The moving of the interest rate goal posts on Melbourne Cup day by RBA governor Philip Lowe was described as very elegant. If that was the case, I would not want to see him in a barn-storming mood. Clearly, Lowe is not an advocate of thoughtful disagreement, labelling the bond market’s pricing of short-term maturities as a “complete overreaction” to the 0.7% spike in the September quarter core (trimmed mean) inflation.
This spike pushed the central bank’s favoured inflation metric to 2.1% and into the long-held 2–3% band, the first time the reading was above 2% in six years and well before expectations.
The 0.10% yield curve target on the April 2024 maturity was an integral part of the former commitment to not raise the official cash rate until “at least 2024”. The scrapping of the unconventional and controversial yield curve control in reaction to the bond market’s behaviour is a backdown. Lowe elegantly explained “its effectiveness as a monetary policy tool declined as expectations about future interest rates shifted due to a run of data and forecast progress towards our goals.” Interestingly, it was the expectations of others, rather than the RBA, to the “run of data” that triggered the change.
The breathtaking moves at the short end of the Australian yield curve last week reflected the yawning gap between the opinions of the two opposing parties, which came to a head on Friday.
Whether a capitulation or not, the RBA has signalled a change. The 2024 line in the sand for raising interest rates has moved forward into 2023. The bond market continues to price in rate hikes in 2022, but the governor is still struggling “with the scenario that rates would need to be raised next year.” While giving some ground by abandoning yield curve control, Lowe believes based on the RBA’s forecasts it is “entirely plausible” the first increase in the cash rate will not be before the April 2024 maturity. Though on Australia’s biggest gambling day, he had an each-way bet “but it is now also plausible that a lift in the cash rate could be appropriate in 2023.”
The $4bn weekly asset purchases will continue through February, around $64bn in total, and will influence funding rates across the economy, as the yield curve control had done since March 2020. But that does not guarantee commercial banks will not raise rates in the meantime. Their borrowing costs are determined by international bond markets, not the Australian official cash rate. Further easing is highly unlikely, meaning the next move will tighten. Once the taper begins, probably in March 2022, all bets are off as to when interest rates rise.
Despite bullish economic growth forecasts for 2022 and 2023 and elevated asset price inflation, why is the RBA so convinced interest rates should not rise until late 2023? Is it because companies will likely be reluctant to lift a large portion of their fixed costs (wages) as international borders are about to reopen and foreign workers are able to return?
Lowe suggested Australia is different to other countries with falls in the participation rate seen offshore not yet evident here, but that surely reflects a tighter labour market. Interestingly, the US participation rate has increased from 61.4% in January to 61.6% in September, easing from 61.7% in both July and August. Australia’s rate is down from 66% in January to 64.5% in September. It has been falling from June’s 66.2% print for three consecutive months.
While we were focused on our backyard, economic data elsewhere suggests the ‘transitory’ tag could also be attached to several other metrics, not just inflation. Some central bankers, economists and commentators have been quick to suggest inflation’s supply-side pressures are transitory, while believing the demand-side forces are enduring. There is little, besides a quiet prayer, that policymakers can do to influence or change supply-side issues. Their toolboxes are only stocked with demand-side tools of monetary and fiscal policy.
The Fed fires the starting gun on the taper
Monthly assets purchases will be trimmed by 12.5% from US$120bn to US$105bn starting mid-November and will reduce by the same amount in December. Expectations suggest the taper will be completed by June 2022, however depending on incoming economic data, it may be earlier or later. Regardless of the duration of the process, this taper is much faster than its 2013 predecessor, with Fed chair Powell explaining this was due to “very very very strong demand.”
It appears the Federal Open Market Committee (FOMC) is adopting a cautious rather than a dismissive stance about inflation. Much hinges the definition of full employment in a post-pandemic environment. The current participation rate of 61.6% is below the long-term average of 62.9 from 1948–2021. If this is a permanent change, then perhaps full employment will be reached sooner, and the dual mandate settings would indicate rate increases will closely follow the completion of the taper. This would suggest increases starting in the September quarter of 2022.
The bond market’s reaction to the Fed’s taper announcement was to push yields at the long end moderately higher, with the yield curve steepening. The 10-and 30-year yields rose by 5 and 8 basis points, respectively. The completion of the taper process will end the annual purchases of US$960bn of Treasuries and $480bn of agency mortgage-backed securities. This will leave a US$1.44 trillion vacuum to fill on the buy side of the US bond market. The likely outcome is for yields to rise, even without inflation issues.
On the other hand, bond bulls believe the enthusiasm around the strength of the economic recovery and its duration is misplaced with growth falling back below long-term trend in 2023 after a spurt in 2022.
The close correlation between the rate of growth of the Fed’s balance sheet and the S&P 500 is uncanny. Despite spelling out the taper process quite clearly, expect volatility in equity markets. But the taper is likely to be ending as economic growth in 2022 is peaking.
Overseas data causing a re-think?
The US headline GDP growth came in at 2.0%, well below the consensus of 2.7%. It was down sharply from 2Q’s robust 6.7%, savaged by the spread of the Delta variant and consequent shutdowns. Personal consumption (consumer spending), the lifeblood of any economy, increased at an annual clip of just 1.6%, down from double-digit growth in both 1Q and 2Q of 11.4% and 12.0%, respectively. Undoubtedly, 4Q GDP will show a strong recovery, but will it match the Fed’s implicit forecast of 8.7%?
Interestingly, personal incomes dipped a large 1% in nominal terms and 1.6% in real terms in October, considerably worse than consensus estimates. The slide in October was due to the significant fall in fiscal handouts, which more than offset increases in wages. With growing consumer demand and falling real incomes, the savings buffer is depleting quickly. The personal savings rate, which peaked at 26.6% when handouts also peaked in March is back at 7.5%, just below the pre-pandemic level of 7.8%. (Exhibit 1)
China’s latest official Purchasing Managers Index (PMI) provided a sombre snapshot of the health of the world’s manufacturing hub. October’s reading of 49.2 was down from 49.6 in September, the second consecutive contraction in factory activity and below expectations of 49.7. A reading below 50 signals contraction, above expansion. The production and new orders subindices contracted to 48.4 and 48.8, respectively while the subindex for outprices soared to 61.1, the highest since 2016. This reflects rising inflationary pressures while economic activity and output slows. This is not an attractive combination and does point to a potentially low growth quarter to farewell 2022.
Industrial production rose 3.1% year-on-year in September, the weakest pace since March 2020 with environmental curbs, power restrictions and rising raw material prices acting as a brake. But for the nine months to September industrial production grew at 11.8% year-on-year, still a solid performance overall. (Exhibit 2)
As US markets continue to make new peaks, investors are displaying confidence in the economy’s recovery. Solid 3Q earnings reports reflect strong consumer demand which has tempered concerns over supply-chain disruptions and consequent rising prices. The CNN Fear and Greed index is now in the Extreme Greed zone.
With complacency running high, those investors will be hoping alleged transitory symptoms in inflation are not contagious and don’t spread to other critical underlying demand-side economic metrics.
Reproduced from Morningstar, written by Head of Equities Research Peter Warnes.