Sunday, 18 December 2011

Could the RBA cut 50 basis points in February?

At the moment, there aren’t too many people thinking the RBA will cut 25 basis points (bp) in February, let alone 50. But increasingly, the clever money is starting to seriously price in the possibility of a 50bp cut. The IB market is now close to fully pricing in a 50bp cut (about an 85-90% chance).

What would make the RBA go 50 instead of 25?

Critical will be the December quarter CPI due for release on 25 January. As a negative headline result looks likely for inflation (the prices of many goods are falling), the underlying measures are also set to remain near the 14 year low result of 0.3% recorded in the previous quarter. A low result, plus the current mix of other influences means the RBA will go at least 25bps, but a surprisingly low inflation result will open the door for a 50 cut.

From an Australian perspective, what happens in China will dominate issues in Europe and the US, although admittedly, these are all inter-related. Signs in China of weakening property prices, dodgy banking issues, falling share prices, falling inflation and weakening GDP are massive risks for the Australian economy. If the trends in these and other measures in China intensify, the RBA may wish to go hard. Broad commodity price measures are already weak and any further softness will present a significant downside risk to Australia.

The banks funding issues will also be important for the RBA. While finance is clearly available, it’s the price of getting money that is causing a margin squeeze for our friends in the banking sector. If wholesale funding costs remain high or get even higher, the RBA may want to go 50 knowing that there will be 30 or 35 bps for retail interest rates and 15 or 20bps for the banks. This alone would be a good reason to go 50.

We can then throw in the usual run of other data between now and the February meeting – most notably the December labour force data which if weak again would demand an aggressive RBA approach. Retailing looks to be in recession, as is government demand under the weight of aggressive fiscal contraction.

I might be talking myself into it, but I am getting close to thinking the RBA will cut 50 in February. Like all mere mortals, including those at the RBA, the drip of news over the next 7 weeks will help determine what it does.

Maybe the risk is they go more than 50 if market conditions fracture. That’s for closer to the time of the February meeting.

I note that for the February RBA meeting, the TAB is offering $7.00 for the RBA cutting by 50 basis points or more. This looks to me to be great value given the risks out there right now. Off to the TAB I go.

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