Tag Archives: Australia

Iron ore cracks the half-ton

Paging Michael Pascoe, et al: Australia’s most important export commodity is rapidly siding with the doomsayers:

The iron ore crash that so few took seriously is now moving towards its endgame. Australia’s Dog Days have arrived.

But the tragedy-farce is not over yet; there’s still two big projects gearing up this year (h/t DLS):

RIO’s is due to commence production within the next couple months, while Gina’s ore will hit the market in September. And it’s all being dumped upon contracting demand.

We are in the grip of a very severe bust indeed.

For now, however, the impending collapse of Western Australia’s economy is a boon for NSW and Victoria, as it adds to expectations of further rate cuts. Further cuts, in the absence of tough regulatory disincentives, will toss more kerosene on the Sydney and Melbourne property frenzies.

The last cut ushered in a veritable swarm of buying in Sydney. As Domain Group’s chief economist recently put it:

“This is the hottest of hot auction markets ever.”

Obviously this cannot go on indefinitely. The WA export juggernaut is the foundation on which the hyper-financialized East Coast economies rest. Currently there’s a torrent of offshore capital flowing into these markets, so overall conditions are fairly robust. But eventually, without a sustainable, internationally-competitive productive base, bubble economies inevitably unravel. I have my own thoughts on when this might happen and what the triggers might be, but really it’s anyone’s guess.

Updated

Chinese iron ore futures have been crushed again today, currently a whisker away from limit down.

Further into the mire we sink…

Australia’s extraordinary failure

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When I started this blog, I was well aware that its dominant theme was to be the stark divergence emerging between key sectors in the Australian economy: On one hand, the terms of trade were crashing, declining resource investment was primed to rip a hole in domestic expenditure, and Australia’s poor international competitiveness was inhibiting the revival of investment in non-resource tradable industries. On the other hand, we had the cyclical upswing centred on the Sydney and Melbourne property sectors, which policymakers hoped would boost consumer spending and employment growth. Whichever sector gained the upper hand in the short-term, I argued, would determine the next move in interest rates.

As we know, the army of professional forecasters was wrong; the RBA cut interest rates in February this year. Partially as a result of this, the sectoral divergence in the Australian economy has reached truly deformed levels of late.

I say partially for a couple of reason. Firstly, Australia’s external shock has gathered pace quicker than I anticipated (and as anyone who’s read this blog can attest, I’m about as bearish as they come on Australia’s terms of trade outlook!) The relentless slide in iron ore and coal prices (iron ore especially, of course), has hit national income hard and added urgency to the miners’ cost-cutting drive, which directly reduces household income. Furthermore, the oil price bust has hammered the economics of Australia’s gold-plated LNG projects, and ushered in a new emphasis on austerity in that sector as well. These trends are exacerbating the divergence in the economy on the structural side, and are obviously unaffected by Australian monetary policy.

Moving in the other direction with disquieting rapidity is the boom in the East Coast property markets, Sydney’s in particular, which has shifted into a higher gear following the latest stimulus from the RBA. Pick any measure you like; Sydney property is white hot. Auction clearances have soared, investors are increasingly dominating new mortgage issuance, and price growth has rebounded to around 14% from a year earlier.

The property boom on the East Coast is undoubtedly being juiced by lower interest rates. But I believe it is incomplete to assign more than partial responsibility to the blunt tool that is the RBA’s cash rate.

The economy needed low interest rates, and it needs lower ones still,mainly to further reduce the value of the Australia dollar. As national income recedes with the terms of trade, and as resource investment winds down, unemployment will rise sharply unless we can revive activity in non-mining tradable sectors. This is not a lazy ‘competitive devaluation’: Australia had a very strong currency during the boom, and now that the boom has passed it is imperative that the value of the currency falls to match our lower national income and support employment. (Recent falls against the USD are welcome but on a broader basis, particularly against other commodity currencies, there is work to be done.)

So interest rates had to fall to reduce the value of the Australian dollar and repair our international competitiveness, but in so doing they’ve stoked a dangerous boom in property prices (which, incidentally, is a drain on productivity and so worsens our international competitiveness).

To overcome this apparent paradox, the RBA, in tandem with APRA, should have implemented regulatory controls to stifle speculative mortgage lending, especially when funded by offshore borrowings, before embarking on the latest easing cycle. That they did not, so soon after property bubbles ripped apart numerous developed economies, is a blemish on Australia’s economic policymakers. That they were dismissive of such options well into the boom is a serious indictment. That they finally started talking about macroprudential tools 6 months ago, was something of a relief… And that they still haven’t implemented the mooted controls with any bite, at such an advanced stage of the boom, is frankly an extraordinary failure.

Not only has this failure to act sowed systemic risks into the economy at about the worst possible moment, it is also seriously hindering the restoration of Australia’s international competitiveness; there are now strong indications that the RBA will have to hold off cutting interest rates for fear of fueling the rampaging property leviathan. From Peter Martin this on Friday:

Concern about the Sydney property market is shaping as an impediment to another interest rate cut at the Reserve Bank board’s next meeting in April, encouraging it to postpone the decision until May, a week before the federal budget.

A month of two more with an extra 25bps on the cash rate is not going to rein in the investor frenzy. Only rate hikes or a tough macpru regime has only prospect of success. Does the RBA want to sacrifice the wider productive economy to calm the passions of a property investors, or would be it preferable to slap tough, targeted regulatory impediments on the industry and carry on with the post-boom adjustment of lower rates and a lower Aussie dollar?

Strayan Rates – November Update

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Let’s start with a quick refresher on where we’re at.

There have been strong countervailing forces exerting themselves on Australia’s economy this year, and this is why the cash rate has gone through an unusual period of stability. The cyclical boost from the last easing cycle has not been sufficient to overcome the structural drag of the softening resource sector, and so the RBA has been unable to seriously countenance higher rates. At the same time, house prices, especially in Sydney and Melbourne, have appreciated excessively, and this has left the RBA reluctant to cut further.

As I’ve hopefully argued with clarity thenceforth, my view at the time of this blog’s establishment was that the structural headwinds battering the Australian economy were too potent for the traditional interest rate-exposed sectors (housing and consumption) to overcome, and so interest rates would fall further before they rose. I have strived to present all possible circumstances that would invalidate this view, but for me none of the arguments against further cuts has been satisfactory.

Developments over the past month have mostly favoured a dovish view on rates. The most important has been the rout in iron ore prices, which has challenged widely-held expectations, my own included, that the final quarter of this year would deliver respite for iron ore producers. Economic policy in China is shifting to a more stimulatory footing, which many hope will presage an improvement in the fortunes of bulk commodities. However, there seems scant chance of the resumption in credit growth and investment being substantial enough to achieve this. Domestic capital expenditure held up better than expected in the third quarter, though was still down 8% from a year earlier.

On the cyclical side, the housing prices were flat in November, with building approvals down sharply and credit growth accelerating slightly. Retail sales were healthy enough, though households appear disinclined to eat into savings. There hasn’t been a material slowing of activity on the cyclical side to warrant cuts just yet, but neither is there much sign of sufficient pressure to raise them.

Terms of Trade

The news this month for Australia’s key commodities has been dour. Iron ore has suffered grievously, a few months ahead of my expectations. There’s increasing agitation globally for reduced dependence on coal, and LNG is facing its own ‘iron ore moment’ due to lacklustre demand and crashing oil prices.

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Coal’s days of boosting Australia’s export earnings are well and truly over. Last month I wrote:

Despite tougher times, coal isn’t going anywhere. Aggressive expansion plans are being tempered, but the industry will continue to make a significant contribution to Australia’s economic output and export earnings. Nevertheless, the days of coal serving up windfall profits and tax revenues are past.

This was a bit lazy, I will admit. Coal is Australia’s second largest export and so in that sense it will ‘continue to make a significant contribution’ to its export earnings. But what we’re concerned with here are rates of change. Will coal support additional gains in Australian living standards in the future? Very likely it will not.

China’s demand for coal has underpinned the windfall in that sector over the last decade. Now that it’s facing severe environmental degradation and hazardous air quality, the government has announced a planned cap on coal consumption. Australia will need to look elsewhere if it wants to expand its export markets, and the only viable candidate really is India. India possess plenty of coal, but its inept state mining company has historically under-delivered. It is intent on changing this, with Power and Coal Minster Piyush Goyal recently declaring, “Possibly in the next two or three years we should be able to stop imports of thermal coal.” Whether this is achieved remains to be seen, scepticism is reasonable, but with China moving against it and oil and gas plentiful, it’s hard to get excited about the prospects for coal.

Whitehaven’s shareholders agree.

In any case, whether or not coal will enjoy an unlikely renaissance in a warming world isn’t of much relevance to my purposes here; there’s effectively zero chance of a short-term rebound in coal that will alter Australia’s interest rate outlook. As such, I won’t bother discussing coal in subsequent interest rate updates unless there’s some news of note.

LNG is starting to get interesting. I haven’t got much in the way of LNG data unfortunately but this chart from David Llewellyn-Smith at Macrobusiness paints the picture.

LNG is mostly sold on long-term contracts linked to the price of crude oil. The above chart shows the Japan Korea Marker, a benchmark constructed by Platts and a proxy for the emerging spot market:

The Japan Korea Marker (JKM™) is the Platts LNG (Liquefied Natural Gas) benchmark price assessment for spot physical cargoes delivered ex-ship into Japan and South Korea. As these two countries take the largest share of LNG imports in the world, the JKM™ is thus a key reference in marking product value/market price from supply source to the destination market.

In the LNG market space, traditional patterns of trade are evolving fast; where cargoes once changed hands only through opaque bilateral deals, the market now exhibits open sell and buy tenders for multiple and single cargoes, brokered trades, cargoes sold in longer chains and speculative trading positions taken up by non-traditional players, adding to liquidity on the spot market.

The recent collapse in spot prices is all the more concerning coming as it has in the lead up to the northern winter. As you can see on the chart above, we’ve seen prices rise in previous years ahead of stronger winter demand.

Weak domestic demand has seen Kogas, South Korea’s monopoly gas supplier, pare back on purchases recently. From Platts:

Kogas, which has a monopoly on domestic natural gas sales, sold 27.6 million mt of LNG over January-October, down 9.6% year on year.

