• The RBA picked up in 2018 where it left off in 2017, leaving the cash rate on hold at 1.50% in February.
  • While the cash rate has remained anchored, the yield curve has moved around substantially over the past two months.
  • Markets have found themselves in a funk as they recalibrate their expectations on the reality the monetary policy punchbowl is being taken away.
  • Expectations for a cash rate increase in Australia continue to dwindle as concerns over the outlook for consumption remain the biggest risk to the outlook.

Rates Recap

  • The RBA left the cash rate on hold again in February with the cash rate remaining at 1.50% since August 2016.
  • Despite the cash rate remaining anchored, the Australian interest rate curve has move substantially over the past two months.
  • The short end of the yield curve has been dragged lower as expectations for a move up in the cash rate get pushed further and further out.
  • While Australia’s long rates have moved higher, they have done so by less than other major markets with the yield spread at the 10 year part of the curve falling to almost 0% against the US.
  • The narrowing yield spread could place pressure on the AUD were it to turn negative and continue to widen.
  • The US yield has steepened substantially over the past two months as growing inflation expectations and the scale of the US Treasuries funding task continues to grow, pushing up long term rates.

Rising Rates Driving Market Funk

In what feels like an eternity now, I wrote back in December about two themes I thought would be key to how the year ahead unfolds. The first of those was ‘Unwinding of the Great Monetary Policy Experiment’. The core to that theme was how the removal of extremely accommodative settings of monetary policy around the globe could impact global markets and the economic outlook.

Six weeks into the new calendar year and we already have markets in a funk. While sudden emergence of volatility across global markets isn’t being solely driven by this underlying factor, it is certainly contributing.

Since the re-emergence of volatility a little over a week ago, many have pointed to a jump in wages in the US and the subsequent impact on the inflation outlook as being the data point that spooked markets. However, a broader look at developments over the past couple of months suggests rather than being a surprise, the wages data built on an already evolving narrative.

The wages data and what it may mean for the inflation outlook certainly suggests that both short and long term rates will continue to rise. The thing is, long rates have already been on the move since mid December. Following the approval of  the US Tax plan, long rates in the US have been heading higher with the 10 year bond yield even breaking out of its 30 year downtrend.

The Tax plan in the US was widely applauded as it is expected to add to growth over the years ahead. That additional growth is expected to then generate additional tax revenue to eventually offset the reduction in the tax base driven by the tax cuts in the first place. The problem is, until that growth comes through, the increased deficit has to be funded in the meantime by the US Treasury.

The financing of that shortfall adds to an already ballooning funding task. Depending on whose estimate you want to use, the US Treasuries funding task is set to almost double in 2018 to $955bln, up from $519bln. It only gets bigger in the coming years with $1.083trl and $1.128trl expected in 2019 and 2020 respectively.

This increased funding task also coincides with one of the biggest buyers of Treasuries, the FOMC, stepping back from the market, and running down its holdings. Based on current expectations, the FOMC’s balance sheet will fall by $420bln this year and $600bln in 2019.

This isn’t just a US issue. A chart from the RBA’s Statement on Monetary Policy on Friday shows that in 2018 there will be net new issuance of government bonds across the Euro area, Japan, UK and the US for the first time since 2014. That is despite the ECB and the BoJ continuing with their Quantitative Easing programs.

In short, even before factoring in rising inflation expectations, we already have a significant shift in the supply/demand dynamics in global debt markets which suggests long term rates have to rise.

Higher long-term interest rates, especially in the US, will have implications for a number of asset classes as well as the global economic outlook. Where long bond rates go, as do the borrowing rates for a number of companies and countries worldwide. It certainly appears that the worm has turned and the globe is going to have to quickly wean itself off ultra-low rates and an abundance of liquidity.

For some time, global markets have been underpricing expectations for central banks and their intentions to normalise interest rates after an extended period of extremely accommodative settings. As RBA Governor Lowe alluded to in his speech last Thursday, it is this sudden recalibration of expectations causing some angst and repricing across a number of markets.

Outlook for Interest Rates

The RBA followed up only the third calendar of unchanged rates by holding the cash rate steady again in February. The streak for an unchanged rates is creeping closer and closer to a new record, which currently sits at 22 months.

