–  JULY 2021 INSIGHTS BY THE CURVE TEAM –

Highlights

  • Governor Lowe had a busy week following the decision on yield curve control (YCC) and quantitative easing (QE), articulating the reasons behind their decision and delivering a speech on the employment outlook.
  • He made it abundantly clear that employment outcomes hold the key to the outlook for monetary policy.
  • How quickly Australia gets covid under control and what that means for international border policy will prove pivotal to employment outcomes.
  • While the 2024 timeline for rate hikes is still the central scenario it is not set in stone according to the Governor.

Rates Recap

  • The RBA’s decision at the July board meeting to trim QE from $5 billion to $4 billion a month and not to extend the yield curve target was close to market expectations.
  • Following the decision 3-year futures continued to sell off consistent with the curve jumping beyond the YCC target bond in April 2024.
  • Meanwhile the back end of the curve is heading the other way with yields falling over the past month leaving the yield curve much flatter.
  • Many are touting long run growth expectations behind the falling yields as the US Fed start winding back some of the extreme policy settings in the US over the second half of the year.
  • However, playing a larger roll is the sheer weight of money. Overnight repo operations in the US saw a record 1 trillion at the end of June as around 60 counterparties needed a place to park funds.
  • This excess of funds is weighing on the long end of the yield curve with question marks over the reflation trade exasperating the move in yields

Employment Outcomes Key to Rate Hike Timing

Over the past month, covid has returned as the key determinant for the short run outlook. Over the medium to long term though, it is largely irrelevant with the consensus being covid’s impact will be limited to the short run.

This is a stark contrast to last year, with the shift driven by a strong track record across the country to contain covid outbreaks as well as evidence of the efficacy of vaccines around the world just as Australian vaccinations rate rise. However, there remains one key factor from covid that is set to have lasting impact – migration. Namely, its impact on employment, wages, inflation and by extension monetary policy.

As of writing, NSW recorded over 100 cases of covid in the previous 24 hours. This is the culmination of a previous two months where all states except Tasmania had covid scares/lockdowns. Such high numbers and reach across the country in 2020 would have risked markets going into a downward spiral and wildly changed predictions for the economy going forward. Instead, so far, markets, the RBA and economists have taken the rise in numbers in their stride.

Rather than being a perennial reason for caution and justification for loose monetary policy, the RBA now view covid outbreaks as transitory, much like their outlook for inflation. They said the ‘economy bounces back quickly’ once outbreaks are contained.

Indeed, there is an implicit suggestion that it will be contained with their reference to the possibility of ‘further positive surprises’ following a ‘run of better than expected data’. Whereas there was plenty of uncertainty about containing outbreaks last year, the country has demonstrated they can contain the virus after multiple outbreaks.

It helps that both federal and state government have shown their willingness to support the economy by subsidising businesses and wages, even with JobKeeper having expired. In addition, the efficacy of vaccines is clear from other countries and Australia’s vaccination rate is steadily ticking up.

This is not to downplay the risks that still remain from covid. The RBA admitted that at a minimum the latest outbreaks are a reminder ‘that it is difficult to predict the future’ and at worst will mean ‘further setbacks’ for the economy. Economic data is also lagged, so many releases may take time to show the full effects from the latest outbreaks. Nonetheless, the rhetoric has clearly shifted on covid and the economy.

The pace of recovery and levels of economic activity and data despite the ongoing covid risk have been cause for euphoria. Consumer and business confidence have reached record highs. Employment has boomed off covid lows. It has led to markets pricing in rate rises well before the RBA’s central scenario of 2024 at the earliest, with wages and inflation expected to follow other economic variables higher. Covid is viewed as just a blip in the road.

However, rumblings have begun about the ongoing effects that border closures will have on the economy. It follows a speech by Phillip Lowe titled ‘The labour market and monetary policy’. In his speech, he spoke about the secular decline in inflation and wages despite continuously improving employment outcomes. Since 2014, employment forecasts from the RBA have been largely accurate, but wage forecasts have persistently overestimated. Lowe puts this down to labour supply following the increase in demand.

