Interest rates to fall to a low point of 2.75% by the end of this year: Westpac’s Bill Evans

The Reserve Bank board meets next on June 5. We expect that the board will decide to further reduce the overnight cash rate from 3.75% to 3.5%.

We now expect that the low point in this easing cycle will be 2.75% rather than 3.25%, which had previously been our expectation. We expect further cuts in July and August to be followed by a final cut in the fourth quarter.

We do not favour the 50bp cut scenario in June. The decision to cut by 50bps in May was mainly driven by direct concerns around the domestic economy. To us, there appeared to be an element of catch up with the bank holding steady in February–April when the domestic case for a cut was strong. The decision will be built around the impact that the deterioration in global confidence will have on the Australian economy. Since the board meeting in May, US 10-year bond rates are down from 1.9% to 1.6% and the Australian equivalent is down from 3.6% to 2.9%. However, there are a number of key risk events over the next few weeks (Greek elections on June 17, for example) which will be critical for global confidence. We expect a more orderly approach to addressing these issues and thus a more “considered” 25bps move. However, nobody can be particularly confident in gauging the bank's meeting-by-meeting strategy for dealing with these issues.

This is a change in our previous forecast position. We had been expecting that the board would decide to hold rates steady in June, with two further moves expected in both July and August of 25bps each. We now expect that the low point in this easing cycle will be 2.75% rather than 3.25.

These two extra cuts are based on our assessment that the global environment – read Europe – has deteriorated even further since we revised down our call for the low point from 3.75% to 3.25%. In turn, this deterioration is expected to have a more severe impact on confidence in Australia than had earlier been expected.

The stance of policy is currently only mildly expansionary despite the official cash rate being at 3.75%, its lowest level outside the global financial crisis.

We gauge that it is only mildly expansionary because the stance of policy should be assessed in the context of private sector interest rates. With the gap between the Standard Variable Mortgage Rate (SVMR) and the official cash rate now being 140bps wider than in 2007, we assess that the neutral rate has fallen from 5.5% in 2007 to 4.1%. That puts the official cash rate only 0.45% below neutral today – certainly only mildly accommodative.

Another way of assessing this stance is to compare the SVMR with its long-term average. The long-term average SVMR is 7.5%, so the current SVMR, at 7.05%, is also only 0.45% below the average.

A move to 2.75% in the official cash rate is likely to see the rate somewhere between 100bps and 145bps below neutral, depending on the movement in private sector rates in response to the fall in the official cash rate. If there was a full 100bp reduction in private rates then the official cash rate would bottom out 145bps below neutral.

If the reduction in private rates was along the lines of the reduction following the rate cut in May then the official cash rate would bottom out 115bps below neutral. The same logic would mean a SVMR of between 6.05% and 6.5%.

In the three previous easing cycles the official cash rate has bottomed out at 150bps (2008/09); 125bps (2001) and 50bps (1996-97) below neutral.

In those periods the SVMR bottomed out at 5.8% (2009); 6.05% (2001); and 6.7% (1997).

The contrast with 2009 is important. Despite the cash rate falling below its GFC trough, we expect the SVMR will bottom out well above the 2009 level.

In the more recent two periods above, the final rate cut in the cycle coincided with an increase in the unemployment rate of one to two percentage points over the preceding year: 6% to 7% in 2001 and 4% to 5.9% in 2008-09. In 1996-97 the increase in the unemployment rate was only around 0.5ppts, as this was a mid-cycle slowdown rather than a fully- fledged slowdown.

The contrast with those earlier periods the implied stance of policy should also take into account the level of the Australian dollar. In 1997 the AUD/USD was around 68 cents; in 2001 around 50 cents and in 2009 around 70 cents. Clearly the AUD was providing a much more complementary stimulatory support for the economy than in current circumstances where, despite recent weakness, it is still around 98 cents.