–  JUNE 2021 INSIGHTS BY THE CURVE TEAM –

Highlights

  • It is uncertain how sticky rising prices will prove to be. The different forces driving higher prices are relevant to determine whether it will be transitory.
  • Supply side price pressures could prove both temporary and ongoing.
  • Demand side price pressures are contingent on wage growth over the medium to long term.
  • Wages remain the dominant factor that will determine the RBA’s decision on monetary policy.
  • Central Banks will face a challenge if prices rise before wages increase.

Rates Recap

  • A decision on whether to extend the yield curve target and QE will be made in the July meeting.
  • Yield Curve Control is not expected to be extended to the November 2024 bond but will remain for the April 2024 bond until it matures.
  • QE is expected to be extended but in a more flexible means which will allow more open-ended purchasing.
  • There has been a gradual shift by the RBA to be more hawkish and allowing themselves flexibility to go against their forward guidance.
  • The RBA are cognisant of market reactions to their decisions and seemingly want to avoid any surprises or sudden increase in interest rates.

Inflation: Transient or Persistent

As the global economy starts to reopen on the back of vaccine rollouts at a time when mass fiscal and monetary stimulus is in train, inflation has become the central topic of the economic debate. Economists and market commentators are debating with vigour whether rising inflation will prove transient or persistent and what impact that will have on the outlook for interest rates.

The RBA has made it clear that they won’t be acting prematurely in the face of rising inflation expectations. This would have been a distinct possibility in days gone by when the RBA used to act on forecasts rather than actual outcomes as is now the case.

Based on the current pace of inflation, expectations for the next quarter and the base effect from falling prices last year, headline inflation in Australia is expected to print between 3.5% and 4% for the second quarter. This would usually have the RBA on edge and acting to rein in inflation. This time around, the RBA wants further evidence that inflation will be sustained in the 2% to 3% band on a trimmed mean basis.

So, the question is, how sustainable is the current uplift in inflation and will it be enough for the RBA to revise its outlook for interest rates.

To understand that question it is important to understand the factors currently driving inflation. There are both supply side and demand sides drivers.

On the supply side we have two main forces at play. The first being driven by onshoring.  Many global companies are re-engineering their globalised supply chains and onshoring production where possible. Covid-19 exposed a significant flaw in globalised supply chain models where sourcing parts or producing offshore when production was offline due to the pandemic became difficult or non-existent. Given the reason for offshoring in the first place was to achieve a lower cost of production, usually due to labour costs, this will come at an increased cost of production which will need to partly or fully be passed on to end consumers. This will take many years to play out and will likely be an upside factor for inflation outcomes globally.

The second supply side factor is lack of capacity. Many manufacturers face productivity issues and were severely disrupted during the pandemic. As the global economy starts to reopen, many supply chains are struggling to clear the backlog of orders that have built up or keep up with the current level of demand. Inflationary pressure driven by supply side constraints over the medium term should prove transitory. How long it takes for the imbalances to normalise will vary by industry and country specific factors.

On the other side of those supply side constraints is the demand side of the equation. Demand is ramping up for two main reasons. The global economy is reopening at varying speeds around the world. This is releasing pent up demand that was reduced during the pandemic. This is being further fuelled by both monetary and fiscal policy. Low rates are stimulating borrowing while also prompting increased spending and risk taking as money parked in the bank is attracting such a low rate of return. Fiscal spending via cash handouts, infrastructure spending and support programs are also adding to demand.

This demand pulse could last for some time but ultimately should prove temporary. However, it is hard to determine at what point pent up demand, monetary policy and fiscal policy will start to fade.

For the increased levels of demand to become self-sustaining, a higher level of wage growth will be required. Currently, there is plenty of anecdotal stories of labour shortages from industries or geographic areas, not just in Australia but further abroad too. This is hard to reconcile on the surface given the degree of spare capacity based on current unemployment and underemployment rates.

One factor that is driving the current pockets of wage pressure is being driven by labour mobility, both at the local and global level. Despite the progress on vaccine deployment offshore, the global mobility of labour remains much lower than prior to the pandemic. With Australia’s border shut and likely to remain so for some time, this factor will have more significant ramifications for our labour market outcomes than in other jurisdictions globally. How persistent the effect of labour mobility is on wage outcomes in Australia will be driven by the timing of border reopening and Australia’s post pandemic immigration policy.

What that leaves Australia with is several drivers of inflation at present that, except for onshoring, should prove transient over the medium term. The challenge for central banks is how long they are prepared to endure elevated levels of inflation in the absence of broad-based wage growth. Of course, if spare capacity in the labour force is eroded and broad-based wage growth ensues, then tighter monetary policy beckons. Until then, central banks will need to walk a fine line between supporting growth without letting the inflation genie out of the bottle.

Outlook for Interest Rates

July’s board meeting will be arguably the most significant of the year. If not, it is certainly the most important of the year so far, as it is when the RBA will decide if and/or how they will extend yield curve control and QE.