The state utility attributed the decline in domestic LNG sales to the restart of some nuclear power plants, higher coal demand for power due to its relatively lower prices than LNG and weaker power demand due to unseasonably mild temperatures.

And the following is of particular importance:

Kogas plans to work with other Asian LNG buyers to phase out the “Asian premium” that has plagued the region in the past due to the lack of bargaining power and rigid pricing practices, he said.

LNG importers in South Korea, Japan and Taiwan have traditionally paid more for LNG cargoes due to oil-linked contracts and a lack of alternative energy sources.

“Kogas will push for joint purchase of LNG with Asian importers as part of efforts to ease the Asian premium,” the executive said. “Importers in South Korea and Japan would have the same voices.”

Asian demand is reasonably well satisfied at present, yet LNG deliveries to East Asia are set to explode over the next 5 years. Here is the volume expansion from Australia alone (taken from The Future of Australian LNG Exports):

Add in significant expansions to North American LNG capacity, which will arrive a little later than Australian LNG, along with Russian pipelines to East Asia, and you have an emerging gas glut in the Asia-Pacific region. (Though admittedly many of the mooted North American projects will be looking doubtful after the oil price crash.) Thus it’s fair to say an ‘iron ore moment’ is looming over LNG from next year onwards.

As I have argued in the past, Japan’s currency devaluation raises risks of a large-scale shift back to nuclear power, since the economics of importing energy is very poor when they have so much capital invested in a cheaper alternative. Prime Minister Shinzo Abe favours restarting the reactors, but public opinion remains largely hostile to this, given the Fukushima disaster. Japan’s snap election on December 14 could therefore turn out to be of considerable importance to the fortunes of Australian LNG; a strong mandate for Abe would likely see him press ahead with reactor restarts, adding more pressure to LNG spot prices.

Of course, Australian LNG is mostly sold on long-term contracts linked to the oil price, so concerns around an emerging LNG surplus are academic right now, what with the collapse in oil.

The latest hit came last night after OPEC conceded it has no plans to cut production in the face of lower prices. This represents a momentous shift in the dynamics of the oil market, with volatility appearing to be the new normal. In the short-term, many analysts believe $60 is in play, meaning utter carnage for Australia’s gold-plated LNG projects, which are all among the most expensive in the world.

In any case, LNG is not going to provide much of a boost to the economy once it starts leaving our shores in record volumes, even if the oil price does rebound next year. Employment will be much lower in the operational stage than during the construction phase, and the squeeze on east coast gas supplies will hurt local industry. The only real positive effect will come via higher tax receipts, and obviously these are looking fairly lean now.

Iron ore has been bludgeoned over the last month, notwithstanding more positive price action over the past couple of sessions.

Here was my assessment of things in the October update:

Recently I noted that the worst may well have passed for the iron ore miners in 2014. Spot found legs for a solid bounce after that, however as you can see it didn’t manage to hold its gains. Still, buying returned at the end of last week around the $80 level, and it looks unlikely we’ll see falls much below this for the remainder of the year, owing to much improved profitability amongst Chinese steel mills, a thawing of credit conditions in China and some degree of seasonal inventory restock into the year’s end. However, without a fundamental shift in Chinese policy settings, the bounce will be short and soft relative to past years. And with no sign of a let up in the pace of supply expansions from the majors, further declines in iron ore next year are virtually baked in.

$80/t has since crumbled and we’re presently sitting at $70/t (Qingdao port price). The ‘further declines’ I expected to arrive early next year came ahead of time, the reason being an absence of seasonal restocking activity, which I discussed here. The market got briefly excited about an interest rate cut from China’s central bank last week, but that’s faded quickly. The last couple of sessions in China have seen strong buying both steel and iron ore, which could extend a bit further, but the fundamentals for both remain so poor that it’s hard to see a pronounced rebound into the year’s end.

Iron ore is the main drag on the Australian economy today. Over the next year declining mining investment will probably assume that primacy, but what Australia is going through right now is quite simply a monstrous terms of trade bust, one of the biggest and baddest in our history. Without large reductions in supply, it’s likely we’ll see spot iron ore near $50/t by the end of next year. Thus, unless we get a full-blown resumption of the Chinese credit and property booms, and soon, the situation with iron ore makes it very hard to see the RBA hiking rates with the next move.

The iron ore slump (-47% this year), has mostly been about the huge expansion in supply and the endurance of existing high-cost production, especially in China (the failure of Chinese steel demand to continue rising inexorably is the other important aspect). Much of this new supply has come out of Australia, hence our trade balance has not deteriorated too severely thus far.

There will likely be further pressure on the trade balance over the next year, although I don’t expect the headline figure to be all that bad, owing to even more iron ore out of the Pilbara and the ramp up in LNG exports. This will be of little comfort, mind you, since higher volumes are of secondary importance when set against corporate profits, which are taking a beating in both sectors.

Here’s the most recent terms of trade chart (Q3 national accounts arrive next week). Once recent falls in spot prices flow through to contracts, the terms of trade will be approaching the nadir of 2009.

It will be a brave or desperate RBA that hikes interest rates in the midst of a terms of trade bust such as the one we are in the grip of.

China

The Chinese economy continued to slow in October, emphasising why the government has lately shifted policy towards a more stimulatory footing.

Industrial production, fixed asset investment and retail sales growth rates all registered falls from the previous month (charts from China’s National Bureau of Statistics).

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As I outlined in a post on China a few months back, investment levels grew to account for an unsustainably high proportion of GDP following the financial crisis in 2008. Why are very high levels of investment a problem? Investment is intended to raise output of goods or services in the future. If too small a proportion of an economy consists of consumption, then it risks insufficient demand for the extra goods and services produced by all that investment, and therefore poor returns for investors. When high levels of investment have been been funded by a massive expansion in credit, this can be calamitous.

For this reason, the Chinese government has signalled its intention to rebalance its economy away from investment in ‘fixed assets’ (factories, infrastructure and apartment blocks) and towards domestic consumption. It is welcome then that retail sales have declined by less than fixed asset investment over the past year, and that the services sector has expanded more rapidly than manufacturing, but there is still a way to go. The challenge is immense; according to government researchers, $6.8 trillion of wasted investment has been undertaken since 2009. All this spending has of course contributed enormously to Chinese GDP growth, and I simply cannot see how growth rates aren’t going to slow markedly over the coming years as this uneconomical investment binge works its way through the system.

Indeed, without a continuous acceleration of credit, Chinese property prices are sinking. Property data released last week acted as the catalyst for the capitulation in iron ore. At the national level, year-on-year prices are falling at their fastest pace in at least a decade. (Chart from Tom Orlik):

In response to soft data and the bleeding in the property sector, which is itself an automatic consequence of the restraints placed on credit growth, the People’s Bank of China (PBoC) cut interest rates on Friday, adding to the easing of mortgage lending rules in September.

Although this move won’t turn the economy singlehandedly, if it is accompanied by a broader easing of credit conditions then some argue it could herald a lasting rebound in property and support demand for bulk commodities.

I remain highly sceptical that Chinese policymakers are seeking to reboot the credit boom. Debt-to-GDP has soared to 250% this year, from 147% in 2008. Although other nations have higher debt levels, such a rapid build-up of debt is a big concern, especially considering that China isn’t nearly as wealthy as other nations with comparable debt ratios. Moreover, much of the investment spending this credit has funded is are not going to provide a sufficient return, and so the quality of the debt is rather poor. China’s policymakers seem to understand this. I believe they’ll be looking to limit the stress on borrowers as much as possible, without reigniting credit growth. In particular, the shadow (nonbank) finance sector looks to be well and truly curtailed. This, at any rate, is how I am reading the interest rate cut: the government wishes to establish a floor under growth, as far as its feasible, rather than blow the roof off again.

When we remember that inflation has been trending down over the past 12 months, especially in the second half of this year, its clear that the recent interest rate cut is as much about reversing passive monetary tightening as it is active monetary loosening.

With inflation low and falling, a cut was the correct decision. I am doubtful this move presages a return to the credit boom days, and in any case it would need to be truly enormous now to mop up the sheer scale of excessive capacity in iron ore. Chinese policymakers may yet ride to the rescue, but in spite of recent supportive measures, we have not seen policy shifts substantial enough to alter the bleak outlook for bulk commodities.

Investment

I covered yesterday’s capital expenditure data in detail here.

Capex has dodged steeper declines through resilient spending in WA and the Sydney property boom. Without further interest rate cuts, Sydney’s boom will start to cool within 6 months or so. And investment in WA is all about iron ore supply expansions, which hurt the terms of trade, and are likely to slow sharply next year as a result of the iron ore price crash (Fortescue’s announcement today is just the beginning). So although last quarter’s result was a positive, the future remains grim for capital spending.

Public Finances

I have mentioned a number of times how damaging the iron ore rout would be to the West Australian government’s budgetary position, and here’s why:

Spot iron ore is sitting at $70 at the moment, over 40% below what the WA government forecast. Next year it could well average around $60, half of what’s been forecast. In the government’s own words, “General government revenue is also highly sensitive to the iron ore price, with iron ore royalties projected to account for 19.7% ($5.6 billion) of total revenue in 2014-15.” It estimates $49m in lost revenue for every dollar fall in spot iron ore.

The lower Australian dollar will provide some minor respite for the budget, but not nearly enough. Stay tuned for the Great Western Austerity Drive next year.

Although iron ore forecasts in the federal budget have not been anywhere near as aggressive as WA’s, the drop in prices has likely added around $10bn to the deficit this financial year, taking it to $40bn. Should the pain continue next year, it will obviously hit the budget even harder. The pressure will remain on the Treasurer to find savings that can pass the Senate, and these will no doubt be similarly popular to the ones announced in May. The ongoing fiscal retrenchment will likely dampen consumer sentiment in the coming months, making a consumer-led rebound a tougher ask.

Housing

The housing sector moderated somewhat over the month, with Sydney and Melbourne diverging.

ABS data for building activity is only released quarterly, however the most recent monthly building approvals data registered a sharp drop of 11% from the previous month in seasonally adjusted terms.

