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Australia interest rates to go lower, for longer

Sydney, Australia
Adam Jeffery | CNBC
Sydney, Australia

The Reserve Bank of Australia (RBA) holds its August policy meeting on Tuesday and is considered almost certain to cut rates a quarter point to 2.5 percent, bringing this easing cycle to 225 basis points spread over 21 months.

(Read More: How low must the Aussie go before the RBA backs off?)

Market rates have already baked in another move to 2.25 percent by Christmas and there's no hint of a tightening priced in for at least the next two years.

"2014 will be a long year for the economy and a cash rate even lower than our 2.25 percent forecast is now a distinct possibility," said Alan Oster, group chief economist at National Australia Bank.

That outlook has been clearly reflected in government bond yields, with the cost of borrowing out for one year hitting an all-time low of 2.24 percent on Monday. Even two- three- and four-year yields are under the cash rate.

(Read More:Australia Mining Tax Will Not Impact Investment: Expert)

In large part, Australia is a victim of its own good fortune. Its embarrassment of natural resources were just what China needed to fuel its growth miracle leading to a truly massive boom in mining.

As a result, mining investment has quadrupled as a share of the economy but now looks to have peaked. Having risen so rapidly the risk is that spending could fall quite sharply from quarter to quarter, taking chunks out of economic growth.

It is even possible that it could cause two consecutive quarters of contraction, the technical definition of recession, something Australia has not suffered for more than 20 years.

That danger may have been on the mind of RBA Governor Glenn Stevens last week when he noted that mining spending could be in for "quite a big fall" in coming months.

(Read More: No 'Armageddon' for miners: Western Australia Premier)

He has been seeking to enliven the rest of the economy with lower borrowing costs but consumers and business have been slow to respond. Households favor saving over borrowing, while business confidence is low and political uncertainty high ahead of a federal election next month.

The government is in no position to provide fiscal stimulus, having slashed its revenue projections by A$33 billion over four years to reflect slower growth in nominal gross domestic product (GDP).

Not that bad

Still, Australia's outlook is far from awful compared to its rich-world peers.

A Reuters poll of analysts taken just last month found they expected the country's A$1.5 trillion ($1.3 trillion) of GDP to grow 2.5 percent this year and 2.8 percent next. While subpar for Australia, that would be brisk for the developed world.

Helping is a ramp-up in resource exports as all the billions of dollars of investment in capacity comes on line. Indeed, this is really the third stage of the mining boom and will run for years yet. Exports of liquefied natural gas, for instance, should more than quadruple by 2016/17.

(Read more: For Australia, 'R' may not mean recession)

Another positive for the economy has been a sharp fall in the stubbornly high Australian dollar. A drop of over 15 percent since April has eased competitive pressures and delivered a profit windfall to commodity exporters whose products are priced in U.S. dollars.

Analysts estimate every U.S. cent it falls adds around A$100 million to the bottom line for BHP Billiton.

Crucially inflation remains benign, providing the RBA with plenty of room to ease as needed. Inflation ran at 2.4 percent last quarter, well within the RBA's long-term target band of 2 to 3 percent. With unemployment rising and labor costs subdued, most analysts see inflation staying there for all of 2014.

That is a major departure from previous experience for Australia, as almost every other mining boom has ended with runaway inflation which necessitated a severe tightening in policy and led inexorably to recession.

(Read more: Why a Rudd revival spells bad news for Aussie stocks)

It also means this easing cycle could be a lengthy one.

"We expect a cut in August and a further easing next quarter to see the cash rate trough at 2.25 percent throughout 2014," said Su-Lin Ong, head of economics at RBS Capital Markets, adding that this was a bullish mix for bonds.

"We think the increasing focus on the challenges facing the domestic economy should keep front-end yields well anchored as the lower-for-longer theme garners more traction."

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