–  March 2021 INSIGHTS BY THE CURVE TEAM –

Highlights

  • Economic data continues to show a resurgence in economic activity.
  • Q4 GDP growth headlined a run of strong data releases over the month.
  • Upside and downside scenarios for the economy remain disparate, although the downside is looking increasingly unlikely.
  • Optimism must be tempered with the fact the economy remains in a recovery phase.
  • The prospect of an economic expansion over the medium and long term appears very viable, but there is no guarantee high growth rates can be sustained beyond the recovery.

Rates Recap

  • The past month has seen significant moves in a number of markets which have implications for monetary policy settings as well as investment strategies.
  • One of the most significant developments has seen the yield curve steepen over the past month with the 5 year swap jumping almost 50bpts while the three year has jumped almost 25bpts.
  • Despite the RBA defending their anchoring of the yield curve, BBSW has started to drift higher. The shift has only been marginal on the 3 month while the 6 months has lifted from 2bpts to 8bpts over the month.
  • This normalisation of the curve will put some pressure on the RBA and their current stance on monetary policy as the market arm wrestles over the outlook for rates as the pandemic subsides.
  • Helping ease some pressure on the RBA will be the pull back in the AUD. After touching 0.80 through the month, the AUD has drifted back to 0.77, essentially unchanged compared to a month ago.

Optimism Dominates the Outlook

Over February, economic data continued to show a very strong recovery. Should this continue there is plenty of reason for optimism. However, the spare capacity in the economy means it is more fragile. Any unanticipated event or deterioration in the outlook would be more consequential than in usual times. This dichotomy of possibilities means the upside and downside scenarios for the economy have rarely been so disparate. Therefore, although the optimistic case is compelling, it is worth tempering this with alternative possibilities.

GDP for Q4 was the economic highlight for the month. It was up 3.1% for the quarter, which leaves it 1.1% lower than pre-Covid levels. With the domestic economy largely unaffected by Covid over the quarter, and especially as Victoria re-opened, consumption was able to increase. It was up 4.2% for the quarter, leaving it 2.7% lower for the year.

There are plenty of reasons to believe this strong recovery will continue. These include:

  • Employment continues its rebound, with nearly 100,000 jobs added over January. It leaves unemployment at 6.4% and only 50,000 full time jobs are needed to recover to pre-Covid levels.
  • Business and consumer confidence are at very high levels relative to long run averages.
  • Retail spending remains strong, up another 0.5% in January.
  • Household saving remains high at 12%, which gives plenty of space for discretionary spending.
  • The trade balance hit a record surplus in February of $10.1 billion, which will add to the value of GDP.
  • New loans are being approved at a rapid pace, albeit are being offset by quicker repayments.
  • Business investment has picked up, with an 8.9% rise in equipment and machinery over Q4.
  • The Victorian recovery is still yet to be reflect in GDP, with them down 3.4% on pre-Covid levels whereas the rest of the states are roughly back to their pre-Covid levels.

In addition, monetary policy remains very accommodative. Not only is the cash rate target 65 basis points lower than pre-Covid but the RBA has committed to a total of $200 billion in asset purchases (quantitative easing) by the end of the year and will make nearly $200 billion of cheap funds available to ADIs via the TFF by its expiry. Although the RBA are not expected to extend the TFF and may not maintain the target on the three-year government bond, already there is speculation of an additional $100 billion of QE towards the end of the year. All this will make credit cheap for an extended period, which should increase the willingness for businesses and individuals to borrow (theoretically).

Similarly, the federal government have committed to expansionary budgets until there is a substantial improvement in the unemployment rate. They will taper their spending as the economy improves, which is evident by the JobKeeker, JobSeeker and HomeBuilder programs set to end.

Finally, Covid containment and vaccine distribution are proceeding very encouragingly. Australia has only had minor hiccups with Covid outbreaks over the past two months and has begun distributing the vaccine. Overseas, vaccine distribution is already well underway, which will eventually enable overseas travel to re-emerge.

This current economic data and positive outlook make for a very compelling optimistic case for the economy. Current economic data are resembling a V shaped recovery and that is before international borders re-open. Also, market pricing as a leading indicator suggest that inflation and activity will pick up to levels greater than what the RBA expect.

However, the economy is still in a recovery phase. For all the positive data releases, these indicators are almost all coming off very low levels induced by Covid. This has two key implications:

  • It makes the economy more susceptible to any change in the outlook.
  • The change in the growth rate of economic variables is more consequential than the actual growth rate.