As you can see, the overall fall was largely due to the fall in approvals for units (apartments), which declined 21.9% between August and September. Since Melbourne is determined to become ‘Manhattan Down Under’, much of the apartment building surge has been concentrated in Victoria. Unsurprisingly then, September’s fall in national approvals was driven by Victoria.

These data are fairly volatile, so one month doesn’t tell us a great deal. We’ll get the October data next week, and it will be interesting to see if approvals rebound. However, with rents growing far slower than house prices, increases in housing supply will steadily inflate valuations.

HousePricesAnnualChange

Following the steep decline in interest rates between November 2011 and August 2013, the economic case for investing in houses improved substantially. But the consequences of this, namely house price growth far outstripping rental growth as investors piled in and supply increased, have eroded the attractiveness of property as an investment. Of course, Australian housing investors are not in it for the yield, they are in it for capital gains. Nevertheless, after-tax cash flow is important for justifying the borrowing required to speculate on houses, so tumbling yields will, in time, crimp investment demand. Valuations could go truly idiotic in the meantime, but eventually more cuts are going to be required to keep the party rolling. As I’ve mentioned, I can see it running for another 6 months or so, absent some external shock, before cooling on its own accord. If the structural downturn bites harder, property could easily roll over sooner.

The RBA released credit data for October today, which showed an uptick in credit growth over the month.

In comparison to the last speculative housing boom, overall credit growth has been subdued. It is important to recognize though that we’re beginning from a much higher base level of debt this time around. The jump in investor loans is therefore a concern, despite the growth rate being low historically. Also, with national income set to decline, expansions in risky borrowing are undesirable and potentially destabilising; cutting rates could fuel this fire.

This leads some observers, such as those in the OECD, to argue that current activity in the property market is enough to warrant higher interest rates. Higher rates would certainly hit this sector, but they would also hit the economy very hard, right as it’s entering a pronounced structural slowdown. This would be madness, in my view, and its why I cannot see rates rising. There are other tools to slow housing, and the RBA and APRA are presently canvassing their options. At most, if property burns brighter into the new year, it will defer interest rate cuts. In time, the structural weaknesses of the economy will see property roll over. When it does, cuts to interest rates will follow quickly, if they have not already arrived.

Consumers

The Australian consumer is exhibiting less inclination to spend aggressively out of current income than during previous property booms.

There’s been some divergence in consumer sentiment reports this year, with the ANZ-Roy Morgan survey showing a mild improvement, but the Westpac-Melbourne Institute survey showing a weakening. From ANZ chief economist Warren Hogan:

Job vacancies data last week showed labour demand in the non-mining sector continues to gradually improve, particularly in labour-intensive industries such as construction, health and retail. Alongside low interest rates and rising house prices, this should support consumer confidence and retail spending as we head into the Christmas season.

And from Westpac chief economist Bill Evans:

In the near term, prospects for a boost in consumer spending going into the end of the year are not encouraging.

So, ‘who really knows what consumers are thinking right now?’ , seems to be the conclusion. The large decline in oil prices could help sentiment if it ever feeds through to petrol prices. But the salient point, I think, is that as the terms of trade bust and investment downturn gather pace, and as public balance sheets deteriorate, it’s going to be increasingly hard for the consumer to remain so upbeat and willing to spend that he/she overrides this structural downturn.

In any case, with national income falling, consumers will need to dig deeply into savings to deliver the jump in spending required to lift interest rates. As long as the savings ratio remains elevated, consumption will not rise strongly enough to overwhelm weakness elsewhere.

Employment

The Australian Bureau of Statistics’ labour force survey has suffered well-publicised issues in recent months, so the official data is not as reliable as it ought to be, but the trend in unemployment remains up.

And here’s the breakdown of the states and territories:

Public sector layoffs in the ACT and Queensland, along with the beginning of the LNG investment wind-down in the latter, are hurting employment in those states, and will continue to do so. Strong population growth is driving the Victorian economy at present, instead of the other way around. While this works at the aggregate level, with overall state demand rising, it’s meant that unemployment has trended higher. Also troubling is the stubborn rate of unemployment in NSW, in spite of its property bonanza over the past couple of years. With the most spritely phase of the boom likely past, it’s difficult to see where a sustained improvement in employment will come from.

Warren Hogan obviously disagrees, and cites the ANZ job ads report as evidence:

The modest improvement in ANZ job ads in October is an encouraging sign that the pick-up in labour demand is continuing. In our view, this should feed into better employment growth outcomes and see the unemployment rate stabilise.

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As you can see on the second chart, there’s been a clear divergence in the past 18 months between job ads and the unemployment rate. This is historically unusual, and indicates either that the labour market is ready to turn, as ANZ’s economists believe, or that the economy is in the grip of a highly anomalous structural adjustment that will see existing jobs shed faster than new ones become advertised. Most of the uptick in job ads will be connected to the frothy segments of the NSW and Victorian property markets. As I’ve made abundantly clear, I am sceptical that this froth will last for much longer.

Inflation

As discussed in the previous interest rates update, there’s little in the way of inflationary pressures for the RBA to worry about. Although the Consumer Price Index had bumped up against the top of the RBA’s band (2-3%), this was almost entirely driven by the depreciation in the Australian dollar last year, and therefore not something the RBA needed to counter with monetary policy.

Nominal wage growth is currently the lowest on record, though the ABS only has a wage price index reaching back to late 1990s. However, Australia experienced far higher inflation in the preceding decades, so current levels are likely to be lowest in a very long time. Real wage growth is also low, flirting with negative rates.

In short, there is nothing in the prices of labour or goods and services to warrant monetary tightening.

Exchange Rate

As I have written previously, a large and sustained drop in Australia’s real exchange rate is critical to achieving genuine economic rebalancing (as opposed to a short-term cyclical sugar-hit). Therefore, a deep fall in the exchange rate could defer or even eliminate the need to for the RBA to cut rates.

And indeed, there’s been a welcome decline in the Australian dollar in the last few weeks.

These moves have been driven in part by a gradual recognition that rates will need to fall in Australia. What this means is that if the RBA does not eventually cut rates, or fails to signal that they will, the Aussie dollar’s drop will be probably limited. I can see it moving to .8000 now without too much trouble, on a technical basis it is looking quite sickly, but I cannot see it falling hard enough to negate the need for rate cuts.

Conclusion

It remains very difficult to see the RBA hiking rates in light of the ongoing structural headwinds. The cyclical boosters are still supporting activity, but by their very nature these growth drivers require continual monetary easing to be maintained in the current environment. Therefore, if rates do rise, the Australian economy will quickly lose its only propellants, and this will necessitate lower rates again in fairly short order. I continue to expect rates to remain on hold for another 3-6 months before the RBA cuts in Q2 next year.

Capex holds up

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The results of the private capital expenditure survey for the September quarter were released by the ABS this morning, showing a seasonally-adjusted .2% rise, in volume terms, on the June quarter. This solidly beat expectations for a 1.9% drop.

In dollar terms, capital spending by the mining sector dropped 3% over the quarter and manufacturing fell 1.3%, with these falls offset by a 5.6% jump in ‘other selected industries’. Total capital spending was down 4.6% ($1894m) on the same quarter last year, mining was -14.2% ($3475m), manufacturing -10.5% ($253m), and ‘other selected industries’ +12.8% ($1833m).

The main driver of capital spending by ‘other selected industries’ over the past year has been the ‘rental, hiring and real estate services’ industry grouping, which has risen by 40% and contributed $838m of the $1833m in additional spending by that sector. Contributions have also been made by businesses in ‘retail trade’, ‘construction’ and ‘financial and insurance services’.

CapexOther1

Those industry groupings cover businesses benefiting from the last monetary easing cycle and the consequent boom in house prices. Unsurprisingly, seeing as it’s the nucleus of the boom, NSW has accounted for over half the increase in capital spending by ‘other selected industries’ over the past year.

Here’s the division of total capital spending by state.

Evidently, the cyclical boost emanating from the Sydney property sector and the resilience of mining investment in WA have cushioned the overall blow to capital spending in the past year. The latter of those points is important. If capex holds up in WA, it’ll come at the expense of the iron ore price, since capital spending in WA is almost entirely constituted by iron ore capacity expansions.

Here are the expectations for capital spending this financial year:

Mining

Other Selected Industries

Manufacturing

Manufacturing is all but dead so we can ignore that until we see the dollar fall 20-30% in real terms.

Without further cuts to interest rates, the cyclical upswing in NSW is likely to run out of puff over the next 6 months or so, in which case I wouldn’t be surprised to see expected spending by ‘other selected industries’ moderate somewhat by the time the full year’s spending has been recorded. Activity in this interest rate-sensitive space reflects the RBA’s strategy for ‘rebalancing’ the Australian economy as the resource sector slows. This is bubbly economics: papering over a structural downturn with a cyclical upturn in borrowing, asset speculation and consumption. The US famously tried this strategy after the tech wreck early last decade, and it ended up with a catastrophic housing bust.

Thankfully, Australians have mostly kept their heads so far, and the bubbliest segments of the economy are confined to Sydney property speculation and manic Melbourne apartment building. Credit is not growing too rapidly and household savings rates remain reasonably healthy (bearing in mind, of course, that households are already heavily indebted). Nevertheless, the bubbly segments have lately caused enough consternation within the RBA and APRA for these institutions to move forward with ‘macroprudential regulations’, specifically aimed at reducing macroeconomic risks in the property sector and banking system. Despite having cheered it on, the RBA finally grew wary of the housing beast.

It remains to be seen how stringent macpru ends up being in Australia, but it is a welcome move. Some commentators will be inclined to regard this upturn in housing-related activity as healthy rebalancing, but in my view a structural downturn needs a structural remedy, not a temporary sugar hit. We need a lower real exchange rate and productivity-enhancing reforms and infrastructure spending to boost investment in non-mining tradable goods industries. Until we get that, it’s hard for me to get excited about any purported ‘rebalancing’.

As to mining investment, there’s little doubt that we’re going to see it deteriorate sharply over the next two years, particularly given the recent carnage in iron ore and crude oil prices (which LNG prices are linked to). The BREE recently published its forecasts for mining projects.

It’s safe to say that ‘possible projects’ are extremely unlikely, and also that many ‘likely projects’ will fail to break ground as well, without big rebounds in oil and iron ore prices, or a sharp fall in the Australian dollar.

