Rates: RBA Sits And Watches Europe

Standard & Poor's surprise downgrading of Italy's credit rating yesterday has confirmed why the Reserve Bank is watching foreign events more closely than at any time since the GFC.

The ratings downgrade, to single A, with a negative outlook, took markets by surprise, coming ahead of an expected cut by Moody's next month.

The downgrade, which knocked markets here and offshore yesterday, also confirms that Australia remains an oasis of confidence and stability in comparison with Europe and the US, a point implicitly acknowledged by the RBA in the minutes of the September 6 meeting in Perth.

But judging by the amount of space devoted to international events, especially in Europe in the minutes of the RBA board meeting earlier this month, you'd say the central bank probably wasn't as surprised as some in the market were.

The minutes opened with this paragraph:

"Members began their discussion by observing the extreme volatility in financial markets over the past month, which reflected fears about a slowdown in the global economy and escalation of sovereign debt tensions in the United States and Europe. These concerns had led to particular focus on the financial strength of European banks."

And the discussion went on from there. The concentration on events in Europe was greater than in the minutes for the previous month's meetings, as was commentary on the Australian dollar and Australian bond yields, all three being linked.

As a result it is now very clear that the RBA is on hold until events offshore either sort themselves out, or the market tensions and volatility settle back to allow a clearer assessment of what is going on.

So if Greece and Italy remain concerns late next month and into November, then there won't be any rate movement until the first quarter of 2012 at the earliest (remember the NAB says there will be a rate rise late next year, while Westpac is still saying there will be a rate cut by the end of this year).

The only way a rate cut will occur will be if offshore events worsen quickly (such as Greece defaulting) and the RBA sees a need to cushion Australia against the fallout. Weak domestic economic activity, which was the basis for the forecast from Westpac and the AMP's Dr Shane Oliver, won't be a consideration.

The final paragraph of the minutes gives the central bank the freedom to cut rates (or lift rates, or do nothing) if there's a need thanks to events offshore.

"A key question for members was the extent to which recent global and domestic developments would reduce capacity pressures in the economy and, in due course, help to contain inflation. Very little hard data were available, as yet, on which to base such judgements," the RBA minutes said.

"As further information became available on the domestic and international economies, members would continue to assess the medium-term outlook for inflation and growth. For the present, however, members considered that the current setting of monetary policy left the Board well placed to respond to evolving global and domestic economic conditions." (my emphasis)

And then there's the discussion of Australian bond yields:

''Members were informed that, in Australia, market pricing prima facie pointed to expectations of large cuts in the cash rate by the end of the year, but a range of technical factors meant that market pricing might not be giving an accurate reading of the expectations in the current circumstances,'' the RBA minutes said.

"The decline in government bond yields globally was reflected in the local market, with the 10-year yield reaching a low of 4¼ per cent in late August and the 3-year yield declining to as low as 3½ per cent.

"The spreads on state government debt widened sharply, as liquidity in that market deteriorated (though yields still declined in absolute terms). This reflected the fact that while there had been considerable buying of Commonwealth Government securities by offshore investors, particularly foreign central banks, those investors generally have a smaller appetite for state debt."

In other words it has been 'safe haven' and asset diversification purchases by foreign investors, such as central banks (nice to have that confirmation from our central bank), which have helped drive down local bond yields, not a sharp fall in confidence which sometimes produces a fall in yields ahead of a recession or a slowing in the economy.

That would seem to be the reason for the misreading of the economy by some forecasters.

Yesterday's dip under $US1.02 by the dollar after the cut in Italy's credit rating was announced, produced the usual kneejerk forecasts of the dollar falling under parity and staying there.

A rise in the dollar back over $US1.02 made a mockery of those silly forecasts, as the currency once again steadied and traded in a fairly stable range. That was a point made by the RBA in the minutes.

"The Australian dollar traded through a large range, but was more stable than equity markets; this was in contrast to 2008, when the Australian dollar tended to move pari passu with movements in global equity prices.

"The bank's liaison suggested that a growing realisation that the exchange rate was likely to remain at a relatively high level was contributing to a re-evaluation of business strategies. In some cases this was leading to restructuring and even closure of facilities. However, in others it was prompting investment in new capital equipment to remain competitive, consistent with a pick-up in investment intentions in the manufacturing sector reported in the ABS capital expenditure survey."

And the sharemarket's relatively strong performance was also noted:

"The local sharemarket also moved generally in line with its global counterparts, but in contrast to recent months, it tended to outperform other markets. Earnings reports released during the month were, on balance, either in line with or in excess of analysts' expectations, although some of these expectations had been pared back in recent months."

The minutes kicked off what will be four days of commentary from the RBA: later this morning the deputy Governor Ric Battellino speaks in New York, tomorrow morning the head of the banks economics department, Assistant Governor, Phil Lowe speaks in Sydney and on Friday the bank's second Financial Stability Review is released.

We had a preview of that review in yesterday's minutes.

For example the minutes said that, "The Australian banking system remained in a relatively strong condition. The recent global market turbulence contributed to falls in Australian banks' share prices and some tightening in wholesale funding conditions, but the overall effect had been modest compared with the experience in most other countries and in 2008.

"The Australian banking system was better placed to cope with periods of market strain than it was before the crisis, having substantially strengthened its liquidity, funding and capital positions in recent years.

"The Australian insurance industry had coped well with the elevated levels of claims from the natural disasters at the start of 2011, assisted by robust reinsurance arrangements.

"Members discussed the financial position of the household sector in Australia. Over the past year, the household saving rate increased further and the debt-to-income ratio declined slightly. Given the recent renewed volatility in global financial markets, the prevailing mood of caution among households appeared unlikely to lift in the near term.

"While households in aggregate were managing their debt levels well, the mortgage arrears rate had drifted up over the first half of the year, but from a low level by international standards.

"Moreover, this rise mainly related to loans taken out prior to 2009, when banks' lending standards were weaker; newer loans were performing well despite an increase in interest rates."

So the financial system is healthy and not under pressure, which is more than you can say about Europe, the UK and the US.