• After a world record run of almost 30 years of uninterrupted growth, Australia is now officially in a recession.
  • There was one sector of the economy that accounted for almost the entire decline in growth over the quarter.
  • That same sector also holds the key to the outlook.
  • This month also saw the first change to monetary policy settings since the RBA’s emergency board meeting back in the middle of March this year.

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

  • There was one change made to the current setting of monetary policy. The RBA increased the amount of funding available to banks through its Term Funding Facility and extended the window in which funds can be draw down
  • 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.

  • Interestingly, despite the huge excess of liquidity still in the system, the yield curve in Australia has steepened a little over the month with the 10 year futures rising 13bp. Rates out to three years remained largely unchanged due to the RBA’s maintenance of the yield curve target.
  • The AUD continues to trend higher; however, volatility has increased over the past month. 

  • The USD yield curve has also drifted higher over the past month. Fed Chairman Powell’s comments around moving to an average inflation rate target rather than a strict 2% was largely behind the move.

Recession Confirmed as Household Consumption Collapses

Australia’s record run of nearly 30 years without a recession has officially come to an end. As was widely expected, growth in the second quarter was substantially impacted by movement restrictions and other measures designed to reign in the spread of Covid-19.  In what was a result that could have been a whole lot worse, the offical result was a 7% decline in activity.

On a global scale, the economy has outperformed many other developed nations. Many other countries across Europe along with the US experienced much larger contractions in activity in their respective economies. Rate cuts and targeted fiscal policy measures that included direct payments, income support and access to super all helped to boost household disposable income and limit the damage to the economy to a certain extent.

Almost the entire fall in GDP over the quarter was driven by a 12% decline in household consumption. That on the surface is somewhat confusing given retail sales have experienced a strong rebound since the collapse in April as lockdown measures hit.

Rather than spending on retail, it was spending on services that bore the brunt of the decline. In some cases, spending on services was impact by restrictions designed to suppress the spread of Covid-19 and in others, especially for discretionary services, were a result of reduced demand.

The data also threw up some interesting outcomes. Despite wages falling for the quarter, household disposable income was actually higher due to the government payments. With such a large fall in household consumption, the net difference with the increase in income saw the savings rate surge to 19.8%, the third highest read on record. The only two quarters it has been higher since 1959, was September 1973 and June 1974.

Both of those data points will be crucial to the long term outlook for the economy.

As the GDP data highlighted, the government helped prop up household incomes as wages fell. Much of this support evident during the quarter will be tapered over the quarters ahead. JobKeeper and increases to JobSeeker will be trimmed at the end of this month and again at the end of the year based on current policy announcement. Super withdrawals are now largely complete as are the two additional $750 payments to welfare recipients.

As we saw last month, the RBA still expects the unemployment rate to continue to climb towards the end of the year. It is expected it will hit 10% and according to forecasts, only fall to 7% by the end of 2022. That means in the absence of more fiscal support, growth in household income is going to be weak, even with the proposed pulling forward of income tax cuts.

But what about all that savings?

The surge in the savings ratio was something we also saw during the GFC. In times of uncertainty, people naturally take a more conservative approach and trim spending and focus on debt repayment and saving until the confidence in the outlook returns. During the GFC the savings rate jumped from almost 0% to 10%, the average savings rate since 1959 when the data began. It then took more than 7 years before it fell below 5%.

Such a surge in the savings ratio was exasperated by an increase in disposable income combining with a collapse in household consumption. It is unlikely that the savings ratio will remain near 20% over the quarters ahead as disposable income growth will slow and consumption will start to pick back up with most state economies reopened. Just where the ratio normalises at after the Q2 shock will give us a much greater insight into the outlook for the economy.

After falling by 7.24% over the first half of the year, the economy is now expected to grow by 1.33% over the remainder of the year according to the RBA’s most recent forecast. That means growth for the calendar year will be 6% lower than the previous year. The RBA then expects the economy will pick up pace and grow at an annual rate of 4% to 5% over the next couple of years. Whether or not this outcome is attainable will be largely determined on household consumption.

Outlook for Interest Rates

At their September Board meeting, the RBA made the first change to their four pronged Covid Policy response that was announced in at an emergency meeting back in March. The RBA announced they would both increase and extend the Term Funding Facility.

Following the decision, the RBA highlighted increasing the size and extending the drawdown window would “help keep interest rates low for borrowers and support the provision of credit by providing ADIs greater confidence about continued access to low-cost funding.”