If the cash rate moves in line with market expectations, as highlighted in the RBA’s quarterly Statement on Monetary Policy last Friday, we won’t see a move until February 2019.  That would make it a remarkable 28 months between RBA cash rate adjustments. Indeed, the tone from the RBA’s SoMP last Friday suggests that they are in no rush to make any change to the current stance of policy which could see the record stretch even further.

The RBA’s key quarterly release also contained their latest economic forecasts which now stretch out to mid 2020. There was very little in the way of amendments to the forecasts for Growth, Inflation and Unemployment that we saw in their November statement. Growth is still expected to pick up to the mid 3.00% range before easing back and inflation is expected to sneak into the bottom end of the target band.

Interestingly, the unemployment rate is only expected to ease from 5.5% to 5.25% over the forecast period. That outlook suggests there could be much more slack in the labour market given the current robust outlook for jobs growth. It is also important in the context of the RBA’s biggest risk to the outlook which continues to be the consumer.

While the RBA remains upbeat on the broader economy, the consumer continues to be the biggest threat to the outlook. Persistent low wage growth and the large overhang of outstanding debt are presenting headwinds to the outlook for consumption. At the same time, the savings rate is at its lowest level since the GFC. This is important as consumption still makes up close to two thirds of the Australian economy.

The cause of the RBA’s concern can be captured succinctly in one chart  from their SoMP last week. It shows a concerning trend between consumption split between essential items and discretionary items. It clearly shows there is a slowdown in discretionary spending while at the same time, more is being spent on essential items.

This same trend is prevalent in the inflation data. The latest Consumer Price data for the fourth quarter shows inflationary pressures are non-discretionary sectors while there is very little in the way of price pressures in discretionary sectors. This is also evident in last quarter’s retail sales data where heavy discounting by retailers to generate sales continued.

What the RBA really needs and wants to see is wages growth. Not only will it help balance the equation when it comes to the outlook for consumers and consumption, it will help lift inflation, over time, back into their 2-3% target band. While it is too early to tell, the relationship between the underemployment ratio and the wage price index suggests we could see an uptick in wages over the next six months.

However, until we see a sustainable uptick in wages growth, the cash rate looks set to remain firmly on hold for the foreseeable future.

Australian Economic Highlights

  • Growth for Q3 came in at 0.6%, short of both the market and RBA’s expectations. The annual rate lifted from 1.9% to 2.8% after the negative read from last year dropped out of the calculation; however, the market and RBA were expecting an increase to 3%.
  • CPI continued to disappoint, the headline figure only lifting 0.6% for the second straight quarter in Q4. The RBA’s preferred measure, core inflation also remained below the band at 1.9% after a quarterly increase of only 0.4%.
  • Employment data capped off its best calendar year on record with a further 34,700 jobs added in December. The unemployment rate increased by 0.1% to 5.4% despite solid growth after the participation rate rose to a new near term high of 65.7%. 
  • The ANZ job ads report continues to suggest employment growth will remain solid in the months ahead, with a huge jump of 6.2% in January.
  • The NAB business conditions index bounced back to record highs in January on the back of robust profitability and trading conditions. The Business confidence index edged up slightly from 10 to 12, with both indices above long run averages. The employment index dipped from 8 to 6.
  • Consumer confidence has shown a marked improvement over the past two months buoyed by the outlook for the economy with optimists outweighing pessimists in January. That could quickly change in February following the surge in volatility in global markets. 
  • After a very solid November rise on the back of the iPhone and special sales events, Retail sales eased back in December. Inflation adjusted sales were ok for the quarter but show there is some substantial discounting happening to attract sales.
  • Housing finance looks to have topped with the the weakness in investor finance approvals now seeping into the owner occupier market. The number and value of loans were both down in December with re-financing the only segment to show an improvement.
  • Australia’s trade deficit continued to decline in December despite a surplus being expected. The trade deficit grew to $1.358bln as imports continued to outpace exports.  
  • Large swings in Building approvals continue to be seen as high density approvals rise and fall each month. Total approvals remain well off their peak and are unlikely to pick up in the near term.  
  • Motor vehicle sales woke from their slumber with a solid 4.5% to end the year in December. The increase saw the annual pace of sales rise from 2.1% to 6.7%. 
David Flanagan

David Flanagan

Director Interest Rate Markets