The consensus seems to be that yield curve control will not be extended beyond the April 2024 bond. Prior to the RBA’s meeting in June, Economist Bill Evans believed that the RBA would extend the yield curve target to the November bond from the April bond. After the June meeting, he changed his stance, expecting the yield curve target to not be extended.

Markets have largely priced in this expectation. The November 2024 bond, which would be 0.10% if the yield curve target was extended, is currently trading at around 0.30%. Therefore, should the RBA confirm the yield curve target will not be extended, the impact on yields should not be substantial. Albeit there will likely be a tick up in yield in the November bond and longer bonds.

Conversely, if the RBA surprises markets by extending the yield curve target, the November bond will go to 0.10% assuming the RBA’s credibility is intact. Longer bond yields will likely also fall. This would cause more volatility in markets than if they were to remove the yield curve target, which adds another reason to justify ending the target given the RBA’s emphasis on stability in markets.

QE on the other hand is expected to remain. However, the form of QE may change. Rather than being a set volume to be completely by a set timeline, as has been the case in the first two $100 billion QE purchases, it is expected to be more flexible. This would likely involve an open-ended number of weekly/monthly purchases.

It follows a theme from the RBA, which is a slightly more hawkish sentiment and positioning themselves to go against their forward guidance. In the June meeting, the RBA removed the line saying they are ‘prepared to undertake further bond purchases to assist with progress towards full employment’. This followed a change to saying they believe it is ‘unlikely’ rather than they do ‘not expect’ the cash rate to increase before 2024.

All this points to a very gradual shift in the RBA’s stance. They remain dovish, with their expectations of the cash rate remaining the same until 2024 much more conservative than the market, which is already pricing in rate rises prior to 2024. But it seems they are positioning themselves to change their mind should economic conditions dictate. This is evident in the emphasis on ‘the state of the economy’ determining the path of policy, rather than the current forward guidance.

A key part of this positioning is that it is gradual. The RBA are cognisant of how markets are absorbing information and seem eager to avoid any disruptions and increases in volatility. With that in mind, it is unlikely that the RBA will prompt a sudden rise in yields. Rather, they would prefer to see a gradual transition back towards pre-covid rates and if there is a spike in yields it will more likely be market driven.

Given this, expectations of rapid rate rises should be tempered. QE looks likely to remain, which will continue to add liquidity to already enormous amounts of excess liquidity. This excess liquidity and ongoing QE will help absorb the expected primary issues following the end of TFF. Also, there remains the possibility that the economic situation will change. Recent lockdowns in Victoria are indicative of this.

So even with an unwinding of policy in July and an improving economic outlook, low rates will remain. And even as rates rise, it will likely be gradual.

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, predominantly from 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 as projects begin.
  • Unemployment declined in April from 5.7% to 5.5%, but the fall was driven by people leaving the labour force, not from increased employment. Employment was down 30 600 for the month, with part time employment down 64 000 and full time up 34 000. Cyclical factors, including the holiday period, were thought to have had an impact on the numbers rather than the end of JobKeeper.
  • Another strong month for ANZ Job ads in May suggests the momentum in employment is still strong. Ads were up 7.9% from already high levels, which leaves them 38.8% higher than pre-covid.
  • There were more record highs in the business survey, with business conditions up to 37 in May from 32. Business confidence on the other hand was down, but remains very high at 20.  The survey remarkably includes when the Victorian lockdown had begun. The employment index was up to 25 from 20 but there remains little evidence of price pressures from the survey.
  • and conditions for April broke the new records from March. Conditions are at 32 from 24 in March and confidence is at 26 up from 17 in March, which is staggeringly high. The employment index again improved, up to 22, which bodes well for minimising the impact of the end of JobKeeper. Evidence of prices increasing remains minimal though.
  • Consumer confidence fell 4.8% in May to remain at a very high 113.1. Most promising was the 15.3% fall in the unemployment index, which bodes well with the end of JobKeeper. The lockdown in Victoria threatens both confidence and employment for future periods.
  • Retail sales were up once again, rising 1.1% for April. Compared to April last year, when spending plummeted as the country went into lockdown, spending is up 25%. From February 2020 levels, which preceded both the drop in sales and the surge as people stocked up for lockdown, sales are still up nearly 12%.
  • Housing finance remained strong over April, up 3.7%. This is 57% higher than pre-covid levels. Owner occupied loans were back to leading the gains, up 4.3%, while investor loans were up 2.1%.
  • After net exports reduced the economy in Q1, the trade surplus improved in April. Exports were up 3%, with commodities driving the gains. Imports on the other hand were down 4%, leaving the surplus above $8 billion.
  • The first month since the conclusion of HomeBuilder led to a 8.6% fall in dwelling approvals for April. However, there is nuance to the deadlines of the scheme, so it is hard to discern the impact of HomeBuilder ending. In fact, private sector houses were up 4.6% and overall approvals remain 39.2% higher than last year. After a surge in March, a steep drop in high-rise units led the falls in overall dwelling approvals.

Joshua Stewart

Associate - Money Market