OVERVIEW

The recent slew of indicators pointing toward protracted demand trend, as well as Bank Negara Malaysia’s (BNM) shift towards a more concerned tone on the economy as conveyed in its 2018 Annual Report and recent Monetary Policy statements, are compelling signals for a rate cut, presumably in the not too distant future. Hence, we are revising our interest rate outlook towards a view that the Monetary Policy Committee (MPC) may lower the Overnight Policy Rate (OPR) at its next MPC meeting on the 6th and 7th May.

The trigger points include the BNM’s action in toning down its inflation expectation to a “stable” growth of 0.7-1.7% (previously-used terms: “moderately higher”, “inflation is projected to increase”), slashing the GDP growth forecast for 2019 to a range of 4.3-4.8%, below the Ministry of Finance’s bullish projection of 4.9%, as well as highlighting that the economy is enduring a phase of elevated downside risks to growth, arising from both the external and domestic front, such as those pertaining to trade war development, uncertainty in political and policy directions, as well as volatile commodity prices. Interestingly, after analysing each of BNM’s monetary policy statements since 2004, indication of heightened downside risks to growth has always preceded or coincided with a rate cut.

Holding on to the concept of leaning against the wind, fraying demand conditions may have provided a strong basis for BNM to proceed with a looser monetary stance. High-frequency indicators have pointed to persistent weakness in the external and domestic market. Year-to-date, exports have contracted by 0.8% YoY (Jan-Feb 2018: +7.6%), attributable to rising trade tensions, growth slowdown in key exports destination and cyclical downturn of the E&E sector. To a certain extent, these have seeped through to the domestic activity, in which we could observe six straight months of contraction of the manufacturing PMI and downward trend in the retail sales growth, consistent with weak consumer sentiment. In the absence of demand-pull pressure, inflation has remained rather subdued, pushing the real interest rate higher, hence deterring investment and consumer spending.

 Another aspect that we took into account when drawing up our expectation on monetary policy decision is the external factor, as changes in policy rate would not only affect domestic growth, but also influence foreign investors’ decision to hold Ringgit denominated assets especially government-backed debt instruments. Currently, the Fed’s increasingly cautious view on growth and dovish monetary stance opens up a window of opportunity for the BNM to ease. With the Fed seen pivoting away from a rate hike for the rest of the year, the Ringgit, along with other emerging market currencies, has regained its strength, appreciating by 1.3% year-to-date to 4.0802, attracting further inflow of funds into the domestic bond market (Jan-Mar net inflow: RM5.1b), with the average yield spread of the US 10-year Treasury note and the 10- year MGS narrowing to 127 basis points (bps) in March from February’s 130 bps. Historically, we observe that foreign investors have been comfortable holding on to MGS so long its yield gap with Treasury remains above 100 bps and the perception that the Ringgit remains undervalued relative to its fundamentals persists. While we believe that a dovish Fed does not solely prompt concerted rate cuts from other central banks in the emerging economies, we do acknowledge that it provides more leeway for them to ease.

Above all of the aforementioned factors substantiating our stance, we reckon that there is one additional facet that is integral to the decisionmaking and requires more in depth analysis. Specifically, we have to take a step back and thoroughly understand the ultimate objective of cutting interest rate, which in this case is to stimulate domestic demand, in particular spurring up loan growth by reducing the cost of loan (i.e. interest rate), ensuring that any risks from abroad could be weathered by resilient domestic activity. Hence, analysing loan growth would help in identifying the binding constraint. As expected, loan growth has been withering of late, driven mainly by lack of demand for funds from the corporate and household sectors, in spite of the relatively stable level of lending rate. With the loan approval rate ticking up and growth in excess reserves parked at the BNM remained on a downtrend, we believe a banking pessimism is not causing the deceleration in loan growth. But instead, a subjective reasoning may be implicated here where there is a genuine lack of demand from investors driven not only by bleak growth outlook, but potentially by other factors that are beyond BNM’s regulatory control, such as issues related to the political stability and policy direction.

● Premising upon BNM Governor Datuk Nor Shamsiah’s statement that the prospect of an adjusted OPR in the upcoming MPC meeting will be data-driven, we opine that the sustained weakness evidenced by the recently released data should be sufficient to trigger a rate cut by the BNM. Driven by the factors mentioned above as well as historical data which proved cutting rates could help to bump up appetite for loan as much as it would reduce borrowing cost, we revise our stance on the OPR from zero rate cut to one rate cut by 25 bps in 2019, with the decision likely to be made at the 6th to 7th May MPC meeting. Nonetheless, we affirm our view that a rate cut should only be a short-term solution, and that a deeper understanding on the binding constraints to the private sector sentiments are essential in ensuring policy efficacy and allowing a sustained growth recovery.

Source: Kenanga Research - 11 Apr 2019