–  December 2020 INSIGHTS BY THE CURVE TEAM –

Highlights

  • Three different vaccines for Covid-19 showed very encouraging results, which means Australia will likely begin rolling out vaccines from the beginning of next year.
  • GDP for Q3 and employment data for October were very strong.
  • Victoria’s re-opening continues to offer an immediate upside to the economy.
  • The RBA made no change to monetary policy and continue referring to an uneven and drawn-out recovery.

Rates Recap

    • The RBA made no change to their current policy stance at the December meeting, meaning policy remains fixed until February.
    • In the short term, there is still downside risk to interest rates.
    • Economic forces are pushing the Australian Dollar higher, which will make the RBA more sensitive to overseas central bank’s policy decisions.
    • Over the long run, there are forces that will put upward pressure on rates, but this will take some time to eventuate and remains contingent on volatile factors.

Economic Resurgence Underway

The past month has arguably been one of the most positive for the economy in living memory. Despite South Australia having a Covid scare, Australia’s containment of the virus has meant border restrictions and Covid laws have eased. Notably, Victoria has emerged from its lockdown and as of writing has not recorded a Covid case for 38 days.

With the virus contained around the country, GDP for Q3 and employment for October recovered markedly. GDP grew 3.3% over the third quarter and 178 000 jobs were created in October. This recovery for employment especially is remarkable, as it leaves the participation rate near pre Covid levels.

Both employment and growth are expected to build on these gains. Victoria has begun its re-opening which poses a strong tailwind for the economy. Victoria’s GDP remained nearly 10% below pre Covid levels in Q3, so as it re opens Australia’s GDP will lift with it.

Over the medium to long term, the outlook has also improved drastically following positive vaccine news. Three different companies published extremely encouraging vaccine results. Britain has even approved Pfizer and BioNTech’s vaccine. America is set to approve a vaccine later this week and Australia early next year.

Having multiple vaccine options will make the economic recovery more robust. It gives more flexibility in terms of distribution, as Pfizer and BioNTech’s vaccine requires extremely cold storage temperatures, whereas Moderna and Oxford-AstraZeneca’s does not require this. There will likely also be subtle differences in the efficacy of the vaccine with different groups and strains of the virus.

A vaccine will be the simplest means for economic borders to begin re-opening. Without this, Australia’s growth would be hampered, as population growth would be muted and key industries such as tourism and education would have little prospects for growth. There is now a viable means to return to pre-Covid levels of activity.

These updates have occurred while monetary policy in Australia is as accommodating as it has ever been. Also, the government has said it will continue to stimulate the economy until unemployment goes below 6%. Already government stimulus has propelled incomes despite the lower levels of economic activity. Household savings is at 18.9%, which provides a lot of space for consumption to pick up.

This optimism needs to be tempered with other factors. The economy will be coming off a much lower base with GDP still 3.8% lower than last year. The RBA do not expect GDP to return to pre Covid levels until the end of next year and unemployment to still be around 6% by the end of 2022.

It means any slowing in economic activity will be more consequential than usual times. If the virus does manage to spread again in Australia that will hit activity immediately. A vaccine may face issues with distribution or efficacy. Overseas, containment of the virus remains problematic and has disrupted Europe’s return to growth and America’s economic activity.

Despite these risks, for the first time since March when the pandemic put economic activity to a halt, there is a realistic means to have economic activity return to ‘normal’. With the government and central bank behind them, it is now up to businesses and consumers to kick start investment and spending.

Outlook for Interest Rates

The RBA made no change to their policy stance in December. They have maintained the cash rate, Term Funding Facility (TFF) and 3-year yield curve target at 0.10%. Their QE programme will continue as first announced.

Despite the better-than-expected vaccine, employment and growth news, their forecasts also remain unchanged. They expect growth to return to pre-Covid levels by the end of next year, employment to be near 6% by the end of 2022 and the cash rate target to be the same in three year’s time.

This caution is contributing to a changing outlook on rates. Since the pandemic, the RBA has said they will not use forecasted inflation as their target but actual inflation. They’ve also shifted to having employment as being more heavily weighted in their decision. Now, with an economic recovery underway, their cautious outlook on the economy combined with their more dovish approach to inflation could lead to the economy running hotter for longer before the RBA unwind their policy tools.