Bonus Chart

Straya at the Moment – Part 2

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Part 1 – The Making of the Australian Triumph

I’m sure George Megalogenis, journalist and author The Australian Moment, was being sincere when he wrote:

Are we in danger of becoming a great country? When I put the question to politicians and officials in interviews for this book, the majority response is to laugh or sigh.

Be that as it may, just because Australian politicians and officials weren’t seized by a collective great power delusion doesn’t mean that Australian Exceptionalism was absent from our policymaking mindset; far from it. This sense of exceptionalism manifested itself in a constant tendency to overestimate the durability of the mining boom, which has lasted all the way through to the present day. While the Bureau of Resources and Energy Economics has traditionally been the main offender, the most risible delusion today belongs to the Western Australia government, which has forecast iron ore at $122 for 2014-15. So far iron ore has averaged $86 this financial year, and is currently sitting at $70/tonne. There’s been cascade of revisions to iron ore price forecasts lately, and Chinese futures are pricing spot at close to $60 by May next year. Plainly, the WA budget is in big trouble. Although federal budget forecasts have been less sanguine, Canberra is still facing an unpleasant shock; as I’ve argued since this blog’s inception, the public balance sheet is under far greater stress than is typically recognised, mainly because iron ore is in significantly more trouble than has typically been acknowledged (until very recently, of course, when the market made it impossible to deny).

The idea that our prosperity would be underwritten by demand for our minerals and energy has had a pervasive effect on politics over the past decade, and led to what Professor Ross Garnaut dubbed the ‘Great Complacency’. This argument is a noticeable departure from the one advanced by Megalogenis, which I covered in the previous post. This is actually quite odd, seeing as he agrees with most of the particulars but arrives at a completely different conclusion. The thrust of the ‘Great Complacency’ argument is that there weren’t sufficient adjustments made to fiscal policy to reflect the transient nature of the terms of trade boom. We can see this plainly enough in the rather pathetic fact that we’ve reached the denouement of a huge mining boom with a federal budget mired in structural deficit and a current account deficit that never even threatened to close (the current account balance is the trade balance plus net foreign income).

Worse than that, the initial phase of the terms of trade boom, prior to the financial crisis, saw some of the largest current account deficits of modern times, as Australian households threw aside the old art of saving in the new millennium.

This was the legacy of the housing frenzy, which peaked in 2003-04. It was also the period through which fiscal settings should have been much tighter, as corporate tax revenues started pouring in from the early stages of the boom. Alas, the Howard/Costello budgets were too generous, delivering tax cuts and expansions to various entitlement programs, which boosted overall spending in the economy.

The combination of spendthrift households (at least until 2006, when the saving ratio began to rise), and a government eager to feed the habit, left the RBA with the job of leaning against the boom.

This monetary tightening formed part a deliberate strategy for adjusting Australia’s economic settings in response to the terms of trade boom. There were basically three ways that Australian policymakers could have dealt with the boom: a) real exchange rate appreciation by domestic inflation, b) real exchange rate appreciation by currency appreciation, c) a forcible increase in national savings. (Or some combination of all three, of course.) Understanding which approach was adopted, why it was adopted, and what it entailed, helps us understand Australia’s current outlook.

Super-cycles

The boom Australia has just lived through is commonly referred as a commodity price super-cycle. Before I look at the a various ways of responding to the boom, this paper (fee required) by David S. Jacks has an excellent description of what we’re talking about when we refer to commodity price super-cycles (highlights my own):

In this paper as in others it follows, commodity price super-cycles are thought of as broad-based, medium-run cycles corresponding to upswings in commodity prices of roughly 10 to 35 years. These are demand-driven episodes closely linked to historical episodes of mass industrialization and urbanization which interact with acute capacity constraints in many product categories—in particular, energy, metals, and minerals—in order to generate above-trend real commodity prices for years, if not decades on end. Significantly, this paper finds that fully 15 of our 30 commodities are in the midst of super-cycles, evidencing above-trend real prices starting from 1994 to 1999. The common origin of these commodity price super-cycles in the late 1990s underlines an important theme of this paper: namely that much of the recent appreciation of real commodity prices simply represents a recovery from their multi-year—and in some instances, multi-decade—nadir around the year 2000. At the same time, the accumulated historical evidence on super-cycles suggests that the current super-cycles are likely at their peak and, thus, nearing the beginning of the end of above-trend real commodity prices in the affected categories.

Exactly what Australia has just gone through, in other words.

Plans A, B and C

Primary resources account for the vast majority of Australia’s goods exports.

As a result, Australia has always been prone to commodity price boom and bust cycles.

Terms of trade booms entail a significant rise in Australia’s national income, since we’re able to exchange the goods we export for more (or higher value) imports. We get richer.

But most of us don’t sell iron ore on the world market, so how does the soaring iron ore price impact those of us who aren’t directly remunerated by the iron ore industry?

There are a few channels through which this can occur, but essentially it’s through an appreciation in the real exchange rate. The exchange rate that gets quoted to you when you travel overseas is the nominal exchange rate, which doesn’t necessarily tell us much about the relative purchasing power across different countries (think of nominal as ‘in name only’).

This point can be illustrated by way of a simple, stylised example: Suppose Australia’s nominal exchange rate is fixed against the US dollar at parity, but Australia has very high inflation, say 100% annually, whereas US inflation is zero. In a year’s time, you’ll (hopefully!) be getting twice as many Australian dollars in your pay check each week. The prices of haircuts and beers and electricity in Australia have also all doubled, so in real terms you’re no better off buying things in Australia. But you can still exchange each Aussie dollar (of which you now have twice as many) for one US dollar, since the rate is fixed at one-for-one. And since inflation is zero in the US, the prices of haircuts and beers and electricity haven’t changed at all. So if you exchange your Aussie dollars for US dollars, you can head over to the US and buy twice as much stuff! Despite there being no change the nominal exchange rate, Australia’s real exchange rate has appreciated.

An appreciation in the real exchange rate has accompanied all of Australia’s terms of trade booms.

Here’s a close-up of the most recent boom:

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When the terms of trade enters an upswing, additional income starts flowing into the economy, raising profits and salaries in affected industries and boosting government revenues. Unless the government purposely restricts spending by tightening the budget, this increase in income flows into the rest of the economy. Firms raise investment and households consume more. Until 1983, when Keating floated the dollar, Australia’s nominal exchange rate was fixed (well, tightly managed). If the nominal exchange rate is fixed, then there’s no automatic mechanism to make life harder for trade-exposed industries that are not directly benefiting from the terms for trade upswing, so firms aggressively compete for scarce labour, driving wages higher. As spending and income rises throughout the economy, inflation rises. Thus, as I described above, Australia’s real exchange rate rises.

Although I’m not sure it was really anyone’s plan in the past, for convenience I’ll call this Plan A for responding to a terms of trade boom: permit domestic inflation to rise. The biggest problem with this is that it’s all well and good during an upswing, but it can be most damaging during the downturn, and typically entails a recession. The reason being that the economy has become uncompetitive at the new level of the real exchange rate. Returning to the Australia-US example above, if Australians can afford to buy more US-made beer than Australian-made beer, and they can since inflation is so high in Australia relative to the US, then they’ll shift their demand to US-beer. This behaviour is repeated for most other tradable goods, and so higher inflation hurts Australian businesses. When the positive effect of the terms of trade upswing abates, the now-uncompetitive economy cannot sustain full employment, and slips into recession. (Generally there was some belated monetary tightening to address rising inflation, and this would exacerbate the downturn when it arrived.)

This is why it’s commonly agreed that one of the central achievements of the most recent terms of trade boom has been the prevention of an inflationary breakout (see CPI chart above for comparison to past booms). Instead, since it was accepted that the real exchange rate had to rise, the nominal exchange rate did the heavy-lifting, allowing inflation to remain in check (or ‘anchored’, in econospeak). That is, instead of the Australian dollar being fixed against other currencies, it traded freely, and rallied very strongly indeed.

In Macroeconomic Consequences of Terms of Trade Episodes, Past and Present (2014), Atkin et al had the following to say (p. 21):

Prior to the current terms of trade cycle, the RBA adopted an inflation-targeting framework, with the goal of keeping consumer inflation between 2 and 3 per cent on average over the medium term. This framework has provided a clear nominal anchor which, together with changes to the structure of the labour market described in Section 4.5, limited the feedback of the boom to economy-wide prices and wages. Notwithstanding the very significant rise in the terms of trade in the current episode, inflation has been well contained, especially when compared to the experience of the 1950s or 1970s. The floating exchange rate and inflation- targeting framework has also provided the RBA with the flexibility to maintain an accommodative stance of monetary policy more recently to support domestic demand since the terms of trade has started to fall.

And in an earlier RBA research paper, titled, The Mining Industry: From Bust to Boom (2011), Connolly and Orsmond had a similar take (p. 47):

Australia’s freely floating exchange rate has allowed a real appreciation to occur in response to the 2000s mining boom without the adjustment coming through high inflation, as occurred under the less flexible exchange rate regimes of the 1970s and early 1980s. The surge in mining export receipts in the late 1960s and early 1970s generated strong domestic demand and placed upward pressure on the exchange rate. The Government kept the exchange rate fixed, building foreign reserves and allowing the domestic money supply to grow at an annual rate of over 20 per cent in the early 1970s (Figure 25). When the Government finally revalued the exchange rate in late 1972 and 1973, it was too late to restrain inflation, which had drifted up from around 3 per cent in the late 1960s to 7 per cent in 1971. In contrast, during the 2000s, the floating exchange rate began appreciating as the global economy recovered from the 2001 recession, and appreciated further over the remainder of the decade as the terms of trade continued to rise. Furthermore, when commodity prices moved sharply in 2008/09, the exchange rate adjusted to cushion the shock to the economy. Overall, the higher exchange rate has helped to offset the expansionary effect of the increase in mining export receipts and investment.