Lowe cites the rising labour force participation rate, increases in underemployment and overseas workers as increasing the supply of labour which offsets the need to increase wages to attract workers. Labour force participation is at record highs, as more women, part time and older workers have entered/remained in the labour force. With more part time jobs, there has been a growing number who are underemployed, meaning employers can adjust hours rather than wages. Both these trends have been gradual and sustained for an extended period of time, and for the most part won’t be impacted by covid.

The flow of overseas workers on the other hand is acutely impacted by covid. International travel into Australia has virtually come to a stand-still, which has had a drastic effect on employment. Labour force data shows that total employment is up 1% on pre pandemic levels. But when overseas workers are included, employment is down 2.1%. If all overseas workers who left Australia since December 2019 were to return and replace Australian employees, the unemployment rate would rise to 7.5%. So really, strong employment numbers are glossing over the fact that overseas workers have left the country.

The RBA’s mere mentioning of overseas workers suppressing wages was met with pushback. Members of government and economists pointed out that over the long run it has been shown that more migration is not related to lower wages in countries. However, this does not preclude there being a drastic impact if migration were to suddenly come to a halt, as covid has essentially done. Rather than being able to draw on the plethora of overseas workers, which numbered 430,000 temporary visa workers in 2016, employers now have a choice to either push up wages or wait and see.

Assuming the economy overcomes the latest covid outbreak and continues to grow, this decision will become more pressing. The rate of job vacancies to the number of unemployed people is at record highs already, with two unemployed people for every vacancy.

More industries are reporting labour shortages as a pressing issue and unemployment has reduced to 5.1%. The RBA’s research of different industries shows that when unemployment falls below 5%, and especially below 4%, wages trend upwards. The mindset of businesses, which the RBA have found is to avoid increasing costs, including wages, and instead ‘wait and see’ will come under more pressure if the economy booms and borders remain largely closed.

This outlook is still speculative. The latest wage data rose 0.6% in Q1, leaving it 1.5%. Inflation was also up 0.6% for the Q1 and the annual rate even lower than wages at 1.1%. So, there is no evidence yet that wages and inflation are rising. There is also the chance that borders open and workers flood the country before there is an opportunity for wages to materially increase. But should the economy continue to surge and borders remain shut or even restricted, it seems more likely that there will be upward pressure on wages that has eluded the RBA for nearly a decade.

Outlook for Interest Rates

The highly anticipated meeting of the RBA Board in July played out largely as expected. Those expecting a significant shift in the RBA’s current setting of monetary policy and the outlook for rate hikes were underwhelmed.

On the current settings of monetary policy, the RBA left the cash rate unchanged at 0.10% and the rate that it pays on Exchange Settlement Balances at 0%. The current yield curve target of 0.10% on the April 2024 Government bond remains and was not extended to the November maturity, which was in line with expectations.

QE was expected to see the biggest change. The broad expectation was that the RBA would move to a more flexible purchase schedule. Instead they will scale back the purchases from the current $5 billion weekly run rate in early September, which is when the previously announced purchase are set to conclude. They will then purchase $4 billion a week until November when it will be reviewed again.

As for the outlook, the RBA continued to point to 2024 as the likely timing for the first rate hike, saying:

“The Board remains committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target. It will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. The Bank’s central scenario for the economy is that this condition will not be met before 2024. Meeting it will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently.”

Market pricing is currently at odds with that outlook and suggest that rate hikes are more likely to come sometime in 2023. There are even suggestions that rate hikes could come as soon as late next year. Much of that will depend on the impact that the current lockdown in NSW will have on the broader economy around the country.

If the latest outbreak can be brought under control and the vaccination rollout be ramped up, this could be the last lockdown that the country has to endure. Under that scenario, the risk would be that we could see the RBA move earlier than anticipated. If it drags out and vaccination rates don’t improve then we are at risk of another lockdown at some point, putting the recovery on the back foot once again.

