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Australia Rate-Rise Signal Unheeded by Bond Market Seeing Cut by Year-End

Reserve Bank of Australia Governor Glenn Stevens signaled he will raise interest rates when global risks dissipate, a message dismissed by a bond market seeing an escalation in risks among the nation’s trading partners.

Stevens held the overnight cash rate target at 4.75 percent yesterday and for the first time since October -- a month before the last increase in borrowing costs -- cited in his statement the prospect of raising the benchmark. He indicated an “acute sense of uncertainty in global financial markets” had stayed his hand.

With U.S. growth struggling to rebound from a near-stall, and ratings companies further cutting euro-area debt grades, interbank cash-rate futures are pricing in an RBA rate cut by year-end. At stake for who’s right on the outlook are prospects for mortgage holders and retailers, who will be hit by any further boost to the developed world’s highest borrowing costs.

“A tightening bias is clear,” said Paul Bloxham, chief economist for HSBC Holdings Plc (HSBA) in Sydney and a former RBA official who sees a rate rise in the fourth quarter. “The policy choice of ‘least regret’ in this environment is to sit on your hands -- hiking rates would have been very bold, perhaps foolhardy, given the U.S. debt situation and recent weaker domestic sentiment.”

Currency Falls

The highlighting of global risks in Stevens’s statement prompted investors to sell the local currency, which fell the most in four months, and spurred a government bond rally that drove yields on all maturities below the cash rate for the first time since 2009. The Aussie dollar traded at $1.0725 at 4:30 p.m. in Sydney from $1.0979 before yesterday’s decision.

The odds of a 50 basis-point rate cut in December soared to over 100 percent in the interbank cash-rate futures market, compared with 5 percent before yesterday’s decision. A Credit Suisse Group AG index showed traders betting Stevens will cut borrowing costs by 76 basis points over the next 12 months.

Those wagers contrast with Stevens yesterday saying “the board considered whether recent information warranted further policy tightening.” He added that “on balance, the board judged that it was prudent to maintain the current setting of monetary policy, particularly in view of the acute sense of uncertainty in global financial markets.”

Australia’s central bank is eyeing inflation that has approached its top of its tolerance band, driven by the expansion of mining companies including BHP Billiton Ltd. (BHP) that has stretched the nation’s productive capacity.

Inflation Quickens

The central bank’s two preferred measures of annual inflation accelerated to 2.7 percent in the second quarter, compared with a gain of about 2.3 percent in the first quarter. The central bank aims to keep underlying inflation in a range of 2 percent to 3 percent on average.

The International Monetary Fund said the RBA may need to resume raising rates to prevent inflation accelerating.

Demand from China and the rest of Asia is driving a “strong” outlook for Australia’s economic growth, forecast by the Washington-based IMF to accelerate to 3.5 percent in 2012 from 2 percent this year, division chief for Australia and New Zealand, Ray Brooks, said in comments to the Australian newspaper that he confirmed in an e-mail today. In April, the IMF predicted a 3 percent expansion for 2011.

‘Favorable Outlook’

“It is the demand from China and the rest of Asia that is driving this very strong and favorable outlook for Australia despite some of the risks surrounding the euro area and the U.S.,” Brooks said. If those risks turn out to be limited, “there is likely to be a need for a further increase in the policy rate just to contain the inflation pressures that are coming from the impact of the mining boom on the wider economy,” he said.

Stevens’s pause for an eighth straight meeting was his longest stretch of inaction since taking the helm in 2006.

Clouding the outlook are signs of slowing in the U.S. and China, and financial disruptions in Europe. Chinese manufacturing has moderated for a fourth straight month, while data last week showed U.S. gross domestic product posted the weakest expansion in the six months through June than any such period since the recovery began in June 2009.

Funding Pressures

In Europe, Moody’s Investors Service put Spain’s Aa2 rating on review for a possible cut July 29, citing funding pressures. That followed a similar step for Italy on June 17. Meantime, the U.S. is aiming to avoid its own downgrade with a deal to raise federal borrowing authority and shrink the budget deficit, which President Barack Obama has signed into law.

The RBA’s “cautious assessment” of global financial risk may not change quickly, according to Paul Brennan, a senior economist at Citigroup Inc. in Sydney. “The RBA is in no hurry to raise rates again and indeed there is a high hurdle to tightening further, although there is no hint of any consideration of lowering rates.”

Stevens has relied on the Australian dollar’s strength to temper the acceleration in inflation. The local currency has risen about 18 percent in the past year and reached $1.1081 on July 27, the highest level since it was freely floated in 1983.

An additional rate rise, on top of the 175 basis points of increases from October 2009 to November 2010, may further curb households’ appetite to borrow and spend. The nation’s saving rate has surged in recent quarters and demand for mortgages has waned to the slowest annual pace since records started in 1977. Household spending accounts for 55 percent of the economy.

Retail Sales Fall

A government report today showed Australian retail sales unexpectedly declined in June for a second straight month as spending at department stores dropped the most since April 2010.

A separate report showed Australia’s trade surplus narrowed more than economists forecast in June as imports surged to the highest level in more than two years.

The Australian dollar’s appreciation, propelled by higher rates and the mining-investment boom caused by China’s demand for iron ore and coal, has also hammered the nation’s factories. Private reports this week showed manufacturing slumped to a two- year low in July and services have contracted for 10 of the past 12 months.

If Stevens’s statement is any guide, more pain may be in store.

“It is worth keeping in mind how close the RBA was to hiking,” said Stephen Roberts, a senior economist at Nomura Australia Ltd. in Sydney. “If global financial market sentiment improves substantially over the next few weeks, then either the September or October meetings would have significant potential for a hike.”

To contact the reporter on this story: Michael Heath in Sydney at mheath1@bloomberg.net

To contact the editor responsible for this story: Stephanie Phang at sphang@bloomberg.net

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