Reserve Bank of Australia has room to cut rates

Two key developments occurred this week which might pave the way for the Reserve Bank of Australia (RBA) to move its cash rate lower next week. We have discussed the first extensively in our prior note titled “Aussie fiscal tightening will pave way for RBA cuts.” Our argument here is that this year’s budget is likely to see more cuts in order for the government to meet its surplus target. Tax receipts aren’t rising, in fact they are under pressure, so cutting is the only way the surplus can be achieved, if at all. The reduction of government spending provides an opportunity for the RBA to bridge the gap in order to ensure domestic demand doesn’t suffer any further.

The second development this week is the continuation of project deferrals and postponements in the mining, energy and resource space. It’s not a new development in Australia, but part of an emerging trend. Companies are deferring and postponing large projects which were due to commence next year. This removes one of the largest inflationary pressures in the Australian economy. High labour costs and a low rate of unemployment were always going to compound construction costs, but recent movements in global markets have seen a reluctance by companies to commit to projects until clarity emerges.

Postponing not cancelling

Most announcements tend to form a similar tone – projects are being put on the sideline rather than being completely abandoned. This is positive as it opens up a window for the RBA to move while maintaining the long term positive upside to the economy. Incitec Pivot is a leading Australian manufacturer of explosives, fertilisers and related products sold globally. It today announced it will defer the construction of an ammonium nitrate manufacturing complex in New South Wales. One of the main reasons cited is the high cost of construction in Australia, but there is no doubt demand is soft for its products and it has probably realised it can defer large investment until prospects improve.

Incitec Pivot is not alone, Anglo American also announced plans to cut coking coal output in the coming months and postpone any new planned development until markets improve. It hasn’t abandoned its long term target to triple coking coal production by 2020 but instead its Chief Executive says “you can’t completely throw overboard long-term plans”.

Enter the RBA

Markets are now starting to price in a 60-70% chance that the RBA will cut rates by 25 basis points when it meets next week. Even if it doesn’t  a rate cut at either its October or November meeting is now almost a certainty. The mining and investment pipeline is still there, it hasn’t disappeared, instead it’s just being pushed out by a year or two which means a short term window to cover the softness exists. The RBA will also acknowledge the Fed, ECB and BOJ’s recent moves to provide liquidity in the market in deciding to move downwards.