Elaborating on the first, there are still factors that could derail the outlook. One is a shift in fiscal or monetary policy. On fiscal policy, unwinding of government programs could prove more detrimental than expected. The government could also succumb to pressures to reign in debt rather than stimulate the economy, which would put the brakes on growth. Although the RBA have given no indication they will ease their policy thus far, the surging longer dated bond yields and rising inflation expectations could force the RBA to tighten their policy. Yield increases are already an indication that the market doubts the RBA can remain so lax.

Covid is another obvious risk. Should vaccine distribution be derailed or slower than expected, whether due to a mutant strain or supply limits, there will be a limit to economic activity. Although all the above risks are unlikely, they are not impossible and if they were to eventuate, they could very suddenly depress activity.

To the second implication, economic activity will continue to be viewed as relative to pre-Covid levels. While activity remains below pre-Covid levels, which for the key indicators- GDP, employment, inflation and wages it is, then growth rates can only be taken with a grain of salt. It is difficult to differentiate whether the growth is simply recovering what was lost over Covid or whether it represents a sustainable pattern. The latter would pose a viable path to wages and inflation rising, which would allow the RBA to tighten policy. If activity simply recovers to pre-Covid levels, then tracks at growth rates similar to pre-Covid, then it is hard to imagine inflation and wages rising to sufficient levels for the RBA to unwind their current policy.

The case for a slower than expected recovery is easier to believe than the outright downside scenario. There is no guarantee households will tap in to their 12% savings buffer. Typically, after recessions consumers are reluctant to dip too far into their savings. Further, services spending remains 5.49% below pre-Covid levels. Services are a more sustainable form of consumption and although it is expected to pick up especially when international borders open, there is no guarantee the transition will be smooth.

Reliance on credit to fuel growth also has its limits. Loan approvals have surged, but lower rates mean existing loans are being paid down faster. It also increases the debt levels of an economy, which will constrain future consumption. In addition, it makes the economy much more susceptible to rising rates, which as discussed previously, is already being considered by markets.

Considering all the above, the base case for the economy is extremely promising over the short term. This could be derailed, but it is unlikely to. For the medium to long term, the stage is set for an extended economic expansion but is still not guaranteed.

Outlook for Interest Rates

The long-touted increase in yields as the economy recovers eventuated emphatically over February. There were multiple instigators, including vaccine distribution, extremely accommodative monetary policy around the world and the anticipation of a mammoth fiscal stimulus bill in the US. All of which have drastically improved the economic and inflation outlook from the C ovid lows.

The US 10-year Treasury, often used as a benchmark rate, rose 41 basis points over the past month. Even larger rises occurred for the Australian Government 10-year bond. Other benchmark rates, including bank bill swap rates and ADI bonds rose over the month. The change in yields were predominantly at the back end, which steepened yield curves. The RBA’s 3-year government bond target of 0.10% continues to constrain shorter term yields. However, even after the RBA’s policy decision in March, which reaffirmed their commitment to yield curve control, the 3-year government bond drifted as high as 0.13%. Shorter term benchmark rates, including 3-month BBSW and 6-month BBSW rose 3 and 6 basis points respectively.

The suddenness of the moves corresponded with increased volatility and drained some liquidity in markets, which increased spreads. As an example, a 7-year US government bond issue had the lowest bid to cover ratio for a new issue of its kind in over a decade, which suggests there is a lack of demand for such long-term bonds. Partly because of this, the RBA brought forward some of their QE programme to address market dislocations.

The sudden move up in yields has created investment opportunities. Term deposit, cash and even NCD rates have been largely unaffected by the moves in the bond market. Rates in these products are priced according to the demand for funds from ADIs. Because there is still nearly $100 billion of TFF to be drawn down and excess liquidity remains at unprecedented highs, ADIs still have little need to raise new funds through deposits. Therefore, rates have remained low in these products. ADIs are expected to draw down the bulk of the remaining TFF allowance closer to the end of June deadline. Only when this expires are rates in term deposits, NCDs and cash accounts expected to rise. But even then, excess liquidity will keep them subdued for some time.

Bonds on the other hand, work independently to ADIs demand for funds, albeit with a correlation. Recent moves in yields for bonds have lifted fixed rates, especially at the back end. This has posed many attractive opportunities in fixed bonds relative to term deposits. Margins on floating rate notes remain subdued but current market pricing indicate that a lift in the variable rates they price off will occur over the medium to long term. Assuming ADIs demand for deposits remains subdued until the middle of the year and bond yields continue to experience upward pressure, then this trend should continue.

