bank doesn’t want to fall behind the curve on inflation. But it also doesn’t want to damage the economy by acting too aggressively. At present the risks lie more with the economy rather than inflation.

The week ahead

Before the most recent interest rate decision, many economists probably thought they could get away by analysing just the major data releases. But that is likely to change. The economic literati were caught out by the Reserve Bank’s ‘on hold’ decision. So now it is a case of dissecting every piece of information to get clues on the next interest rate decision.

In the coming week new data on tourist arrivals kicks off proceedings on Monday. The tourism sector is struggling at present, as highlighted by double digit unemployment in the Cairns region. But the recent fall in the Aussie dollar and stable interest rates will help tourist operators.

On Tuesday NAB releases its January business survey. Confidence levels fell sharply in December and another fall in January would shorten the odds of the Reserve Bank staying on the interest rate sidelines in March.

Both housing finance and consumer confidence figures are released on Wednesday. New loans to owner-occupiers (people who want to buy or build homes to live in them) may have fallen by around 6% in December after falling by 5.6% in November. The ending of the first home owners boost may lead to softer activity over the next few months before picking up later in the year.

Consumer confidence should have remained strong in the latest month, buoyed by higher share and house prices and stable interest rates. It’s worthwhile noting that confidence levels for Generation Y are at record highs and the ‘on hold’ rates decision will lift spirits for Generation X home purchasers.

The monthly job report is issued on Thursday. Overall we expect that employment rose for the seventh time in eight months, lifting by 25,000. Provided that there isn’t an upsurge of people re-entering the job market the unemployment rate probably held steady at 5.5%. The Reserve Bank would be worried if the job market tightened too quickly, so a sharp fall in the jobless rate would lift the chances of rates rising again.

In the US, the main economic indicators are congregated in the second half of the week. International trade and the monthly budget figures are issued on Wednesday with retail sales on Thursday and consumer sentiment on Friday.

Economists currently expect that the trade deficit held near US$35 billion in December while retail sales lifted 0.4% in January and consumer sentiment was little changed in February.

Other data to watch over the week in the US include wholesale inventories (Monday), business inventories and weekly jobless claims (Thursday).

Sharemarket

The Australian profit-reporting season moves from first gear into second in the coming week with Wednesday shaping up as ‘Super Wednesday’. Among companies that are expected to report on Tuesday are Cochlear and Alumina. On Wednesday, the heavyweights – BHP Billiton and CBA report earnings together with Boral, Billabong and JB Hi-Fi. Among those reporting on Wednesday are Telstra and Rio Tinto. While on Friday, Newcrest, Leighton Holdings and Telecom NZ are scheduled to issue their results.

By and large investors are fixated on capital returns. For instance, sharemarket investors are focussed on where share prices are likely to go over the next year or so. And residential property investors tend to focus on price first and rental returns second.

But have we got it the wrong way around? The researchers from MSCI Barra have dissected returns on shares over the past 35 years across key regions such as the US, Europe, Japan Australia and the UK.

Interestingly Australia came second to the UK over the full 35 year period and actually came out on top over the noughties decade. But the other interesting result for Australia was the fact that dividend income was the main driver of returns. Over the noughties, returns on the MSCI Australia index rose by 9.1% with dividends contributing 4.1 percentage points, inflation 3.2 percentage points and capital returns providing the remainder.

Interest rates, currencies & commodities

Clearly there have been a range of surprises over 2010 and we are only into the fifth week. The Reserve Bank left rates on hold, when all and sundry tipped an increase. The IMF warned about the prospect of a double dip global recession then sharply revised up forecasts for the world economy. Economic data in the US has been surprisingly strong – even with unemployment near 10%. And given the raft of fiscal problems for member countries, investors have become more negative on prospects for the Euro zone. Alternatively, investors have become more upbeat on the US.

The end result is that investors have drifted away from the Euro and Aussie dollar in favour of the greenback. Our CBA currency strategists have digested all this new information and are set to release new forecasts over the coming days. In broad terms the message is to cancel parity parties – that is, cancel any celebrations that may have been planned to celebrate one Australian dollar equalling one US dollar.

But while parity is off the agenda for now, overall the strength of the Australian economy and our dependence on the fast-growing Asian nations will keep the currency at higher levels against the greenback than in the past.

Craig James is chief economist at CommSec.