I’ll call this Plan B: still allow the real exchange rate to rise in response to the terms of trade upswing, but keep inflation anchored, prevent a wage breakout, and leave it to the nominal exchange rate to rise and fall in accordance with the economy’s needs. This entails is a shrinking of various other tradable-goods sectors in the economy, which can’t compete internationally when the Aussie dollar is so strong, to ‘make room’ for the booming resource sectors. As the nominal exchange rate rises, Australians get richer in real terms and demand more imported goods, which are cheaper relative to locally-produced goods. Consequently, trade-exposed sectors and businesses which aren’t benefiting from the boom start to struggle; they reduce their demand off workers and curtail new investment. This process reduces inflationary pressures in the economy during the upswing.

Screen Shot 2014-08-26 at 11.50.34 am

What makes a nominal exchange rate appreciation so attractive is the comparative ease with which the economy will adjust to the downswing in the terms of trade, at least in theory. As the terms of trade decline, and drag down national income with it, the Australian dollar will lose value. As the Australian dollar loses value, sectors which were getting squeezed by the booming resource sector will see an improvement in demand for their products, and this will support business investment and employment.

So we’ve arrived at one of the fundamental points of the Australian economy today: With the terms of trade bust and the resource investment wind-down gathering pace, the Australian dollar must fall substantially from its current level. Most people I think probably appreciate this intuitively. However, we are talking about a very big adjustment indeed, 20-30% lower than where the Aussie dollar is trading presently, at least.

If this nominal exchange rate depreciation is not realized, if the Australian dollar does not lose value against the relevant currencies of trade partners and competitors over the next couple of years, unemployment will rise significantly. Of course, one way or another, it almost certainly will happen. It’s a matter of timing. The Aussie dollar will fall when it becomes clear than Australian interest rates are going a lot lower and most likely staying there for an extended period. Therefore, the longer the RBA waits, the worse the employment situation will get. But rising unemployment is itself one of the most important indicators watched by the RBA, so in that sense the bank will be forced to act sooner or later. Whether the board is proactive or reactive in this instance is the main question.

Sounds pretty simple, doesn’t it? All the Australian dollar needs to do is fall precipitously and the economy will be fine! Would that it were that easy.

Sadly the Australian case is complicated by the situation in the housing market. Although the economy needs lower rates to bash the currency (there are other options but the RBA is loath to countenance these), this action invariably provokes a rapid and destabilising response in the housing market. In the next post I’ll run through the challenge associated with the housing market, and why it complicates the real exchange rate adjustment.

Must we grow richer?

So far we’ve seen Plans A and B for responding to the terms of trade boom. Each entailed a significant real exchange rate appreciation, by domestic inflation and nominal exchange rate appreciation, respectively. But did the real exchange rate have to rise so strongly in response to the upswing in the terms of trade?

The current account balance is the difference between domestic demand for goods and services and domestic supply (you need to add in net foreign income earned in the period as well). As such, a country running a current account deficit is purchasing more goods and services than it is producing. To do so, it must borrow the difference from international lenders (or sell assets to international investors). A country that is borrowing more from than it is lending internationally, is running a capital account surplus. Together, the current and capital accounts make up the balance of payments.

One might be excused for assuming that Australia would have run significant current account surpluses during the biggest boom in exports in over a century. But in fact, as my chart above illustrates, at no stage during the boom did Australia notch up a surplus. Indeed, before the financial crisis in 2008, Australia’s current account deficit reached record highs.

This occurred by a combination of the rising real exchange rate and rising foreign borrowing. As the exchange rate rose, the cost of imports fell and households purchased more of them. There was also a significant increase in household leverage which began in the mid-1990s and continued through to 2008. After 2008, when households boosted savings out of current income (which lowered demand for imports), the trade balance sporadically swung into surplus, but owing to Australia’s substantial foreign liabilities, our net income on foreign investments is deeply negative, so the current account remained in deficit.

This failure to record current account surpluses and reduce Australia’s net foreign liabilities during the boom years leads some to complain that Australia squandered the boom. I count myself among this group. Current account deficits certainly aren’t intrinsically bad; if there’s an abundance of productive investment opportunities in your country but insufficient domestic capital or technological knowhow to exploit them, then importing foreign capital is sensible. But what net foreign liabilities mean is that part of the income generated in your economy each year must flow overseas in the form of interest and dividends. Therefore, large accumulated deficits are a drain on national income. They also leave the economy exposed to the availability of foreign capital, which can pose risks to the banking system.

I am of the view that the Australian government would have been better off running very big budget surpluses before the financial crisis, and parking these savings in an offshore sovereign wealth fund (whether this would’ve been politically feasible is another matter entirely). This would have been achieved by withholding almost all of the increase in additional revenues flowing from booming corporate tax receipts, which should have been further inflated by a pre-existing rent tax on resources. One consequence of this policy would have been lower household spending, including on imports, since tax cuts and middle-class entitlement spending fuelled consumption. With lower imports and booming exports, the current account deficit would have declined. In addition, lower household spending would have lessened the need for the RBA to raise interest rates as high as it did, which would have limited the appreciation in the real exchange rate. Again, this would have lowered spending on imports and eased the hit to non-mining trade-exposed sectors.

Had this policy been in place when the financial crisis arrived in 2008, the federal budget would have been in such healthy shape that subsequent deficits would have been far lower, and in fact the budget could have conceivably remained is surplus. This would have afforded the government far more breathing room to set stimulatory fiscal policy today.

This then is, or was, Plan C: Instead of allowing the real exchange rate to appreciate so strongly, irrespective of how it happens, lean heavily against the boom by running very big federal budget surpluses and reducing Australia’s net foreign liabilities. Some manifestation of Plan C was basically the alternative to Garnaut’s ‘Great Complacency’. In adopting this approach, comparatively subdued household spending acts as a release valve, mitigating the risk of the economy overheating. Contrast this with Plan B (real-by-nominal exchange rate appreciation), where it falls primarily upon the non-mining tradable-good sectors to shrink and so act as the release valve.

A rise in the real exchange rate would undoubtedly have been necessary, but by shifting the balance and leaning against household consumption and borrowing, Australia would have improved its foreign debt profile (the net international investment position), its public finances would have been in much better health, and there would have been less hollowing out of tradable-goods sectors as a result of the boom.

We can’t fully judge Plan B until we’ve seen how the economy performs in the bust, which is presently unfolding. The key question is, will non-mining business investment and hiring rise quickly enough to offset the mining bust? It may yet do so, though the chances seem fairly slim. In my eyes, a greater emphasis on Plan C would appear to have been best option for the nation. Hopefully there’s another once-in-a-century terms of trade boom before too long so we can test that hypothesis!

Welcome to the Ice Age?

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Having had the weekend to digest the Bank of Japan’s shock decision to increase its quantitive easing program, I’ve a few thoughts on what this might mean for the globe.

Permafrost of a permabear

Back in 1996, hyper-bear Albert Edwards unveiled his ‘Ice Age’ thesis, arguing that the West would find itself beset by the same deflationary forces that had seen Japanese equities persistently trade far below the bubbly peaks of the 1980s. This ‘Ice Age’ entailed equities under-performing both in absolute terms and relative to bonds (falling inflation makes fixed-interest securities more attractive, since in real terms the income received rises).

Even with the wild spasms of recent decades, his extreme bearishness towards Western equity markets has been a big loser.

This hasn’t discouraged him; you can see one of his latter-day howlers on the chart below.

The bond market, however, has been considerably more sympathetic to his thesis.

One of his key claims was that the US 10-year government bond yield would spend a long time below 2%. It spent some time below this level in 2011 and 2012 (something many would have considered impossible a decade ago), but news that the Fed was planning to ‘taper’ its QE program sent yields sharply higher in 2013. This, along with signs of growing strength in the US economy, had analysts and institutional desks calling a continuation of the bond sell-off in 2014 (rising yields). Quite the opposite has happened. In fact, as shorts stopped out en masse last month, the 10-year yield sunk briefly below 2%. (This isn’t captured on the chart below as it only plots daily closes).

Despite the conclusion of the Fed’s QE program, markets have been anticipating a passing of the baton to the European Central Bank (ECB) as it initiated its own asset purchase program. This has been highly EUR-negative, and the cycling of funds out of EUR exposure into USD has likely supported demand for US bonds. This strong demand for the USD, as the outlook for relative monetary settings began to clearly favour the greenback, has driven back inflationary pressures.

Falling inflation is uncharacteristic of an economy in an upswing, and has kept demand for bonds healthy even as equities marched higher this year. Indeed, the general absence of inflationary pressures is, to my mind, a central feature of global economy today. As I have said before, “from the US to the UK to China to Japan to Europe and even Australia, the spectre of deflation looms large over the global economy.” So although I tend to ignore Edwards’ hysterics regarding the ever-looming equities Armageddon, his Ice Age thesis, at least the deflation foundations on which it rests, is worth paying attention to.

Bank of Japan’s boreal blast

BOJ Governor Haruhiko Kuroda

It was into this environment, of persistently low global inflation, that the BOJ dropped its QE bombshell on Friday. This chart from the Financial Times illustrates the magnitude of the monetary stimulus afoot in Japan.

The movement of foreign exchange rates, which signify the nominal value of a currency against its peers, basically maps out the relative monetary policy trajectories of the institutions that issue those currencies (central banks). When a central bank is loosening its monetary policy (or rather when markets expect that this will be the case in the future), the currency it is responsible for tends to depreciate, ceteris paribus. Conversely, when the market anticipates monetary tightening, the tendency is for the currency to appreciate. It is useful to recognize then that although currency changes hands when international trade in goods and services takes place, the ‘goods market’ has very little influence on exchange rates in the short- or medium-term, when set against the influence of the ‘capital market’. Which is to say, money changing denominations happens primarily for investing and speculative purposes. (Note: when the euro crisis was raging, currency markets oscillated primarily on a risk-on/risk-off dynamic; the EURUSD being the axis of the market’s risk temperament. After mid-2012, currency markets drifted back to a relative monetary policy dynamic.)

It is scarcely surprising then that the Japanese yen has undergone a massive depreciation since late 2012, when it became clear that the BOJ would embark on a radical expansion of the money base, or that the announcement of further easing on Friday sent the yen into freefall. (USDJPY rising indicates the yen is falling against the USD.)