The cash rate and yield curve target on the 3 year Australian government bonds and the term funding facility have combined to increase the amount of cheap funding available in the banking system. This in turn has dragged down borrowing costs as was intended.

However, there are some unintended consequences of the current policy settings.

With consumer confidence low and unemployment high, the banking system is struggling to generate a net increase in outstanding credit. The fall in borrowing rates has sparked a high refinancing war as borrowers shop around for the lowest rate. Meanwhile those that have seen their rate lowered are paying down more or increasing balances in offset accounts. That is where much of the increase in the savings ratio outlined above has ended up.

That means any new lending is often at the expense of another bank. It also means an increase in lending activity is more than offset by the faster amortisation of existing loans. This is evident in the RBA’s credit aggregates where total outstanding credit has fallen for the past two month. So far it has been driven by falls in personal credit, business credit and investor lending. Owner occupier credit is the only segment still seeing some net growth.

With total credit growth going backwards, the banking system is having trouble digesting all the cheap funding that is on offer from the RBA. In order to draw down the funding from the RBA, they are needing to reduce the level of funding from other sources. That means running down things such as wholesale and retail funding.

In order to do that, rates on cash accounts and term deposits continue to fall. With the Term Funding Facility now available through to the middle of next year, there is also little need for banks to issue new longer term bonds. That has seen the rates and availability of fixed income securities continue to decline. The one exception has been Australian Government and Semi Government securities where supply is still plentiful as governments continue to need to fund spending programs to support the economy.

The RBA will be hoping that lower borrowing costs will help households and businesses in reducing their interest burden and in turn help stimulate consumption and investment. If the RBA remains unhappy with the progress being made, there are other options at their disposal.

At present, taking the cash rate lower or even into negative territory remains unpalatable. Intervening directly in currency markets to lower the AUD to support growth is seen as somewhat futile given the size of the intervention that would be required in such a deep and liquid market.

That means the RBA’s next move, if it is required, would be to push out the yield curve target. They could push it out to the 5, 7 or 10 year mark. It would be expected a lowering of the yield curve would lower the interest rate differential between Australia and other nations and help put pressure on the AUD. However it is still questionable how much impact a lower AUD would have at present.

As far as the longer term outlook goes it will be sometime until we see the RBA moving in the other direction. Unwinding the current settings of monetary policy is likely to prove far more difficult than implementing them.

Australian Economic Highlights

  • As was expected Growth slowed sharply in the second quarter. Economic activity fell by 7% over the quarter with a 12% fall in household consumption accounting for the bulk of the decline. The outcome pushes the economy into a technical recession for the first time 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 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 July saw total employment jump 114,700 people as the economy continued to reopen. Despite the jump, the unemployment rate continued to climb, hitting 7.5% as people started to re-enter the workforce (participation rate up 0.6% to 64.7%). The official statistics continue to be distorted by government policies with the true level of underemployment closer to 20%.
  • The ANZ Job ads report indicated that the rebound in job advertisements stalled in August with a soft 1.6% rise after increases of 41% and 19.1% the previous 2 months. Job ads remain 27% below their pre-crisis level.
  • Business confidence continues to drift lower after initially recovering from the sharp fall at the outset of the pandemic. The improvement in Business conditions has proved short lived with it falling back into negative territory. The big concern was the big driver behind the fall in conditions was the employment index which dropped from -2 to -13.
  • After rebounding from the April lows, consumer confidence has continued to fall. After falling 6.1% in July, confidence fell a further 9.5% in August according to the monthly survey. The biggest concern from the survey is the rise in the unemployment index indicating that consumers fell less secure with their employment which is a bad sign for the outlook for consumption.
  • Retail sales remain the main beneficiary from the governments support program. Retail sales were up a further 3.2% in July to be up 12% over the past year. As was evident in the GDP figures, the collapse in spending on services continues to outweigh the increase in retail spending.
  • 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 narrowed sharply in July, falling from more than $8bln to $4.6bln. The outcome was driven by a sharp rise in imports, up 7%, which was encouraging, however exports were down 4%.
  • Building approvals jumped 12% in July thanks to an 8.5% jump in private housing approvals in a sign that the governments Homebuilder program is having some impact on the outlook for the construction industry. The big question remains will the pipeline of new activity be enough to fill the gap created by current projects coming to completion.
David Flanagan

David Flanagan

Director Interest Rate Markets