–  AUGUST 2020 INSIGHTS BY THE CURVE TEAM –

Highlights

  • Hopes of a swift recovery from the Covid-19 pandemic are slipping away based on the latest update from the RBA .
  • The second wave of the virus in Victoria is only part of the problem with the scars of the current crisis to be with us for some time.
  • Risks are still skewed to the downside with the RBA’s baseline scenario still looking too optimistic.
  • Despite the current settings of monetary policy remaining unchanged, the RBA is buying government bonds again amid calls for further policy support.

Rates Recap

  • The RBA left the cash rate and its yield curve target unchanged once again in August.

  • In light of their downgraded forecasts, the RBA defended that they were doing all they can to “support jobs, incomes and businesses in Australia” by defending inaction on AUD, use of negative rates and the financing of government debt in the subsequent quarterly Statement on Monetary Policy (more below).
  • Benchmark rates such as BBSW and Swaps remained largely unchanged once again over the past month while deposit rates and bond spreads continued to decline.

  • An abundance of liquidity and a lack of credit growth continue to distort market rates despite benchmarks remaining stable.
  • The AUD continues to trend higher, however momentum has slowed over the past month as it struggled to continue to make new highs. It is very much tied to risk assets as present and where they go it seems to follow.

  • The USD yield curve has flattened over the month as the virus continues to take hold around the country and the economic outlook deteriorates.

RBA’s Outlook Highlights Harsh Reality

Three months ago, the RBA attempted to provide some forward guidance around the outlook, delivering updated forecasts in the midst of the biggest global pandemic in a century. In doing so they provided a Baseline scenario along with Upside and Downside scenarios, giving us a broad range of potential outcomes.

The good news three months later is that “the contraction over the first half of 2020 was smaller than anticipated three months ago.” Unfortunately that is where the good news ends.

According to the latest update from the RBA in their Quarterly Statement on Monetary policy “the pace of recovery is expected to be slower than previously forecast.” One of the core reasons for this, beyond the second wave of the virus in Victoria and the subsequent implications for the outlook, is that “generalised uncertainty and deficiency in demand have turned out to be more of a drag on growth than previously thought”.

As the Statement went on, the caution around the outlook continued with the RBA stating that “although a gradual recovery is underway, the nature and speed of the recovery remains highly uncertain and the pandemic will have long-lasting effects on the economy.”

In the early stages of the pandemic, there was some hope that if Australia and the globe could contain the virus, the economic pain would be short lived and and an ensuing rebound in economic activity would be robust. Unfortunately, the pandemic has had a resurgence in Australia and never really slowed in some nations, especially in the United States.

The RBA outlines three key reasons why hopes of a snap back in economy growth have faded:

“There are a number of reasons why activity is unlikely to bounce back completely after lockdowns end. Firstly, some activity restrictions usually remain even after the most stringent lockdown measures are lifted. Secondly, some people continue to engage in some social distancing beyond what is mandated. Thirdly, and probably most importantly, the deficiency in demand and a general increase in uncertainty induces people and firms to be more cautious in their spending decisions. So demand remains weak for some time.”

As a result of the weak recovery, employment growth will be the greatest challenge for policy makers on the other side of this pandemic. With our international boarders closed indefinitely, the prospects of the economy being able to pivot and replace the lost growth are slim. Even under the RBA’s optimistic forecasts for growth in the outer years of its forecasts, the unemployment rate is expected to remain stubbornly high.

The Statement made this point clear, saying that:

“Even prior to the most recent set of restrictions applied in Victoria, the outlook for much of the economy was very uncertain, and forward indicators of activity and the labour market were weak. It will take a considerable period of time to recover the lost output and employment resulting from the COVID-19 outbreak.”

A strong employment market is essential for overall growth, especially in a service based economy such as Australia. Without core components of the economy firing, there is less need for services than those who are employed in core sectors to spend their money on. A strong employment market is also important for wage growth.

In their Statement, the RBA also provided a pretty harrowing outlook for wage growth. While the forecasts point to wage growth between 1% and 2% over the forecast periods, the statement also said that:

“Around 35 per cent of firms in the liaison program expect to implement a wage freeze in the year ahead. Overall, around half of the surveyed firms expect wages growth to be lower in the year ahead than the current rate of growth, as a result of wage freezes and smaller wage increases.”

