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Tuesday, 3 February 2015

Commodities slide ahead of RBA decision day

Iron ore slips further

Another morning, another slide for iron ore prices in US$ terms, today down to $61.30/tonne.

While the price of coal has shown a spirited bounce in recent days, the price of Australia's other key commodity is slipping back down to levels last seen in first half of 2009.

Commodities index slides

On a related note the Reserve Bank released its Commodities Index yesterday for the month of January 2015.

While rural commodities and lately base metals have been holding up, the key bulk commodities which comprise a heavy weighting in Australia's commodity index have slipped dramatically over the past year.

The weighted commodities index fell by 0.9 percent in January following a revised fall of 3.4 percent in December in SDR terms.

Thus over the past year the commodities index is down by 20.4 percent, largely driven by the twin declines in iron ore and coal.

While in theory movements in the currency could absorb some of the shock, the index in Australian dollar terms is also down by 19.1 percent over the past year.

Of course some of the falls in commodity prices have been offset by - and to some extent caused by - significant increases in export volumes as the production phase of the mining boom ramps up.

Nevertheless, stylised examples demonstrate that volume increases have to pull very hard to make up for lower export prices and thus there will be a negative impact on income.

In short, margins matter, and both interest rates and the Aussie dollar probably has further to fall this year towards 70 cents.

Cash rate tracker

It is against this backdrop that we come to today's much-anticipated interest rate decision from the Reserve Bank of Australia.

Today's Board Meeting will be followed with additional interest in media circles since it is a genuine "live" decision.

In other words economists and markets are split down the middle as to whether rates will be cut further or left on hold for yet another month with a dovish change to the wording of the market release.

At the time of writing markets see about a 62 percent chance of rates being cut to 2.25 percent and thus a 38 percent chance of rates staying on hold at 2.50 percent.

Perhaps as significantly, futures markets see interest rates almost certainly heading lower over the months ahead, pricing in a cash rate of well under 2 percent way out until the second half of 2016.

Over the past week we have had a soft Producer Prices Index release, while yesterday's TD-MI inflation gauge for January recorded annual inflation of only 1.5 percent, suggesting that inflationary pressures are well contained.

That represents a lot of ticks in the "cut interest rates  now" column!

The case against a cut seems largely centred around concerns that cuts to interest rates could ignite a boom in dwelling prices.

House prices rise 8 percent year-on-year in Janaury

Yesterday's release from RP Data for the month of January showed that in a rolling terms annual house price growth has continued to slow in Australia on a national basis, with capital cities recording 8 percent capital growth, slowing down from a peak of 11.5 percent.

Of course, the headline data masks significant variations by capital city.

Sydney continues to surge as expected with prices rising by another 1.4 percent in January to be 2.4 percent higher this quarter.

John McGrath's contention that "Sydney's inner suburbs will stay hot forever" may be gaining some traction, it seems.

A potential mini-surge in Hobart prices (+4.4 percent over the past quarter after a torturous period of zero growth) driven by a dearth of dwelling construction and a falling dollar mooted here a few times previously appears unlikely to be sustained over any meaningful period of time.

Perth and Brisbane also saw prices rising by 2.2 percent and 1.8 percent respectively over the quarter to January 2015, although both interstate migration and sentiment in Perth have been softening.

Meanwhile price growth elsewhere has been soft or negative with a minimal quarterly gain in Adelaide (+0.3 percent) more than matched by declines in Canberra (-0.2 percent) and Darwin (-2.6 percent).

Rates on hold today?

Since the beginning of 2009 Sydney dwelling prices have easily outperformed (+57 percent) those in other capitals such as Adelaide (+10 percent) and Brisbane (+9 percent), while dwelling prices in Canberra (+18 percent and now declining) and Perth (+17 percent) have largely only tracked household income growth.

If rates are cut then this may risk seeing the Sydney housing market accelerate, but this doesn't sound like much of a case for cruelling the economy.

I first wrote about the Reserve Bank being forced to wear a Sydney housing book back in early 2013, and it seems we may be heading for that territory. 

Expect to see more "umming and ahhing" today with interest rates on hold, but a significant mindset shift in the wording of the press release to reinstate an easing bias for the months ahead.