rba plans drastic rates cut

Are the economic guru's clutching at straws?

David Uren, Economics correspondent | October 17, 2008

FINANCIAL markets are tipping a 2.25 percentage point cut in official interest rates by Easter as fears for the global economy cause further havoc on share markets.

The Australian share market dived 6.7 per cent yesterday, with massive falls suffered by major resource stocks. Rio Tinto shed 20per cent of its value, while itssuitor, BHP Billiton dropped 17.2 per cent.

The fall in the local market followed the biggest drop in the Dow Jones Industrial Average since October 1987, sliding 7.9 per cent. In Tokyo, the Nikkei index lost 11.6 per cent. London's FTSE 100 was down 2per cent in trading last night, while Wall Street was back up 1per cent early today.

"The weekend's G7 and G20 meetings have done a lot to avert systematic financial failure, so the focus is more on the global economic outlook and therefore resource stocks," Nomura Securities research head Eric Betts said yesterday.

Kevin Rudd will hold a "council of war" with business leaders in Sydney today to discuss plans for a united response to the global financial crisis. Executives from BHP, Deloitte, Microsoft, News Limited and mining giant Xstrata are expected to attend the talks with the Prime Minister and Wayne Swan.

On credit markets, there is growing confidence the co-ordinated banking guarantees and rescues around the world will stabilise the financial system. But there is increasing pessimism about the world economy.

ANZ's head of Australian economics Warren Hogan said the gap between bank funding costs and the Reserve Bank's cash rate narrowed from 85 basis points (0.85 per cent) to 76 basis points yesterday. More importantly, he said, markets expected the gap to drop to between 35 and 45 basis points by the end of the year.

"The market believes that eventually the government guarantees will work and the flow of credit between banks will start to free up," he said.

However, Mr Hogan said the credit markets, like equities, were concerned by the prospect of a global economic slowdown, and had started to price in heavy interest rate cuts.

"Markets expect the Reserve Bank to cut interest rates aggressively to less than 4 per cent within six months," he said.

"This kind of interest rate reduction is unprecedented in the inflation targeting era."

The futures markets expect the Reserve Bank to cut rates at its November meeting on Melbourne Cup day and at its final meeting for the year in December, with reductions totalling 1.25 per cent, bringing the cash rate down to 5.5per cent. By March next year, analysts expect the cash rate to be down to 3.75 per cent. This would reduce the average mortgage rate from about 8.6 per cent now to 6.3per cent, with the possibility that rates might fall even further if the premium on bank funding costs were cut.

A cut of those dimensions would reduce the monthly payments on a standard $300,000 mortgage by about $470.

University of Western Sydney associate professor of economics and finance Steve Keen predicted a 2 per cent cash rate by the end of next year, dropping to 0 per cent in 2010. "The debt bubble is bursting, and when it bursts, people stop spending and borrowing," Professor Keen said. "They (the RBA) can cut the pain, but they can't boost the economy."

Further evidence of the slowdown in credit growth in Australia was released yesterday, with the growth in credit card debt falling to 4.6 per cent, the slowest since records started 14 years ago.

Mr Hogan said financial markets expected the Reserve Bank had not reacted to the Government's budget stimulus, but expected Reserve Bank rate cuts to carry the burden of stimulating the economy.

He said the moves by world governments to shore up the financial system had removed the "worst-case scenario" but did not change the view that there was a substantial adjustment in the financial sector that would likely result in a deep recession in the US and a more moderate recession worldwide.

There have been fresh indicators of the US downturn, with retail sales dropping by 1.2per cent in September, the biggest fall in three years.

In parliament yesterday, the Prime Minister cited testimony given by Federal Reserve chairman Ben Bernanke that the funding pressures on US financial firms posed a significant threat to economic growth. "Financial market turbulence and instability in recent times has flowed through not just to equities markets but also to the real economy, and that of course has implications for jobs," Mr Rudd said.

The Government resisted requests from the Opposition to say whether its $10.4billion spending package was based on estimates that Australia's growth would dip below 2per cent.

Nor would it reveal the size of the contingent liability which the decision to guarantee bank wholesale funding would place on the public sector balance sheet.

"This is the height of Mr Rudd's contempt for parliament," Opposition Leader Malcolm Turnbull said.

"I mean, really, we ask him for basic information - information that every journalist, every member of the public would like to have - reasonable requests for information and all we get is indignation."

The weakness in the Australian share market yesterday partly reflected the growing concern about the US. However, investors were also shaken by Rio Tinto's admission that its Chinese market was becoming more difficult.

ABN AMRO chief economist Kieran Davies said there was increasing anecdotal evidence that China's construction industry was slowing while spot prices for iron ore and coal were tumbling.

The spot price for iron ore peaked at $210 a tonne in March and is now down to $95, which compares with the contract price for Australian exporters of about $140 a tonne.

For thermal coal, prices peaked at $193 a tonne in July but now stand at $116, below the contract price of about $125.

Mr Davies said the increasingly negative outlook for commodities was leading companies to cancel investment plans. He estimated that a 10per cent fall in export prices would knock two percentage points from the nominal GDP.

Other commodity prices were also falling, with the oil price dropping to $US75 a barrel, barely half its peak price of $US147.50 reached in July. Aluminium prices fell by 5per cent yesterday and were down by a third from their high.

Alumina Ltd led the price falls on the ASX yesterday, dropping 20per cent, while oil stock Santos lost 15per cent.

Nomura's Mr Betts said companies were now being priced well below their fundamental value, with companies like Rio Tinto and BHP Billiton trading at only five times their prospective earnings. In normal times, that ratio would be two or three times higher.

He said the only companies that were holding out against the wave of selling were those that had gained from the devaluation of the Australian dollar and which had businesses not driven by the business cycle, such as the plasma products company CSL and insurer QBE.

"The only safe haven is really cash, especially now that the Government has kindly agreed to guarantee it," he said.