With unemployment remaining elevated and wage growth flatlining, it is hard to envisage an economy growing north of 4%. However, that is exactly what the RBA is forecasting. After declining throughout 2020, the economy is expected to bounce back and grow by 5% in 2021 before easing back to a growth rate of 4% in 2022.

Let’s put that in perspective. The economy grew at an annual average rate of 3.6% between the end of the recession in the early 90s and the GFC. Since then, the annual average pace of growth has slowed to closer to 2.5%. That slowdown has come despite interest rates falling to record lows.

If we take that one step further and look at per capita growth, the annual average rate has slowed from 2.4% prior to the GFC to under 1% since the GFC. That means if we account for population growth, the economy was barely growing at all in the lead up to the onset of Covid 19. Why is per capita growth now more important that ever? Because our international boarders are going to be closed for the foreseeable future and migration has been a large source of population growth in many years.

The bottom line from all of this is that unemployment is going to be high, wage growth low and overall economic growth weak for some time to come. That also means that it is going to be some time before the RBA can hit its mandate of achieving core inflation between 2-3% and full employment.

With the RBA unlikely to achieve their mandate over the forecast period, calls are growing louder for more to be done. Suggestions such as taking rates negative and expanding Quantitative Easing to other assets as the Fed has done overseas.

However, the recent experience of the Australia economy would suggest that any further easing would be a fruitless exercise.

Borrowing rates prior to the pandemic were already at record lows and credit was plentifully available to those who wanted it. Despite this, growth was weak and slowing. Wage growth was low and unemployment remained stubbornly above a level consistent with full employment. That suggests cheap and plentifully available credit is not the biggest issue facing the Australian economy.

Both globally and domestically, central banks have been relied on to smooth the business cycle for too long. Interest rates have been lowered time and time again and debt levels have exploded at almost every level; households, businesses and governments. Going further down this path might help in the short run but it won’t lay the foundation for a sustainable increase in long run growth.

It is time to address long run structural issues plaguing both domestic and global economies. Falling interest rates and abundantly available credit has made households, businesses and government’s lazy. Debt has been used largely for unproductive purposes rather than to build productive businesses and infrastructure. It is now time for both sides of politics to stand up and provide solutions.

New and innovative policies are needed to foster an environment in which entrepreneurial businesses can come forth and carry the economy forward. Most established businesses are fighting for survival and will continue to manage the margin at the detriment of employee numbers. A new direction is needed as more of the same will only take us further down an unsustainable path.

Outlook for Interest Rates

The RBA remains staunch in their desire to support the economy through the Covid-19 pandemic. They once again concluded the accompanying statement to their August Board meeting by saying:

“The Board is committed to do what it can to support jobs, incomes and businesses in Australia. Its actions are keeping funding costs low and assisting with the supply of credit to households and businesses. This accommodative approach will be maintained as long as it is required. The Board will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band.”

In the subsequent quarterly Statement on Monetary Policy, released on the Friday after the meeting, the RBA also alluded to an ongoing review of their current stance of monetary policy that had taken place.  As part of the review, the “Board also discussed experience with a range of other possible monetary measures, including foreign exchange intervention and negative interest rates.”

It was like they were anticipating the wave of calls that would come for them to provide more support in the wake of their updated forecasts. The RBA was transparent as to the outcome of the review, stating that:

“The Board concluded that, at a time when the value of the Australian dollar is broadly in line with its fundamentals and the market was working well, there was not a case for intervention in the foreign exchange market. Intervention in such circumstances is likely to have limited effectiveness.”

AND

“The Board continues to view negative interest rates as being extraordinary unlikely in Australia. The main potential benefit is downward pressure on the exchange rate. But negative rates come with costs too. They can cause stresses in the financial system that are harmful to the supply of credit, and they can encourage people to save rather than spend.”

They also had something to say to those who have been calling for the RBA to directly monetise the Government debt to support Government spending to prop up the economy. The Statement said that:

“The Board also reaffirmed the importance of the longstanding principle of separating monetary policy from the financing of government. This principle has served Australia and other nations well. Australian governments are currently able to fund themselves at historically low interest rates and have retained ready access to capital markets. Monetary financing of budget deficits is not an option under consideration in Australia.”

One thing that the RBA did flag this month was that they would be re-entering the market to purchase more government bonds. With their yield curve target of three years starting to straddle the April 23 and April 24 maturities, the RBA has over the past few days bought additional government bonds. The yield at around three years hadn’t deviated too far from the target. Also, the new volumes purchased have been quite small so it appears more of a reminder to the market that they stand ready to defend the target level if and when required.