It is this uncertainty that has resulted in the Governor qualifying the 2024 timeline for rate hikes by saying:

“I want to re-emphasise the point that the condition for an increase in the cash rate depends upon the data, not the date; it is based on inflation outcomes, not the calendar.”

There are too many moving parts at the moment when it comes to the outlook for anyone to know for sure. What we do know is that the RBA has made it crystal clear that they will be reactive to data, not pre-emptive as once was the case. That means that any major shift will need to be supported by the data and far more predictable than would have previously been the case.

On that basis we are still some way off seeing rate hikes by the RBA. The first clue will come from the wages data. Only when we see a sustainable rise in the pace of wage growth, such as the annual rate breeching 3%, will we see the conditions for a rate hike start to emerge.

Australian Economic Highlights

  • Australia’s GDP recovered to be above pre covid levels in Q1. The economy was 1.1% higher than last year following a 1.8% rise in Q1. Investment was the predominant driver in Q1, with a 5.3% rise off the back of dwelling investment fuelled by the HomeBuilder scheme. Consumption is now flat on last year’s levels.
  • Inflation underwhelmed in Q1, up only 0.6% when 0.9% was expected. It leaves the annual rate at 1.1%, which will spike next quarter as the drop over Q2 last year induced by Covid is removed from the annual figure. HomeBuilder grants over Q1 contributed to subdued Q1 prices and is expected to wane on the index for some time as grants are received and projects begin.
  • Unemployment fell sharply in May after a jump in total new jobs of 115,200. There were strong gains in full time employment, which was up 97,500 with part-time growth accounting for the remaining 17,700. The fall in unemployment was made more remarkable by a slight lift in the participation rate after a fall last month.
  • June was another strong month for ANZ Job ads with a further rise of 3%. This adds to the already high level of jobs vacancies. Adding some context was RBA Governor Lowe’s comment that 250,000 visa holders with the right to work have left the country since March last year meaning plenty of jobs need workers to replace the vacancies created.
  • After hitting record highs, virus fears have hit business confidence with the index slipping 9 points in June after a 4 point drop in May. NSW was the hardest hit with the survey taken during the upswing in new covid  cases. QLD also fell heavily after recording cases over the month. Confidence was also down mildly elsewhere. Business conditions also gave up the surge from the previous month to a record high, dropping back 10 points to 35. There were falls across the main sub indices with profitability, trading conditions and importantly the employment index all lower. The key here is context with both the conditions and confidence indices still well above long run averages. How they move from here will hinge on the duration of the lockdown in NSW and containment of the outbreak.
  • Consumer confidence faded further in June to be down nearly 10% over the past two months. Melbourne lockdown was flagged as the main driver behind the fall. If that was the case and if the weekly ANZ-Roy Morgan updates are any guide, confidence will take another hit in the months ahead. Of note was the unemployment index which jumped during the month while expectations for economic conditions for the next 12 months fell heavily.
  • Retail sales drifted higher again in May with the 0.4% increase leaving sales 7.7% higher than a year ago as the base effect from the initial covid lockdown starts to fade. Next month should see the annual figures normalise. Supermarket sales continue to benefit as more people eat in.
  • New housing finance commitments continue to surge to new highs with another 4.9% increase in May. As prices rise and affordability is stretched investors are coming back into the market and first home buyers are fading. The value of owner occupier commitments were only up 1.9% for the month while investor commitments were up 13.3%.
  • The trade surplus jumped again in May as a 6% gain in exports outpaced the 3% growth in imports, both of which are a good sign for the economy. The net difference saw the trade balance jump to $9.7 billion, which if sustained in June, will help exports add to growth in the second quarter.
  • Dwelling approvals continue to fall in the wake of the end of the homebuilder stimulus program. Total approvals were down a further 7.1% in May following April’s revised 8.6% (previously -5.7%) decline. Private housing approvals provided the drag once again which was to be expected, falling 10.3% over the month.

Co-Authored by David Flanagan and Joshua Stewart