The reason I have mentioned Albert Edwards is that back in September he received a fair amount of attention for his call on the USDJPY (from Bloomberg):

A divergence in U.S. and Japanese monetary policy — with the Fed slowing stimulus and the Bank of Japan expanding the money supply by record amounts — may have started the exchange rate moving. Now that the yen is past a tipping point, Edwards says the psychology of traders is likely to take over and turn the currency into a runaway train.

“Now we’re heading to 120, which is the 30-year support,” he said. “You break through that, and you can see it moving to 140, 150 very, very quickly indeed.”

Edwards found the yen’s price graph so compelling, he devoted an entire client note to it last week. He called it: “Presenting the most important chart for investors.”

I shared his view towards the yen wholeheartedly, although I certainly wasn’t expecting the BOJ to move this early on further stimulus, nor, consequently, that the yen would move so fast so soon (and remember that it was only by a 5-4 majority that the BOJ decided to increase its QE program on Friday).

So, with the USDJPY now on track to breach 120 within the next 6 months or so, we best reflect on some of the possible implications of this move, remembering, as always, what Aristotle may or may not have said: It is the mark of an educated mind to be able to entertain a thought without accepting it.

Currency chills

A currency devaluation is akin to a tax on domestic consumption and a subsidy for domestic production. When the currency falls, it reduces the purchasing power of domestic households. This tends to cause fall in demand for imported goods, which are now more expensive relative to local goods, and an increase in demand for locally-produced goods. Total consumption tends to decline as the wealth effect dominates the substitution effect. On the production side, firms can now lower the foreign currency price they charge for their exported goods, since a lower foreign-currency price can provide them with the same revenue in domestic-currency terms. Straight away, therefore, we can see that this tendency to reduce consumption and increase production is inherently disinflationary for trading partners. The bigger the economy is, the greater the international impact of the devaluation.

(Of course, the BOJ is easing because it is trying to increase inflation in Japan. A currency devaluation raises the prices of imported goods, and it is hoped that this contributes to sustained gains in domestic prices, especially wages, and in so doing negates the need for perpetual currency depreciation. Whether this domestic goal is met is uncertain; the export of disinflationary pressures as a side-effect is not.)

Currently Japan is the third largest economy in the world. A big depreciation in the yen will therefore have important global consequences, and indeed these are likely to be playing out already.

Glacial creep

China undertook a significant currency intervention earlier this year, which has no doubt contributed to the rise in net exports in recent national accounts data.

This fall has been partially retraced in recent months, despite pronounced USD strength, as the People’s Bank allowed its foreign reserves to decline. Recent moves in the USDJPY, and the likelihood that it will devalue to 120 in fairly short order, therefore represent a jump in China’s real exchange rate. By and large, China still produces lower value-add products for export than Japan, for instance fully assembled automobiles and vehicle components remain Japan’s largest exports by a long way, whereas China exports few fully assembled cars (though it has developed a stronger presence in vehicle components). Nevertheless, China has been rapidly closing the gap in this regard, and therefore Japan’s currency devaluation will make it more difficult for China to compete in those higher value-add industries which Japan currently enjoys a lead.

Moreover, Japan is China’s third largest export destination (8.3% of total), and China’s largest source of imports (10%), so the sharp depreciation of the yen against the renminbi will place substantial pressure on China’s competitiveness with a very significant trade partner. This will add to what are already difficult times in China’s economy, and if it’s not offset by stronger credit growth and a rebound in property (and there are tentative signs of both) then the PBOC may well judge it necessary to place further weight on the renminbi. Any depreciation in the renminbi would amplify China’s exporting of deflationary impulses, which has arisen from domestic overcapacity. We should therefore keep a close eye on Chinese factory data, and remain alert to any signs of a policy shifts.

There has been some improvement at the margins in Europe over the past year, with Spanish unemployment falling to 24.4% from high of 26.3% early last year. Clearly, this is still a monstrously high figure, and celebrating the fall requires a certain sadistic sense of humour. And sadly, more important than any signs of life in the periphery this year has been the weakening of the core, namely Germany. There is a risk that the Q3 national accounts will show Germany in a technical recession, and inflation has been falling (as it has across Europe). Similar to Japan, Germany’s export engine is heavily skewed towards cars and vehicle components.

Japan’s assault on the yen therefore represents a stiff challenge to Germany, whose economy has been consciously engineered to be hugely reliant on export competitiveness. So far this year the EURJPY has been largely flat, as the EUR sold off heavily in anticipation of ECB easing.

Now that the yen is getting hammered, a bold monetary response from the ECB is assuredly required to prevent further deterioration in Europe. Whether we get this in the near-term is debatable; there is still staunch opposition to large-scale quantitative easing from Germany. We’ll have to wait and see if Japan’s devaluation forces a capitulation from the Teutonic hawks. If the ECB stops short of a significant easing program, there is ample room for a EUR rally, which has hit the single currency area hard. Conversely, if they do deliver, it will provide yet more support for the rampaging USD rally.

The frozen core

Evidently, the discussion so far has centred on how affected countries might respond to the threat of increased competition from Japanese exports in the event that the yen continues to sell off sharply. The threat, of course, is to the production base of those countries. As Japanese production rises and consumption falls, real global aggregate demand falls and supply rises, unless the shifts in Japan are offset with less supply and more demand in other countries. But if China decides its shift to internal consumption demand entails too great a slowdown, and rescinds on its commitment to undertake structural reforms (say by devaluing the renminbi or funding more investment spending); and if Europe moves to protect domestic production by easing monetary policy, further devaluing the EUR against the USD, then clearly the international adjustment will fall upon the only economy with the wherewithal to absorb such a burden: the USandA. (Note: this is why commentators are, or should be, so interested to see China and Germany rebalance their economy towards internal consumption, not just for their own sake, but for the global economy’s.)

As exchange rates are priced in terms of other currencies, one currency’s loss is another’s gain. Given the weakness in yen, euro and sterling in the second half of the year, it is no surprise that the trade-weighted USD index has seen brisk gains. (This is not to say that the USD has been rising solely due to others weakening; it has been the divergent outlooks for monetary policies in the respective regions where each currency is used, that has led to these moves.)

There are a few ways the US economy can react to this development, and these adjustments become more pronounced the greater USD revaluation. Essentially, a rising currency provokes the opposite responses in the home country from when it is falling. So a higher USD tends to increase consumption demand amongst US households, since their purchasing power has increased. Likewise, there is a marginal substitution away from locally-produced goods in favour of imported goods, which are now cheaper. Therefore, a rising USD exerts disinflationary pressures on the domestic economy.

A currency devaluation typically raises a country’s trade surplus, or reduce its deficit, whereas an upwards revaluation reduces the deficit or increases the surplus (speaking generally). If the US allows its currency to appreciate strongly over the next few years, the inclination will be for the US trade deficit to increase, as it responds to higher foreign production and lower domestic production, and lower foreign consumption and higher domestic consumption. But if the US is consuming increasingly more than it is producing, it must borrow the difference from foreign lenders. Luckily, higher foreign production and lower foreign consumption necessarily entails higher foreign savings, which can be lent to the US to fund its trade deficits. In fact, this process is just about automatic in the modern international system. Since the US issues the reserve currency, there is very little it can do to impede the flow of capital into or out of the USD.

This increase in capital flows into the US economy can either be directed to investment, be it productive or unproductive, or consumption. During the US housing bubble last decade, the US found itself accumulating massive foreign liabilities which were funnelled into speculative (unproductive) housing investment and consumption. Without the government stepping in and running big deficits, the private financial sector was left to allocate the capital, and did a spectacularly bad job of it.

This brings us to one of my core arguments concerning the present state of the global economy; a sustained USD bull market likely means the US must experience another private credit boom, funding unproductive investment and consumption, or that the government needs to run big deficits. (it is no use arguing that private business investment ought to rise; a strong USD reduces US competitiveness and more or less automatically crimps private business investment). If neither of these conditions are met, then the US economy will experience a prolonged period of weakness and constantly flirt with frigid deflation.

Some qualifications

The Federal Reserve could respond by loosening monetary policy further, and in so doing quash the USD rally and negate the debt-or-deflation trade-off. I examined the possibility of more QE last month, and felt that there was far more likelihood of an extension of zero interest rates than more asset purchases. Nevertheless, the risk of more QE rises the stronger the USD gets and the further inflation falls. More QE from the Fed would then mean an (unintentionally) coordinated global monetary stimulus, which would reduce the necessary adjustments in goods and capital markets from currency movements (since the movements would be less pronounced). This would be fine, except that owing to the nature of modern central banking, this stimulus would almost certainly feed asset bubbles long before it fed general goods and services inflation, setting the global economy up for another crash at some point in the future.

Another consideration pertains to developments in energy markets. When the US was running monster trade deficits during the housing bubble last decade, the most important surplus nations were the East Asian economies (China especially) and petroleum exporters. (See chart below.)

As an aside, there is a school of thought, to which I subscribe, which argues that these global imbalances were a fundamental condition of the various bubbles leading up to the crashes of 2008 and then the Euro crisis. (Although, arguing that they themselves were the cause of financial crises merely demands an explanation of the causes of the global imbalances.)

The shale gas and then oil booms have therefore been of signal importance to the US economy’s reduced susceptibility to large trade deficits.

Whenever we generalise about the mechanics of economic adjustment, such as when we assert that a currency appreciation forces a deterioration in a country’s trade balance, we must be alert to the myriad of real-world nuances that could prevent such a response. There is no doubt that cheaper oil, should it be sustained, provides a significant boost for the US economy, even with the shift towards domestic production. More to the point, if the US manages to reduce the cost of shale drilling, fend off the challenges from overseas and continue pushing its oil production higher at a rapid clip, then this phenomenon could dominate the effects of a stronger dollar. In which case the trade balance may not worsen, and the debt-or-deflation trade-off I believe would arise from such a development may not be a meaningful consideration. All it would mean is that part of the burden of adjustment from the various currency devaluations around the world would shift to petroleum exporters (hardly an unwelcome prospect).

In summary, in the absence of a renewed preparedness to deploy monetary stimulus from the Fed, the appreciating USD could well force upon the US a choice between rising indebtedness (again) or stagnant prices and labour markets. As I see it, the manner of this adjustment will depend heavily on developments in the crude oil market, and the degree to which other major economies take upon themselves the burden of consumption. Most importantly, if China suddenly started running big trade deficits owing to higher domestic consumption demand, this would lessen the need for the US to choose between debt or deflation.

