Category Archives: terms of trade

Strayan Rates – Part 2: Terms and Conditions

The most recent resource boom in Australia has by most measures been the biggest. The prices we receive for our exports relative to our imports, the terms of trade, reached never-before-seen heights. Furthermore, the boom ran longer than any preceding it.

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This experience dramatically realigned Australia’s trading relationships.

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And greatly accelerated the evolution of the industrial composition of the economy, with manufacturing’s share of output now among the lowest in the OECD.

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The cornucopia was at its fullest in 2011, and since then the trend in commodity prices has been down…

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…led by iron ore and the coals, which together account for roughly 35% of Australia’s exports.

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Commodity prices move in familiar cycles: Demand rises, with supply initially unable to keep apace, sending prices higher. Over time, elevated prices encourage large amounts of capital to be allocated towards supply expansions. Often, demand peaks and starts to decline around the same time that supply catches up, and prices bust.

Australia has witnessed enormous investment into its commodity sectors, raising output of key exports; we are right in the thick of the supply expansion stage.

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This dizzying surge in export volumes is regularly adduced to assuage concerns around lower prices. However, if we consider iron ore, it must be remembered that the recent price decline (over 35% this year in AUD-terms) has largely been a consequence of increased supply. If Chinese demand cools materially, the combined effects of rising supply and falling demand risk another more serious leg down in prices. At that point, increasing supply may well be self-defeating (though there are undoubtedly industry-specific strategic factors to consider).

That the boom will pass is something of a truism; in the long run, all commodity booms are dead. The issue for Australia today is whether the adjustment is gradual and orderly, giving us time to adjust our economic settings, or whether it happens in a hurry, with our naked bodies left embarrassingly exposed by the receding tide.

Of course, this process has certainly already begun. Thus far, however, the timidity of a clique of cadres in Beijing has deferred a more serious correction emanating from China. At the same time, Australia has made progress shifting its growth drivers away from mining, towards other sectors. Mostly, housing is picking up the slack. While the uplift in residential construction is welcome, the surge in house prices is less so, and is likely compounding the risks that have been brewing to our north for the past couple of years.

Part 3: China

All charts courtesy of the RBA

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Strayan Rates – Part 1

The economic fate of the world’s inhabitants is remarkably beholden to the trajectories of its key interest rates. Of these, the apex rates are those on US government debt securities. Considerable (though far from absolute) influence is exercised the over these rates by the Federal Reserve, and thus rivers of ink are flowing at present in service of the question, When will the Fed adjust the target federal funds rate?

The answer may not be as momentous, but we’re asking a similar question in Australia. Picking the path for the RBA’s cash rate is a prime task for any would-be economic forecaster, as it’s both a key indicator of economic conditions as well as a critical determinant of them.

Let’s take a look.

Presently the cash rate sits at 2.5%. This is generally reported as being the lowest on record. It certainly is since inflation targeting was gradually adopted in the early 1990s, the period over which comparisons are most relevant.

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Last week Tim Toohey of Goldman Sachs caved and discarded his 2014 rate cut call. That leaves industry forecasters in unanimous agreement (so far as I am aware): the RBA is not cutting interest rates again. Time to fix those mortgages!

So if no more cuts, when will the RBA hike? AMP, CBA, Barclays, HSBC, and St. George reckon Q1 next year. Citigroup and ANZ think Q2. Westpac and JPMorgan are eyeing Q3, and Deutsche Bank thinks not before 2016.

The RBA is evidently happy to maintain its inaction for a while yet, reiterating in the last monetary policy statement that “the most prudent course is likely to be a period of stability in interest rates.” Such tranquillity is unusual. Indeed, if we make it through to April next year, it will mark the longest period absent a change in interest rates we’ve ever known.

In a country like Australia, changes to interest rates tend to be quite effective in influencing economic conditions. Lower rates stoke borrowing, asset prices and consumption, giving way to higher rates, and vice versa. Why then are we drifting across a calm blue ocean of low interest rates?

Primarily due to the uneasy schism that has emerged in our economy. On the one hand we have the descent from what has almost certainly been the biggest terms of trade/investment boom in our nation’s history. On the other we have a raging house bubble boom. Which force prevails in this struggle will determine the short- to medium-term direction of interest rates.

Part 2: Terms and Conditions