So the summary from this month’s RBA updates is that the current setting of monetary policy is here to stay. We are certainly unlikely to see any tightening of policy setting for some years. If anything we might see some adjustments to the yield curve target but even that seems unlikely in the near term.

What continues to evolve is the impact that the RBA’s current policy settings are having on market based interest rates. Benchmarks such as the actual overnight cash rate, BBSW and swaps have remains rather steady. However bond spreads and deposit rates continue to fall.

These declines have been driven by a couple of main factors.

One is the abundance of liquidity that the is currently sloshing around the market and broader economy. Broad money has surged in recent months. The RBA is partly responsible as they have made liquidity abundant as to assist market functionality and credit availability. Unfortunately credit growth is going backwards as repayment of exisiting debt outpaces new debt growth, adding to the liquidity dilemma.

Government stimulus and lock down measures have also added to the liquidity problem as households are receiving payments but can’t readily spend or are choosing to pay down debt and boost savings instead.

With government support being tapered back slowly in the coming months this could reduce some of the liquidity build up. The closure of the Term Funding Facility drawdown window is also fast approaching. Once this widow closes, liquidity pressures could also abate a little.

What that means is at least until October, we are going to be dealing with an ongoing abundance of liquidity putting downward pressure on margins and deposit rates. Beyond that it is a little more unknown as stimulus measures and loan growth are largely contingent on how the economy evolves in the face of the ongoing virus fight.

Australian Economic Highlights

  • Growth for the first quarter dipped into negative territory, falling by 0.3% with the economy slowing as Covid-19 containment measures ramped up. It means with the second quarter expected to be deeply negative, the Australian economy is in the midst of its first technical recession in almost 30 years.
  • Inflation fell heavily in the second quarter as was widely expected. The headline inflation index was down 1.9% taking the annual rate to -0.3%, the first annual fall in prices since the Asian crisis in the late 90s. The last only other negative read was in the early 60s. The trimmed mean was also negative, falling 0.1% over the quarter with the annual rate slowing to 1.2%. Inflation is expected to bounce back in Q3 as one-off impacts are reversed.
  • The Employment data for June saw total employment jump 210,800 people as the economy continued to reopen. Despite the jump, the unemployment rate continued to climb, hitting 7.4% as people started to re-enter the workforce (participation rate up 1.3% to 64%). The official statistics continue to be distorted by government policies with the true level of underemployment closer to 20%.
  • The ANZ Job ads report saw new job ads continue to rebound from their crisis lows, rising a further 16.7% in July after rising 41.4% in June. Despite the solid bounce job ads are still significantly below pre-pandemic levels.
  • Business confidence soften in July, even before Victoria announced the stage 4 lockdowns with the index falling from 1 to -14. Business conditions improved again with the index climbing from -8 to 0 as the country continues to slowly reopen. However that could change as the fallout from the escalation in Victoria ripples through the economy.
  • After rebounding from the April lows, consumer confidence has started to soften once again as the second wave of the virus has taken off in Victoria. Interestingly, consumers still tend to look more favourably at their own finances, thanks to government support measures, while holding greater fears over the outlook for the economy. This could change as support measures are tapered in coming months.
  • Retail sales continued some of the momentum experienced in May with another reasonable rise in June where total sales climbed 2.7%. While sales have bounced back strongly it will do little to help growth. When adjusting for inflation, total retail sales actually fell for the quarter. It is likely overall consumption for the quarter will be much worse than the 3.4% decline retail sales suggests. This is due to the fact spending on services makes up a larger chunk of household consumption and would have experienced a far more acute decline during the quarter.
  • New housing finance approvals showed some signs of life in June as the economy continued to reopen. The value of Owner Occupier approvals were up 5.5% with investor approvals up 5.5%. Both measure remain well below pre-pandemic levels.
  • Australia’s trade surplus remained elevated in June with exports continuing to outstrip imports by a considerable margin. The trade surplus came in a touch above $8bln, exports rose 3% and imports were up 1%.
  • Building approvals remain in free fall as the economic outlook sours. Total approvals were down a further 4.9% in June and have fallen for 4 straight months. Concerns are growing over what will happen to the construction industry once projects currently underway come to completion.
David Flanagan

David Flanagan

Director Interest Rate Markets