–  February 2021 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The economic recovery has continued strongly despite some hiccups with covid lockdowns.
  • A transition from government led growth back to consumers and businesses will begin in the middle of the year.
  • Plentiful cheap funding from the RBA and high levels of household savings provide an impetus for business and consumer led growth, but it is not guaranteed.
  • Although the outlook is much improved, there is still uncertainty with Covid.

Rates Recap

  • Overseas central bank’s policies putting upward pressure on the Australian Dollar and continued slack in the economy were motivations for the RBA’s decision.
  • Short term interest rates will likely remain low for some time given the enormous quantity of cheap funding available to ADIs.
  • The term funding facility and 3-year government yield target will be the first policies to be unwound by the RBA.
  • Long term interest rates are more uncertain and will be influenced by the global economic recovery. The RBA expanded their QE programme, adding another $100 bln to their planned purchases of semi-government and government securities.

RBA Doubles Down as Transition Approaches

After a hiatus over the holiday period, it was a busy week for the RBA last week. It included their first monthly board meeting for 2021, a speech from the Governor, an appearance before parliament and on Friday they released their quarterly Statement on Monetary Policy.

The big surprise was the RBA going early on another increase to their Quantitative Easing Program by a further $100bln. Despite the RBA outlining that the recovery from the height of the pandemic has been much stronger than was first anticipated, the calibration of monetary policy is not immune to the relativities of what other central banks around the globe are doing.

Australia is one of the most enviable nations globally on the health front with the handling of the pandemic and the rebound in our economy. However, as a small open economy with a floating exchange rate, what happens abroad has implications for the domestic economy. The pandemic is still in full swing, albeit with vaccines being rolled out, so other developed central banks are still pushing monetary policy settings to the limit.

This has implications for our currency, which in turn impacts overall monetary conditions. If other central banks continue to ease policy and Australia doesn’t follow suit, the Australia dollar would be higher than would otherwise be the case. Hence the reason for the RBA to continue to keep pace with its offshore counterparts by increasing their quantitative easing program.

Given that the domestic economy as a whole is hardly over heating at present there is little to lose by going harder earlier as they can always back pedal if needed. There is still much to do on the employment front to eat into the slack in the labour force. The RBA forecasts has unemployment reaching 5.5% by the end of 2022, which is much improved from previous forecasts but still higher than pre-covid. While inflation expectations are starting to rise, the RBA has made it clear that they need to see wage growth to achieve their inflation target.

More importantly for the RBA is that we are slowly approaching the final step in a significant transition.

Since the pandemic first hit fiscal policy measures have helped immensely in helping the Australian economy avoid a truly cataclysmic economic disruption. It kept people connected to the labour force and put more money in people’s pockets. Much of that money is still sitting in bank accounts. However, many of those support mechanisms are being wound back. At the end of next month, many such as JobKeeper and the JobSeeker supplement will cease to exist.

What that means is we are going to see the main engine of growth transition away from government spending to households and businesses.

The RBA has openly stated their objectives of the current setting of monetary policy. They have suggested that banks have been a little too risk averse in recent times and they want them to get out there and lend. That could result in higher losses but the additional earnings on the growth in lending should offset those losses. The theory is that the increased lending activity will help drive growth.

Whilst this is sound in theory, so far, we are yet to see it transpire. New lending commitments are growing at a solid clip, up 31.2% on last year for housing. Countering this is the repayments of existing loans, which are being repaid at record speed due to low rates. This means the growth of outstanding debt remains muted. It could also be influenced by the fact that many people are rushing out to get approvals due to the favourable conditions but haven’t yet drawn down on the approval.

So instead of a surge in lending, much of the liquidly that the RBA is pumping into the system is sitting idle. It is either being deployed into low yielding liquid assets, being left in Exchange Settlement Accounts (ESAs) with the RBA or being used to pay back higher cost forms of funding such as deposits. This situation is untenable over the long run so it will be interesting to see how it unfolds.

The other key development that the RBA is hoping for is a pick-up in consumer spending. They are hoping that as the government winds back its support measures, consumers will make use of the large growth in savings to sustain spending. Historically the household savings rate has had an inverse relationship with government savings so when the government slows spending, households should start saving less.

How the consumption story unfolds will be impacted by two key elements.

The first is that households will need to be confident in the outlook before running down some of the buffers built up since the pandemic began. Any uncertainty would likely mean households will sit on their hands rather than part ways with their cash.

The other element is having something to spend those funds on. We have seen a huge surge in retail spending after the early days of the pandemic. With international and domestic travel, along with many services being unavailable during the pandemic due to government-imposed restrictions, retail spending was the big beneficiary. With flash lockdowns still continuing as outbreaks emerge, many services are still limited or not available. So, retail spending could remain strong for a little while longer.

With a vaccine expected to begin rolling out later this month, it should be accompanied by an increase in confidence, absent any further Covid-19 outbreaks, which will underpin the outlook. If that is the case, there is a good chance the economy can make a reasonably smooth transition away from government led growth back toward consumption driven growth. If not, we could see a few more bumps in the road before a truly sustainable recover emerges.

Outlook for Interest Rates

Given the RBA current monetary policy settings, the outlook for interest rates is very much about context and what rate we look at.

If looking at the cash rate, then according to the RBA there is little chance of it moving before 2024. At their latest meeting, where they announced an additional $100bln in Quantitative Easing, the RBA concluded their accompanying statement by saying:

“The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.”

