Weekly Economic and Financial Market Snapshot. 19 December 2007

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Abner Rodgers
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1 ECONOMICS Weekly Economic and Financial Market Snapshot 19 December 7 Indicative Rates & Prices (a) Year Ago Last Week This Week Today Interest Rates (% pa) cash bank bills -day day day Swaps 1-year year year year Exchange Rates units of FX per $A $US yen euro TWI (b) Commodities gold ($/ounce) $US $A oil ($/barrel) $US $A base-metals (c) $US $A Equities All Ords 5,562 6,695 6,425 6,281 Dow 12,418 13,576 13,346 13,232 Notes: (a) Indicative wholesale prices/yields. With the exception of cash and all data in the today column, all observations are weekly averages ending Wednesday. Cash is snapshot on the Wednesday of the relevant week. (b) Trade-weighted index value of $AUD, based at May 19 =. (c) Composite index based on London Metal Exchange (LME) prices of aluminium, nickel, copper, zinc and lead; weighted by each metal s relative importance in the RBA s index of commodity prices. Base of index is 3 January 5 = Page 1 of 5

2 Global debt markets still unsettled, but coordinated central bank liquidity provision has induced a tentative recovery Local -day bank bill spread over cash retreats from last Friday s eight- year high LIBOR spreads over cash also falling, but remain well above normal RBA minutes reveal they probably would have raised the cash rate in December if not for global debt market disruption, so Tightening bias remains intact Debt markets may not have settled by February, so May cash rate increase now our base-case expectation, although Probability assigned to another increase has dropped a few percentage points in the last couple of weeks, as Sub-prime contagion starts to spread beyond the financial economy - if it hadn t already Global debt markets remain significantly disrupted by sub-prime contagion, but key risk premia spreads in the US are retreating, although they remain volatile and well above normal at the short end of the curve. Moreover, the drop in spreads is contingent, at least in the nearterm, on the continuing success of coordinated central bank intervention to provide adequate liquidity. The spread on local -day bank bill yields over cash touched 76 basis points last Friday - although by the end of the day it had retreated to 68 points. But even the lower spread was nevertheless the highest since the Y2K (remember that?) spike in the spread between Christmas 1999 and new year. And only just shy of the June 1998 end of day peak of 77 basis points in the wake of the impending collapse of the high profile hedge fund, Long-Term Capital Management (LTCM) - which in turn was due to contagion (sound all too familiar?) from the Asian currency crisis a year earlier. I am not sure that I recall anyone, when the Thai baht collapsed in July 1997 joining dots all the way to Russia defaulting on its sovereign debt in August 1998, which finished off LTCM for good. The point is, contagion from a shock to the global financial system can find its way to the most unlikely places, which is the crux of the dislocation to global debt markets as extreme risk aversion continues to dictate lenders appetite to lend to each other. The local -day over cash spread has dropped back further, to 57 basis points at the. Sydney fix today, while Australia s LIBOR spread over cash remains well below its US and UK equivalents. Given that the local -day over cash spread is retreating even in the face of the effective reaffirmation yesterday in the minutes of the December RBA Board meeting that the central bank maintains a tightening bias, the modest drop in the spread adds to promising signs from the US. Nevertheless, the global financial system is only ever a surprise write-down at one or more big investment banks away from being back to square one, so it is way too early to call an end to sub-prime contagion within the financial sector. Page 2 of 5

