THE BIG PICTURE: Market optimism tempered by a watch on rates

When the Reserve Bank sets interest rates in Australia, it must broadly assess financial conditions and then determine whether a change in rates is warranted.

First it looks at the level of interest rates and compares it with long-term averages to assess the stimulus being applied. The Reserve Bank also looks at borrowing, asset prices (basically home prices) and the level of the Australian dollar.

Interest rates are mildly stimulatory at present, and this is broadly appropriate given low inflation and global economic risks. Then there is borrowing. There is tentative evidence that consumers and businesses are borrowing again, but it is still early days. Then there are asset prices. Australian home prices are starting to lift, but again it is early days.

And, finally, there is the Aussie dollar. The Reserve Bank has noted that the Aussie dollar has moved higher despite the weak global economic outlook and softer commodity prices. And that out-performance of the Aussie dollar compared with commodity prices is clear from the current chart. The measure of commodity prices is the CBA commodity index in Special Drawing Rights (SDR) terms – effectively in currency neutral terms.

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Interestingly the chart on commodity prices, together with indexes such as the CommSec iPad and iPod indexes and The Economist Big Mac index all suggest that the Aussie dollar may be overvalued by around 5%.

So if the Aussie dollar is a bit high at present, what could the Reserve Bank do? There is probably little sustainable benefit from direct intervention. But if the Reserve Bank felt that overall financial conditions were a little too tight at present, the main option would be to lower interest rates.

The week ahead

Relative quiet has descended on the economic front. In Australia over the coming week, the Reserve Bank dominates proceedings. And in the US, the spotlight shines on the housing market. Based on forecasts, there may be reason for investors to celebrate.

In Australia, the week kicks off on Monday with data on imports of goods. While the figures are influenced by oil prices and fluctuations in the Aussie dollar, imports are very much tied to business and household spending, so the results are of keen interest.

On Tuesday, the Bureau of Statistics releases yet more tools to access Census data while a census of a different kind – the motor vehicle census – is released on Wednesday.

Also on Tuesday, the Reserve Bank issues minutes of the board meeting held on August 7. We will be looking at any fresh views about the strength of the Aussie dollar.

And on Friday, the Reserve Bank governor Glenn Stevens faces his six-monthly grilling by parliamentarians. No doubt the governor will again be quizzed on the strong Aussie dollar, and more specifically the options the RBA is considering should the currency continue to rise and metal and energy prices go in the other direction.

In the US, the week kicks off with the Chicago Federal Reserve index on Monday and weekly chain store sales data on Tuesday.

On Wednesday, minutes from the Federal Reserve meeting held over July 31/August 1 will be issued.

At present, analysts are divided about the strength of the economy, but overall the Fed is in “wait and see” mode before deciding whether more stimulus is required.

Also on Wednesday, data on existing home sales is released. Economists predict sales to rebound by 3% in July after falling by 5.4% in June. The path won’t be straight, but housing market activity will continue to recover in coming months as a rising population demands more homes.

On Thursday, weekly data on claims for unemployment insurance is released together with new home sales figures, the home price report from the Federal Housing Financing Agency and the Markit “flash” manufacturing index. Encouraging analysts tip a 4.3% lift in new home sales while home prices probably rose again also.

And on Friday, data showing new orders of “durable” goods is released – goods with a lifespan of more than three years, such as cars, equipment and aircraft. Economists believe that this indicator of business investment rose by 1.3% in July after a similar rise in June. If the forecast is fulfilled together with those for new and existing home sales, speculation of a new US recession will be squashed.

Also worth watching over the week are “flash” readings on manufacturing activity for Europe and China to be released on Thursday.

Sharemarket, interest rates, currencies and commodities

The Australian profit reporting season moves into the fourth week. On Monday amongst the companies listed to report include Bendigo Bank, BlueScope Steel, Challenger and Macmahon Holdings.

On Tuesday, Amcor, CFS Retail Trust, Commonwealth Property, Charter Hall, Mirvac, Oil Search, Sonic HealthCare, Tassal Group and Seven West Media are expected to report.

On Wednesday, Asciano, BHP Billiton, Boral, Coca Cola, CSL, Suncorp, The Reject Shop, Super Retail, Ridley Corp, Woodside Petroleum, Wotif.com are amongst those to issue profit results.

On Thursday, Automotive Holdings, Fortescue, Fairfax Media, Hills Group, IAG, Qantas, QR National, Ramsay Health Care, Sydney Airport, Transpacific and Tatts Group are expected to report.

And on Friday, Billabong, Woolworths, Bega Cheese, Iress, Telecom NZ, PanAust, NRW Holdings, Sims Metal, Whitehaven Coal are all scheduled to report.

The shape of the yield curve can reveal much about the way investors and traders are viewing economic conditions – the current state of play as well as the outlook. The cash rate stands at 3.5%, bank bill yields (1-month through to 6-month) are around 3.65%, then there is a step down to 1-year to 3-year swap yields around 3.45% and then a gradual rise in yields to around 4.10% for the 10-year swap rate.

Overall, investors are of the view that cash rates are unlikely to be adjusted in the short term, although there is still the chance that the Reserve Bank will cut rates again. But looking further out, investors believe that the economy will continue to record healthy growth and that inflation will gradually drift higher from current levels.

Fine-tuning the yield curve analysis to one indicator, the differential between the 10-year and 3-year swap yield is not a bad guide to investor views on the economy. Currently the differential stands at 44 basis points, not far from the decade-average of 60 basis points, but up from recent lows of 12 basis points in late July.

Bottom line: investors have become a little more optimistic on the economic outlook but, understandably, still hold a number of reservations.

Craig James is chief economist for CommSec.

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