This implies the front end of the curve is expected to remain anchored at almost 0% for some time to come. Before the RBA touches the cash rate, they will look to unwind many of the other elements of monetary policy that have emerged since the onset of the pandemic.

The first thing to go is likely the Term Funding Facility. After drawing the bulk of their initial allocations under the program, the second round of funding under the facility is essentially untouched. That means there is still close to $100bln of funding available to be drawn by banks at a rate of 0.10%.

On top of that, there is already so much excess liquidity in the banking system that there is almost $130bln in excess reserves sitting with the RBA in Exchange Settlement Accounts. Usually, those funds would attract a rate of 25bp under the cash rate. However, with the cash rate at 0.10%, those funds are currently earning 0%. That means that there is so few options for banks to use those funds that they are sitting idle earning absolutely nothing. It also means that the banking system could fund almost $230bln of loans without the need for any additional funding at present.

Given the sheer quantity of funding available that is currently earning nothing or at a rate of 0.10%, it means that other sources of funding will not be too desirable over the months ahead.

Next in line to be removed by the RBA is the target rate of 0.10% on the Australian Government’s 3-year bond. After initially buying bonds to help with the functioning of the bond market in the early days of the pandemic, the RBA has not had to do a whole lot of buying to defend this target rate. The fact that there is so much liquidity in the system and that they have an open-ended commitment to defend the rate has meant it has largely remained around the target range.

Along with the cash rate target, the 3-year target has helped to anchor the risk-free rate out to three years. This, along with quantitative easing, has dragged down spreads on other securities such as semi government and bank debt, relative to the government rate as well. Recent developments beyond the three-year range are less predictable.

With vaccines being rolled out around the world as fiscal and monetary policy remain extremely accommodative, yield curves are on the move. A combination of an economic rebound and a pick-up in inflation has seen long end rates steadily rise in recent months. The 10-year government bond rate in Australia has risen from a low of 0.61% during the depths of the pandemic to be sitting at 1.25%. That means that the spread between the 2 and 10 year rate, a common benchmark for curve steepness, has risen to 115bp, the highest level in 7 years.

A snap back in global growth, which is in turn accompanied by demand driven inflation through wages growth would be welcomed. It would also precede an unwinding of many of the stimulus measures and a normalisation of monetary policy settings. However, if inflation driven by supply chain changes and disruption occurs, then the RBA and other central banks could find themselves in a bind.

So, while the outlook for interest rates from a cash rate perspective is very stable, beyond that there is uncertainty creeping into the outlook for interest rates more broadly. The RBA will be watching this space closely over the months ahead to ensure these various developments do not derail the achievement of their objectives.

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. The RBA have upgraded their forecasts for growth in their latest Statement on Monetary Policy. 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 strongly. Over December another 50 000 jobs were added leaving the unemployment rate at 6.6%. Remarkably, the participation rate is higher than pre-Covid levels, being at 66.2%. Another 112 000 full time jobs are needed to recover to pre-Covid levels, while there are 24 000 more part time employees than pre-Covid. 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. They were up 2.3% over January, which is 5.3% higher than pre-Covid levels.
  • Business confidence and conditions have strangely been uncorrelated over December and January, but both have rebounded very strongly and are above long run averages. Confidence fell from 13 to 5 in December but has since recovered to 10 as Covid fears alleviated. In contrast to this, conditions were up from 8 to 16 in December then levelled out to 7 in January.
  • After reaching lofty heights in November, December consumer confidence levels dropped 4.5% following lockdowns in Sydney and the border closures towards the end of the month. Confidence stands at 107, which is still 14.6% higher than last year. It will remain vulnerable to Covid induced lockdowns, but with income levels high and vaccine distribution imminent there is plenty of scope for sustained levels of high confidence.
  • Retail sales were volatile over November and December. Retail sales were up 7.1% for November off the back of a 22.5% rise in Victoria. This has since levelled out following a 4.2% fall in December. They remain a strong point for the economy, being up 6.4% in real terms on last year. Uncertainty with lockdowns, income levels as government spending eases and the potential for spending to switch to services as economies open up mean retail sales will likely continue to be volatile.
  • Low interest rates and the Government’s homebuilder scheme has led to a sharp rise in housing finance approvals. Overall new housing finance is up 31.2% on last year following rises of 8.6% in December and 5.6% in November. Refinancing is part of the story, but more significant is first home buyers, whose approvals are up 56.6% on last year. The approvals are yet to flow through to overall credit growth, as the pace of repayments outstrips new approvals and others forms of credit remain sluggish.
  • Australia’s trade surplus yo-yoed over November and December. It dipped in November as imports shot up 9.3%, then bounced back over December to be $6.8 billion up from $5 billion. The main influencers continue to be strong demand for our metal ore exports, which contributed to a 2.8% rise in exports over December. Imports have also fluctuated as domestic demand has been unpredictable with lockdowns. Imports and export values remain below pre-Covid levels.
  • The end of the $25 000 grants under the HomeBuilder scheme has sparked a surge in building approvals. They were up another 10.9% in December, leaving them 22.8% higher than last year and 57% higher than the Covid lows. $15 000 grants are available until the end of March, so approvals are set to remain strong at least until then.

David Flanagan

Head of Money Markets