It is ironic that the RBA saying they don’t expect to unwind their policy tools for some time could lead to them doing just the opposite. It is worth noting though that there is much to unwind. Even if lending picks up and the economy kicks into action, there is a lot of slack in the labour market, so wages won’t spike immediately. The RBA also have their QE programme, 3-year yield curve target and TFF that they would likely unwind before lifting the cash rate.

In addition to this, the RBA’s policy will still depend on policies of overseas central banks. The RBA are cognisant of the Australian Dollar being too high. High iron ore prices and an increase in risk appetite from investors has seen the Australian Dollar appreciate despite the RBA’s recent policy change. If overseas central banks were to ease their policies further, then the RBA may follow suit so there is no more upward pressure on the dollar.

This means the outlook for rates is still that they will remain low in the near term. If anything, there will be a bias to go even lower, given overseas central banks could ease further and the economy may not recover as expected. Over the long term there is the prospect for inflation and economic activity picking up to the point where a tightening of monetary policy will be required, which naturally will lead to higher rates. In the US, where the Fed has similarly gone more dovish by using average inflation over the cycle as a target rather than actual inflation, inflation expectations have picked up for the medium and long term.

A lot still has to go right for this to eventuate. And even if the most optimistic scenario occurs it will take some time for rates to rise significantly and for the RBA to consider increasing the cash rate target. Hence their current guidance of the cash rate being on hold for three years.

Australian Economic Highlights

  • Growth bounced back in the third quarter. GDP increased 3.3% over the quarter, leaving the economy 3.8% lower than this time last year. There is much scope for further improvements, with Victoria still nearly 10% smaller than last year and household savings at 18.9%.
  • Following a sharp fall in Q2 of 1.9%, Inflation recovered to record a 1.6% rise for Q3. Unwinding of childcare subsidies and rising petrol prices contributed to the rise. The annual rate remains muted at 0.7%. Wages remain subdued and are expected to remain that way as long as there is slack in the labour market. The RBA view a recovery in wages as the primary means to have inflation reach the 2-3% target band.
  • The Employment data continues to be much stronger than expected, especially in November. 180 000 jobs were gained for the month despite a negative read being expected. The participation rate is only a tick below pre Covid levels, meaning the unemployment rate of 7% is a fairly good indication of the state of employment. A measure of the effective unemployment rate, which accounts for the participation rate and those working zero hours but still counted as employed under JobKeeper payments has unemployment at 8.3%.
  • The ANZ Job ads continue to surge, rising 13.9% for November. This follows a 11.9% rise in October. Victoria’s re-opening is fuelling the recovery.
  • Business confidence has surged over the past two months, sitting at 12 after being -3 in September. November in particular saw a jump, rising from 3 to 12. Business conditions likewise improved to be 9 after being 2 in October and 0 in September. The employment index won’t budge, remaining at -5, meaning there was no improvement from October. The other improvements likely reflect the re-opening of Victoria and positive vaccine news.
  • Consumer confidence increased by 2.5% for November to be 107.7. This is the highest read since 2013. Hopefully the read will flow on to higher levels of consumption. The unemployment index remains softer than desired. The read does not account for the positive vaccine news from last month.
  • After stalling in August, Retail sales picked back up in October. Victoria’s slow re-opening was the impetus, as Victorian sales rose 5.1%. The rest of the country rose a more modest 0.3%.
  • New housing finance continues to be strong, up 0.7% for October. Overall approvals are now up 23.3% for the year with owner occupied approvals up 31.2%.
  • Australia’s trade surplus improved markedly in October despite expectations of a neutral read. Exports were up 5.4% on the back of rising metal ore prices. Imports only rose 0.6%, which left the trade balance at $7.5 billion, up from $5.8 billion.
  • Building approvals were up 3.8% in October. The government’s homebuilder scheme continues having an effect, with overall building approvals up 14.3% on last year.

Joshua Stewart

Associate - Money Market