Whether bond yields continue to rise is unclear. Volatility will likely continue due to the disparity between the upside and downside scenarios for the economy, as discussed in the previous section. As markets grapple with the outlook, there is a wider range with which prices can plausibly go. Additionally, the economy is still recovering so is susceptible to any change in the outlook. This means any worse than expected scenario would hit yields harder than in normal times.

The main variable that could change the trajectory of yields is the RBA. At the moment their policy is working contrary to their intentions. QE, which was extended last month, should reduce long term rates, whereas rates have risen sharply this month. The fact that the RBA have committed to maintaining an accommodating policy, which includes not expecting to raise the cash rate until at least 2024 and a willingness to do more if necessary (which is speculated to imply a further extension of QE at the end of the year) is fuelling speculation that inflation and economic activity will surge. If the RBA were to suddenly tighten policy, by ending QE purchases for example, it is unclear if this would send yields even higher or if the decision would change the outlook for inflation and activity and decrease yields. This uncertainty of the impact of RBA activity will only add further fuel to volatility.

To summarise, uncertainty is ironically the only certainty in the outlook for rates. As a central scenario though and using the previous section as a guide, the pressure on rates will likely be upwards until there is an impetus to change. Much of the improvement in economic activity and inflation is already priced in to yields, but as positive economic news continues and growth rates remain high, the stronger the case will be for sustained economic expansion and inflation levels above 3%. Were the economy to suddenly slow, the RBA to change their policy stance or some other unforeseen scenario eventuate, then there could be a sharp correction in yields. For now though the optimistic economic outlook shows no signs of abating.

Australian Economic Highlights

  • Growth in Australia continue to rebound into the end of the year positing a second consecutive increase above 3% in the Q4. The recovery in growth continues to be driven by consumption, which was also the hardest hit component of growth during the Covid downturn. GDP is expected to return to pre-Covid levels by the middle of the year and grow by 3 ½ per cent in 2021 and 2022.
  • Inflation continued to recover over Q4, up 0.9%, which was the same read for the annual rate. Childcare continued to be an outsized factor following the unwinding of free childcare. Inflation will be coming off a low base so may appear high in the near term, but sustained upward pressure is still a way off given the RBA’s forecasts for unemployment.
  • Employment continues to recover much faster than most had anticipated. The re-opening in Victoria has kept momentum going in the most recent data. The latest increase of 29,100 jobs saw the employment rate fall to 6.4%. The RBA expects unemployment to have peaked and decline to 5 ½ per cent by the end of 2022.
  • The ANZ Job ads continue to surge in line with employment. A further rise of 7.2% in February has taken the number of jobs ads well above their pre-crisis level as some employers look to attract new workers as the economy re-opens.
  • Business confidence and conditions rose in sync over February. Confidence rose from 12 to 16, the highest level since 2010. Conditions improved from 9 to 15. All the states have largely reached similar levels, so how quickly these levels revert back to long run averages will be of interest.
  • Consumer confidence has shaken off some of the lockdown induce pull back from January with a 1.9% rise in February. Exceptions for economic conditions over the next 12 months was the big driver as the Victorian lockdown ended up being much shorter than first expected.
  • The month to month volatility in Retail sales has eased back in recent months. December saw a much more muted gain of 0.6% which was followed by a 0.5% rise in January. As the economy gets back to a more normal footing over the coming month, the focus will shift towards spending on services rather than on retail.
  • Housing finance approvals continue to surge thanks to record low rates and government incentives. Underlying conditions are also encouraging more first home buyers to get into the market. New approvals were up another 10.5% in January with both owner occupiers and investors posting solid increases.
  • Australia’s trade surplus surged to a new record high in January, breeching the $10bln mark for the first time. Demand for our exports, mostly iron ore and other bulk commodities, continues to surge, jumping a further 6% to start the year. Imports on the other hand played their role in the increase in the surplus by falling 2%. Imports of consumption and capital goods over the coming months are worth keeping an eye on.
  • The tapering of the $25,000 grants under the HomeBuilder scheme looks to have contributed to a sharp fall in building approvals in January. Private housing approvals remain at an elevated levels despite pulling back 12.2% in January while multi-dwelling approvals continue to fall.

Josh Stewart

Associate - Money Markets