RBNZ Expected To Cut OCR By 50bps On 14 November
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The accumulation of negative global and domestic economic data, and the view emerging as we revise our economic forecasts, means that we now believe that a 50bps cut in the official cash rate (OCR) is the most likely outcome when the RBNZ next reviews monetary policy on 14 November (70% probability). This would take the OCR to 4.75%. While not our central view, our bias is that the OCR could fall further early next year if the emerging data remains poor, with little sign of light at the end of the tunnel. Indeed, given continued aggressive easing by central banks globally, and a developing view in the market that New Zealand's run of good economic fortune may be about to end, the market may well begin to flirt with the possibility that the OCR could fall as low as 4.0% after the 20 March Monetary Policy Statement.
Given our revised cash rate call and our view of the balance of risks around that call, we think that NZ long bonds are a now good buy, both in an outright sense, and in spread terms against Australian bonds and, to a slightly lesser extent, US Treasuries. However, given the risk of further near-term weakness in the NZD, investors may want to consider hedging the currency risk on any NZD holdings. Since the RBNZ last cut its cash rate by 50bps on 19 September, largely in response to the terror attacks in the US on 11 September, our view has been that the Bank would reduce the OCR by a further 25bps at the 14 November Monetary Policy Statement (MPS) meeting, with a clear risk of more easing, rather than less. Indeed, over recent weeks, our view has been that the probability of a 50bps cut was has high as 35%. Over this period, the market has moved from pricing little more than a 25bps cut to now fully pricing a 50bps cut (with some chance of more to come early next year). The shift in market sentiment recognises the continued very poor run of global economic data, and increasingly, emerging evidence of a weakening in domestic economic prospects.
We are currently in the process of updating our quarterly economic forecasts, taking into account the latest view of global growth prospects, the string of more recent local economic data releases, and particular impacts on the New Zealand economy as a result of the 11 September terror attacks. Consensus forecasts of trading partner growth have slumped dramatically since 11 September. While the terror attacks are a key explanatory factor, we believe that the US economy was already entering a new downward phase prior to these attacks. Forecasts compiled by Consensus Forecasts indicate that New Zealand's 14 largest trading partners are now expected to grow by just 2.1% in 2002, down from the 3.4% expected when the RBNZ finalised its last published projections in July. Cumulative growth over 2001 and 2002 has been reduced by 1.9pps since July. Moreover, further downgrades seem likely over coming months. We think that this slowdown will have a substantial impact on export demand and prices received.
Based on the RBNZ's own analysis in a scenario set out in the August MPS, all else equal, and assuming approximately proportionality, such a substantial downgrade in growth prospects could easily be used to justify an OCR of 4%, if not lower. Of course not all else is equal. With the economy growing by more than twice the RBNZ's forecast in Q2, the RBNZ can be more certain than previously that the economy is operating above the level consistent with a stable path for core inflation (as suggested by survey measures of capacity utilisation and various labour market indicators). Indeed, had a reduction in growth prospects not occurred, the RBNZ would likely now be considering a gradual rise in interest rates, rather than further reductions - a point emphasised by the RBNZ in its August MPS. In addition, the NZD is tracking a little below the RBNZ's August assumption, providing additional support to the economy.
However, a range of indicators, of which today's NBNZ business survey is but the latest, suggests that the outlook is for much more modest rates of economic growth over the period ahead. Confidence indicators, in particular, have been hit hard despite the RBNZ's uncharacteristically aggressive 50bps cut on 19 September. With consumer confidence well in negative territory, past relationships suggest that consumer spending may stall over coming months. Indeed, August retail data was much weaker than expectations, and indicators suggest that September was also soft. Similarly, weaker business confidence seems destined to result in delays to investment spending and a more cautious attitude to employee recruitment. Finally, the export sector will be hurt directly by weaker demand for New Zealand's goods and services (with the tourism sector especially impacted by the events of 11 September) and reduced prices for goods and services. Our provisional forecast is that, following a robust Q3, GDP growth will remain well below trend over the coming 12 months with some risk that either the current quarter, or perhaps more likely Q1 next year, is flat or negative.
Over the past year, compared with the RBNZ, we have adopted a less optimistic forecast of the medium-term inflation outlook, reflecting our view that the New Zealand economy would operate substantially above its non-inflation capacity over the coming year, as well as our concern about the impact of high headline inflation rates - largely due to the weak NZD - on wage and price setting behaviour. Given the economic outlook that we now envisage, there seems less risk of excess demand pressures spilling over into a rise in core inflation, or of relatively high rates of headline inflation spilling over to medium-term inflation expectations. Rather, there is some risk that the extent of economic weakness proves more extreme than is consistent with the persistent element of core inflation remaining comfortably within the middle of the target band. In our view, this provides more room for the RBNZ to attempt to head off an even more dramatic decline in confidence than seen to date.
Tactical issues are also relevant. ?The RBNZ has made good progress this year in restoring some of the credibility lost - not as an inflation fighter, but as an economic manager - due to its handling of monetary policy during the Asian crisis and its use of the monetary conditions index. With most global central banks continuing to ease aggressively, even a 25bps easing on 14 November would been seen as a timid move, especially as the RBNZ will not have another opportunity to reduce rates at a scheduled meeting until 23 January (whereas many central banks may well cut rates again in December). We think a 50bps easing leaves less room for regret. At this juncture it seems extremely unlikely that interest rates will need to move substantially higher in a six-month timeframe. However, it is possible that interest rates may need to move substantially lower if the NZ economy slows as rapidly, or more rapidly, then emerging indicators are suggesting is now possible. Even if subsequent events suggest that the outlook for the economy and inflation is more robust than currently expected, we think the RBNZ will be able to quickly retighten policy in 2002 without fear of criticism.
Given the above, we believe that a 50bps cut is now the most likely outcome on 14 November (70% probability). This would take the OCR to 4.75%. While not our central view at this stage, our bias is that the OCR could fall further early next year if the emerging data - both globally and domestically - remains poor, with little sign of light at the end of the tunnel. Indeed, given continued aggressive easing by central banks globally, and a developing view in the market that New Zealand's run of good economic fortune may be about to end, the market may well begin to flirt with the possibility that the OCR could fall as low as 4.0% after the 20 March Monetary Policy Statement.
Given our revised cash rate call and our view of the balance of risks around that call, we think that NZ long bonds are a now good buy, both in an outright sense, and in spread terms against Australian bonds and, to a slightly lesser extent, US Treasuries. However, given the risk of further near-term weakness in the NZD, investors may want to consider hedging the currency risk on any NZD holdings.