One final point bears mentioning. It may seem odd to be mulling over the global economy’s polar prospects in an era of mass money printing. Surely this is all going to be madly inflationary at some stage? However, it is important to remember the delivery channel of quantitive easing. When central banks wish to expand the money supply, the attempt to inject money into the economy by purchasing financial assets (mainly government bonds) from financial institutions. In modern experience, the money those financial institutions receive in exchange for their assets is overwhelming left idle as reserves deposited with the central bank. Hence the extraordinary monetary stimulus of recent history has left little in the way of an inflationary legacy. This could all change if for some reason banks embarked on a mad lending spree, pumping those idle reserves into the economy. For now though, there seems scant chance of that.

‘Strayan connection

As usual, Australia would be tossed about like flotsam in the surf were all this to play out. First and most obviously, a strong USD typically hurts commodity prices. Much of this would be offset by a weakening Australian dollar, and there are obviously much more pressing concerns with say iron ore than a strong USD. The long suffering coal industry would come under further pressure, as US exports directly compete with Australian coal (all the more so after the shale gas and oil booms displaced coal as a power source in the US). However, of much greater concern to Australia is the risks that the yen devaluation poses to our emerging LNG industry.

In March 2011, Japan was devastated by a tragic triple-disaster of earthquake, tsunami and nuclear meltdown. One understandable consequence of this disaster was the shutting down of all Japan’s nuclear reactors, which required an immediate switch to imported fossil fuels. This drove Japan’s trade balance into deficit, where it has remained in spite of the massive currency depreciation from late 2012.

One reason why this has happened by been the inelastic nature of Japan’s demand for energy. With few available alternatives, Japan has needed to import the same amount of oil, gas and coal to meet its domestic needs, and all this imported fuel has become more expensive following the yen depreciation. There was already concern within certain segments of corporate Japan that the costs of higher energy were offsetting the competitiveness improvements from the lower currency.

If the USDJPY is indeed on its way to 120 and beyond, I find it hard to see Japan weathering this depreciation in the yen without turning the nuclear reactors back on. It is true that there is strong community opposition to this, but the more expensive energy becomes, the less sway this sentiment will hold. There have already been moves to restart some reactors lately. Should this occur on a large scale, it will pile pressure on to Australia’s gold-plated LNG industry, which is already facing challenges from US and Russian gas, and the slump in crude oil prices to which LNG contract prices are linked.

Further reading

For a more detailed discussion of the mechanics of international trade and capital flows, and the issue of global imbalances generally, see Michael Pettis’ book, The Great Rebalancing, and/or his blog, China Financial Markets.

There was a spirited debate last decade, prior to the financial crisis, concerning the sustainability global imbalances, dealing especially with the question of the US current account deficit. One influential school of thought argued that the US current account deficit was a natural and healthy feature of the international economic system, largely explained by the inability of immature financial markets in developing countries to fully allocate their savings domestically, which entailed no painful adjustment. This view was exemplified by Dooley, Folkerts-Landau & Garber (2003) and (2004), but was evident also in Chinn & Ito (2005), Bordo (2005), and Backus, Henriksen, Lambert & Telmer (2009).

On the other hand, some authors did recognize the risks building up due to ballooning global imbalances, and sounded warnings accordingly. Examples include, Obstfeld & Rogoff (2005), Edwards (2005), and Roubini & Setser (2004).

It should come as little surprise that I side wholeheartedly with the latter camp.

Strayan Rates – October Update

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The Australian cash rate is one of the focal points of this blog. In my first post on ‘Strayan rates, I wrote:

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.

Whenever the RBA next adjusts the cash rate, it bears acknowledging that the 25bp move isn’t likely to be the critical determinant of economic conditions at that point in time. It will have an impact, but my focus has more to do with what the move will intimate about the state of the economy.

With this in mind, my first series on rates sought to sketch out a portrait of the Australian economy. My conclusion was that the evidence pointed to a greater probability that rates would fall with the next move, rather than rise.

Each month or so, beginning with this post, I’ll provide an overview, of varying detail, of the most important economic indicators for Australia, and update my view on interest rates accordingly.

Onya, Timmy!

Before I begin I want to mention the work of Tim Toohey, head of Macro Research for Australia and New Zealand at Goldman Sachs. I intentionally singled him out in that first post two months ago, as the loss of his rate cut call at the time left blanket agreement across institutional research teams in Australia that the next move in the cash rate would be up. (What better moment to dive in and swim against the tide, I thought!)

He abandoned this call with considerable reluctance, and last week he reiterated why that was the case:

A feature of our research over the past 18 months has been to break away from the guide posts that have served us well in obtaining a read on the future direction of economic activity over the past decade. Historically we had looked to easing financial conditions, rising confidence and rising wealth as important touchstones for a future acceleration in economic activity. These were indicators that had proved their worth over the prior 30 years. As such, our decision to adopt a far more cautious view than the consensus over the past two years was not born of the idea that these indicators were suddenly of less worth. They were born from the idea that there were other forces that were likely to be more powerful, namely the likely sharp decline of the terms of trade, the likely sharp decline in mining investment and a lack of economic incentives to drive a pickup in broader business investment, the likely persistent challenge of fiscal consolidation and an uncompetitive production base relative to Australia’s trading partners.

As will be clear to anyone who has read Strayanomics in any detail, this matches my own view of the economy with precision. (The most prominent voice advocating this view has long been David Llewellyn-Smith of Macrobusiness, to whom I owe much. Lately, Stephen Koukoulas has also joined the merry men, and is the only economist of 27 surveyed by Bloomberg who expects the next move to be a cut. For a longer-term perspective on why those of us calling rates lower are doing so at this time, see Ross Garnaut’s Dog Days, an immensely insightful book.)

Back to that first ‘Strayan rates post:

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.

As the rest of that series made clear, I have based my forecast for lower rates on the view that the terms of trade decline, the mining investment wind-down, lacklustre business investment ex-mining, the fiscal squeeze, and weak competitiveness would outweigh the impact of rising asset prices, speculative activity and consumption demand that have flowed from the last easing cycle. When Mr Toohey discarded his longstanding rate cut call in mid-August, he was conceding to the power of the latter.

Nevertheless, he has made a strong case for the ongoing possibility that rates could fall further, and his thesis is one that I think deserves attention.

Outline

The rough qualitative model I’ve been using essentially places the terms of trade and mining investment downturns, along with weak government finances and Australia’s poor competitiveness, into the structural basket. On the other hand, brisk gains in house prices, which have been driven increasingly by investor mortgage lending, and the boom in residential construction (especially apartments), I place in the cyclical basket, as they’re directly attributable to the last easing cycle. It’s a slightly clumsy oversimplification of terminology, but it serves its purpose.

Broadly speaking, structural forces argue for lower rates, whereas cyclical forces tentatively argue for higher. This, of course, is exactly the dynamic Tim Toohey and others have been emphasising.

Terms of Trade

Commodity prices have seen further deterioration in the last couple of months. Iron ore and coal contribute approximately 35% of Australia’s export revenues. LNG contributes much less at present but its share is set to jump enormously over the next few years.

As reported in the Australian, there was some hope of a rebound in coking coal recently.

Like iron ore and thermal coal, prices for coking coal — Australia’s second-biggest mineral export earner — have been hard hit this year, falling by 24 per to $US113.50 a tonne on a spot basis.

But the call has gone out that prices have bottomed and are set to bounce back to between $US130 and $US150 a tonne in the near term, and $US170 a tonne in the longer term.

Unfortunately, this optimism was short-lived, from Bloomberg:

The quarterly benchmark price for metallurgical coal dropped to a six-year low, according to Doyle Trading Consultants LLC, amid a slowdown in Chinese demand for the steelmaking ingredient.

Australian coal producers and Japanese steel mills agreed to a fourth-quarter price of $119 a metric ton, down a dollar from the third quarter, Grand Junction, Colorado-based Doyle Trading said in a report yesterday.

Chinese imports in August were 39 percent lower than a year earlier, according to customs data, amid a glut of domestic steel. Iron ore demand is also suffering, with prices at a five-year low.

May I say, the idea that coking coal is going back to $170 is fanciful for the foreseeable future. Not even the BREE expects this, despite its unimpeachable record of overestimating future commodity prices.

Likewise, thermal coal offers little cause for cheer, squeezed by continued (though reduced) oversupply globally and the shale boom in the US (which has seen gas displace coal as a power source).

From the BREE:

Coal prices are forecast to remain subdued throughout the remainder of 2014 in response to weaker import demand from China and a continued abundance of supply. At lower spot prices many producers are unprofitable, which is expected to support further cost-cutting measures and signals the risk of more mine closures or production curtailments over the remainder of the year.

While coal consumption is forecast to remain robust in 2015, particularly in the Asia-Pacific, the global supply overhang is expected to persist and contribute to continued softness in prices. Contract prices for JFY 2015 are forecast to decline by 6 per cent to settle at US$77 a tonne. From 2016, the market balance is expected to tighten as import demand continues to increase and lower prices during 2014–2015 reduce investment in new capacity and force less competitive operations to close. The contract price is projected to rise to US$86 a tonne (in 2014 dollar terms) by 2019.

Despite tougher times, coal isn’t going anywhere. Aggressive expansion plans are being tempered, but the industry will continue to make a significant contribution to Australia’s economic output and export earnings. Nevertheless, the days of coal serving up windfall profits and tax revenues are past.

As you can see from the chart below, Australia’s exports of LNG are set to skyrocket over the next couple of years, making Australia the world’s largest supplier.

This will improve Australia’s trade balance and therefore boost headline GDP, however we’re unlikely to see the kind of boom in corporate profits that characterised the iron ore and (to a lesser degree) coal booms over the past decade. I have written about LNG here. Since the impact on domestic demand will be minor once the surge in exports begins, and may even be negative as local gas price leap and construction workers are laid off, LNG offers little in the way of upward pressure on Australian interest rates.