3 And in any case, contagion beyond the financial economy is clearly in play - as if Centro s shareholders didn t already know. The main question is whether it will, or already is, manifesting itself as a sharp slowing in US private consumption, in which case exposure to American shopping malls would amount to infection from at least two strains of sub-prime contagion - directly via inability to roll over maturing short-term debts in the face of global debt market disruption and indirectly if falling US house prices do in fact trigger a sharp cutback in consumer spending. And if not for the disruption to global debt markets, the minutes of the December RBA Board meeting strongly suggest that the central bank would have followed up its November hike with another one this month in view of the outlook for inflation. But global debt market dislocation is a big if not for at the moment. Will it still be when the RBA meets for the first time in 8 on the 5 th of February, given that by then the December quarter CPI will have been published? Probably yes. At the very least the CPI would need to be a shocker to trigger a February cash rate increase if global debt markets remain unsettled, which seems likely. But by the time the March quarter CPI is published in late April, assuming debt markets have settled and sub-prime contagion hasn t spread to China, the RBA will probably have enough ammunition to tweak monetary policy once again to limit the risk of crystallisation of upside inflation risk. The assumption about China isn t by any means controversial, but the one about debt markets having settled by May is a biggish call. Nevertheless, if risk premium spreads have not fallen markedly by the end of April, a whole new set of drivers - and probably not very skilful ones at that - will be shaping the monetary policy decision anyway. So our base case expectation still incorporates one more 25 basis point cash rate increase, to 7.% pa, although the probability that we assign to it is more like per cent than the 75 per cent that we had a couple of weeks ago, reflecting the risk that sub-prime contagion either persists and/or gets worse. Moreover, we have pushed out the expected increase from February to May. We think that 7.% pa is more likely than not to be the cyclical peak in the cash rate, although the risk of multiple cash rate increases is more than negligible - maybe something in the order of 25- per cent. The proponents of multiple further cash rate increases will draw inspiration from the LTCM aftermath and the post-october 1987 stock market crash emergency easings of monetary policy, both of which were quickly reversed (see last week s Snapshot). Perhaps another piece of evidence that US debt markets may be on the mend is to be found in the US dollar s maintenance of its hard won stabilisation, which is now in its sixth week. One of the main risks associated with the sub-prime fallout was always, and still is, to be sure, if a simultaneous fall in all key non-cash asset prices (bonds, equities, property and commodities) either triggers or is precipitated by a disorderly realignment of currencies. When the big dollar was in free-fall, its realignment was in fact on the verge of disorderly, so its bottoming is a welcome respite. But, as has been the case ever since the Asian currency crisis of 1997, the US dollar s gain is the Australian dollar s loss. The local currency s depreciation is limiting the speed of the decline in $US denominated base metal prices, but even in local currency terms their steady fall continues, although not at a precipitous rate by any means. And not at a rate fast enough to extinguish the RBA s continuing concern about the outlook for inflation - as reiterated in the very last line of the December minutes. Alan Langford Josh Rubin Natalie Sullivan alan.langford@hbosa.com.au josh.rubin@hbosa.com.au natalie.sullivan@hbosa.com.au Page 3 of 5

4 Cash Rate and -Day Bank Bill Over Cash Spread - 7 cash rate (% pa) spread (basis points) spread cash basis points 3 Month LIBOR Over Cash Spreads GBP USD AUD 3-Year Swap Yields - 7 Base Metal Prices - 7 Per Cent Per Annum Index - 2 January 7 = $US $A J F M A M J J A S O N D US Debt Market Risk Premium Spreads - 7 (basis points) bonds (a) commercial paper (b) (a) yields on -year Bloomberg composite B rated corporate bonds over US government bonds (b) 3 month USD LIBOR over OIS 1 1 Basis Points US Commercial Paper over OIS Swap Risk Premium Spreads month 3 month Page 4 of 5

5 115 Trade-Weighted Index Exchange Rates 1 5 Index - January 1984 = start of Asian currency crisis $US $A Jan Dec 7 Months 83 US Dollar Trade-Weighted Index Index - March 1973 = The information contained in this publication is of a general nature and is not intended to be nor should it be considered as professional advice. You should not act on the basis of anything contained in this publication without first obtaining specific professional advice. To the extent permitted by law, HBOS Australia Pty Ltd, its related bodies corporate, employees and contractors accepts no liability or responsibility to any persons for any loss which may be incurred or suffered as a result of acting on or refraining from acting as a result of anything contained in this publication. Page 5 of 5

Christopher Kent: Financial conditions and the Australian dollar - recent developments

Christopher Kent: Financial conditions and the Australian dollar - recent developments Address by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the XE