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RBA cut fully priced as markets buckle on trade war – 14 May 2019

Australian Financial Review

The escalating trade war between the US and China has convinced financial markets that there will be a RBA interest rate cut in August, as 10-year government bond yields touched a fresh record low, the Australian dollar sagged, and the ASX skidded in response to a fresh bout of global market turmoil.

The probability of an Australian interest rate cut advanced after a turbulent session on Wall Street, with the Dow Jones Industrial Average closing down 617 points, or 2.4 per cent. The S&P 500 fell 2.4 per cent and the Nasdaq shed 3.4 per cent in Monday trading.

“The market has reacted negatively but you have to think about where it started from,” said Vertium Asset Management fund manager Jason Teh. “Shares were at three-month highs. So markets were set up for any bit of negative news with little margin of safety.”

Still, the latest breakdown on trade talks isn’t a positive development by any means, he said, particularly as the renewed tensions have emerged at the same time as signs of a tentative recovery in global economic growth. “Any negative macroeconomic events make the recovery more fragile,” he said.

But he’s also expecting global central banks to respond to the latest threats to the growth outlook and said “central banks are fully aware that to prevent a global growth slowdown they need to act accordingly.”

Financial markets hiked pricing of a US interest rate cut by the end of the year to 80 per cent by the end of Monday’s US session and are also now fully pricing in a quarter-percentage-point cut from the Reserve Bank of Australia by August, up from a 98 per cent chance of a cut on Monday.

Australian rate cut expectations were given further weight after a drop in the conditions component of the National Australia Bank business survey to 3 points, from a reading of 7 points in March, with the employment component dropping sharply.

Ten-year Australian government bond yields fell to a record low of 1.68 per cent and the S&P/ASX 200 index dropped heavily, with the equity market falling 1.2 per cent to 6220.

The market turbulence came after China said on Monday it would slap tariffs on $US60 billion ($86 billion ) of US goods from next month, in retaliation for the latest increase in US tariffs on Chinese goods.

On Friday, the US raised tariffs on Chinese imports to 25 per cent from 10 per cent on $US200 billion of goods. The US has also threatened to impose a 25 per cent tariff on another $US325 billion of Chinese goods.

“Broadly speaking, there has been a quicker realisation that the latest escalation of trade tensions is here to stay,” said National Australia Bank currency strategist Rodrigo Catril.  “We have seen an acceleration of those tensions and it’s caught the market by surprise.”

Mr Catril said that, in place of tariffs from China, markets may have been expecting less obvious measures on trade from the Chinese government, such as making it a bit harder to do business in China or allowing its currency, the yuan, to further depreciate.

“If the Chinese currency is allowed to further depreciate, that will trigger concern about the outlook for China,” he said, noting that the last time the currency was allowed to depreciate there were large capital outflows from China.

Given Australia’s economic ties to China – its biggest trading partner – the Australian dollar has historically shown it is very sensitive to moves in the yuan, Mr Catril said.

“If there is a sudden move in the yuan to 7 per dollar – and it already has had a big move as it is – then the market will be looking hard at that,” he said. The yuan traded at 6.9178 per dollar after a 1 per cent slide, while the Australian dollar traded at US69.50¢.

Royal Bank of Canada economist Tom Porcelli said that, broadly, financial markets were concerned that the fresh trade tensions would lead to heightened uncertainty for the global economy.

If fresh doubt over trade triggered significant market turbulence, that could have a negative effect on business and consumer confidence and kick off a subsequent negative feedback loop for activity, he said. “We risk talking ourselves into a slowdown.”

 Article appeared in The Australian Financial Review on 14 May 2019.

Article written by Sarah Turner.

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