With the glory days of coal long since past, the burden shifted to iron ore to keep the party alive. Sadly, as you can see from the RBA’s chart, iron ore has had a particularly rough ride in 2014. Here is my own year-to-date chart:

This year’s decline is directly attributable to soaring supply from major producers, especially Australia.

Rising volumes are offsetting some of the squeeze on profits margins, but not enough to prevent a big hit to the economy if prices remain at or near current levels.

Recently I noted that the worst may well have passed for the iron ore miners in 2014. Spot found legs for a solid bounce after that, however as you can see it didn’t manage to hold its gains. Still, buying returned at the end of last week around the $80 level, and it looks unlikely we’ll see falls much below this for the remainder of the year, owing to much improved profitability amongst Chinese steel mills, a thawing of credit conditions in China and some degree of seasonal inventory restock into the year’s end. However, without a fundamental shift in Chinese policy settings, the bounce will be short and soft relative to past years. And with no sign of a let up in the pace of supply expansions from the majors, further declines in iron ore next year are virtually baked in.

China

It should be no secret by now that China faces an immediate choice between slower, sustainable growth that is much more biased towards domestic consumption in place of investment, or faster growth that’s increasingly unstable and ultimately unsustainable. The government is more than aware of this trade-off, and has largely opted to curtail the excesses of previous years (without being too aggressive). Should the government’s resolve waver in the face of a more serious downturn, then risks would increase of a ‘big bang’ stimulus that could temporarily elevate demand for raw materials and most likely provide a sufficient boost to Australia to see rates rise, also temporarily, as cyclical influences take precedence.

China has witnessed a noticeable slowdown in the property sector this year, which has weighed on growth.

Along with the usual monthly data indictors, we received China’s national account data this week. As you can see, the growth rate of real estate investment continues to slide.

This is dragging down fixed asset investment generally, which is by far the most important form of spending for Australia’s economy.

I only have data going back a decade, so all I can say is that this is the slowest pace over the period I can see. But I would be very surprised if this were not the slowest since the Asian Financial Crisis or earlier.

The property-related slowdown has been sharp, and so far as I can discern, only a jump in net exports has cushioned the blow to GDP growth (cynical observers may be less charitable). For a large part the slowdown is the result of policy restrictions on mortgage lending this year, among other measures. However, unlike the previous cooling in 2012, the property market now appears to be structurally oversupplied (and even more overvalued). Looser credit conditions could certainly mitigate the severity of price declines, but it would require a complete abandonment of credit rationalisation to reignite the boom, which the government has long been reluctant to do.

Thus it was to much fanfare that the government eased restrictions on mortgages late last month. This is apparently already lifting activity in tier 1 cities. Credit growth remained subdued in September, and this is going to be the key indicator going forward determining whether the looser policy stance translates to a meaningful resumption of price gains and investment activity. I don’t think we’ll see this, but I wouldn’t be surprised to see the slowdown moderate, or mild gains in prices over the next 6 months. Nevertheless, I’m highly sceptical that this moderation, if it does manifest, will be enough to mop up excess steel supply, and even less so excess iron ore, implying more pain for the latter next year.

It appears that China’s rebalancing (which is a polite way of saying ‘slowing’) is continuing, albeit with the government easing its foot off the break a little. I still do not see a resumption in the kind of frenzied building that delivered Australia’s commodity bonanza and was extrapolated far out to justify surging investment in capacity (and still is). With another wall of iron ore supply careering towards markets next year, policy shifts from China have not yet been substantive enough to change my view on Australian interest rates.

Investment

Not much to report here since my post on engineering construction work a couple of weeks ago. The outlook remains soft as LNG mega-projects wind down.

A couple of charts from the RBA help paint the picture.

Mining investment is set to decline sharply over the next two years, and non-mining business investment will need to be revived to mitigate this. To do so, the AUD will almost certainly need to come down markedly. In the absence of this, business investment is going to be a big drag on the economy and will argue in favour of lower rates.

Public Finances

The federal government handed down a tough budget in May in a bid shore up public finances. Partly owing to this effort, the deficit is expected to decline over the next few years.

It is very hard to see this happening with iron ore where it is. The AUD is lower than was forecast, but this has not been enough to offset the larger-than-expected decline in the terms of trade. In addition, the government has had great difficulty getting its savings measures through the Senate. Do not be surprised if the mid-year economic and fiscal outlook (MYEFO) in December shows a marked deterioration compared with what the government had intended.

State balance sheets are also under pressure, and it’s only been the property booms in Sydney and Melbourne that have prevented much worse outcomes in NSW and Victoria this year. By their nature, the support from these booms will prove transitory.

The pressure on public balance sheets will in turn keep the pressure on governments (both state and federal) to search for further savings, which households will not like. The outlook for the Australia’s fiscal settings therefore offers scope for further monetary easing.

Housing

The housing sector remains robust, with no let up in prices over the past month.

And for a longer term perspective:

Naturally, this has been driven by surge in mortgage lending over the past 2-3 years.

Notably, however, owner occupier lending has clearly flattened out this year, while remaining at an elevated level (the share going to first home buyers has collapsed).

This has meant local investors and, to a degree we can’t fully ascertain, foreign ones, have become increasingly dominant in the Australian housing market, especially in Sydney and Melbourne.

With strong prices in the capitals, dwelling construction is booming, at least relative to recent history. (It is true that Australia has long underinvested in housing, though not the extent that it can fully explain recent price gains.)

One result of this building boom has been a shift in the relative economic performance of the states. Reversing the pattern of previous years, state final demand has been contracting in Queensland and WA, while being stronger in NSW and Victoria.

This excludes exports, so it’s misleading to say QLD and WA are in recession. However, foreign purchases of a state’s export commodities don’t necessarily provide much in the way of direct support for local jobs; it was monster profits and hurried investment that had a big impact on local economic conditions. And this is a reality that will be felt more acutely in the coming years as profits continue to fade and investment winds down.

In spite of healthy growth in demand in NSW and reasonable growth in Victoria, unemployment rates remain elevated, with Victoria faring the worse of the two.

Nationally, rents are now growing roughly in line with the CPI, while house prices are up around four times that. Rental yields have plunged as a result and will of course continue to do so if prices keep rising. It is often argued that high house prices in Australia can be explained by tight supply. Supply has not been as responsive as it could be, but if it really were a central reason for elevated house prices, then renters should be getting squeezed harder than they are. Since it’s prices that are soaring, but not rents, we can conclude that the demand side of the market is the primary driver of house prices.

So we have a hot housing market that is being propelled by investors seeking returns in the form of capital gains, since income produced from these assets is paltry. As more supply hits the market, growth in rents will remain subdued and may even fall. Low income generation can be justified when interest rates fall significantly, since this reduces the cash outflow from the investment. As prices rise, larger mortgages are required to speculate on houses, weakening the economic case for housing investment. Thus there is a limit to how far a housing boom will run on lower interest rates alone (though what that limit is precisely is a matter for the behaviourists). Indeed, recent consumer surveys have indicated that expectations for house price growth have well and truly rolled over.

In addition, we have the RBA signalling it will implement some form of macroprudential regulation by the end of the year, in a bid to cool investor activity in the housing market. Whether or not this has a significant impact in the absence of rate hikes remains to be seen. But I would expect it to hurt at the margin at the very least.

I can see the boom in house prices continuing for perhaps another 6-9 months before running out of puff. If macpru bites hard, then it may wind down earlier. Exactly when this latest investor frenzy for housing cools is immaterial, what matters for our purposes is that this boom is not translating into labour market tightness or inflationary pressures. On the contrary, the boom is barely holding the unemployment rate where it is. Hiking interest rates to deflate the housing boom would therefore necessitate lower rates in quick succession. For these reasons, I continue to judge that the RBA will not feel compelled to hike rates to quell strength in the housing market, which is likely approaching its denouement anyway.

Consumers

See here for a more detailed treatment of consumer spending.

A large part of the why the housing boom has not had the wider economic impact one might have expected is that households have been reluctant to respond to higher net worth in the usual manner of saving less and spending more.

After a jump into Christmas, retail sales growth has been tepid this year; not what you would expect given the ongoing improvement in household wealth.

I cannot be sure exactly why Australian households have altered their behaviour in this way. Watching financial meltdowns and long, deep recessions across much of the developed world has probably endowed us with a greater degree of cautiousness towards gains in paper wealth. The budget undoubtedly damaged sentiment, and the travails of commodity prices will be hurting as well, especially in WA.

Whatever the cause, consumers have chosen to remain stubbornly parsimonious in the face of rising wealth. Until they throw caution to the wind, there is little in the outlook for consumer spending to recommend higher interest rates.

Inflation

I’ve paid relatively little attention to inflation in Australia in my posts on interest rates, which may seem strange given the primacy of price stability in the RBA’s mandate. The reason I haven’t looked at inflation much is because I don’t consider there to be any serious risk of it posing a problem for the RBA.

There was some hand-wringing this year among more excitable observers as the CPI bumped up against the RBA’s ceiling rate of 3% (the RBA seeks to contain inflation at 2-3%). For the past year I have steadfastly maintained that this was a temporary occurrence resulting from the sharp decline in the Australian dollar last year (which raised the price of imports) and the introduction of the carbon tax. The effect of ‘tradables’ inflation on the CPI, from rising import prices, was especially pronounced.

Rising tradables inflation from one-off adjustments in the value of the AUD is not problematic, in fact it is wholly desirable at this time. As I have discussed previously, one of the central economic challenges for Australia is our elevated real exchange rate, which translates to weak international competitiveness and therefore low business investment in trade-exposed sectors outside resources. The least painful way to devalue your real exchange rate is to reduce the value of your nominal exchange rate (the value of your currency against other currencies) and not offset this with higher wages. Wage growth is very low today and the AUD is falling against other major currencies, so progress is being made. By its very definition, a lower nominal exchange rate implies higher import prices; this is what it means to improve Australia’s competitiveness. For this reason, tradables inflation is desirable so long as the depreciation of the currency does not spiral out of control (and there is very little prospect of that today).

Australian Dollar

This need to improve Australia’s competitiveness was why I highlighted the Australian dollar as an additional and important consideration in Part 5 of my initial series on rates. A significant drop in the AUD would alleviate many of the structural weights hanging around the neck of the economy. It would improve the profitability of exporters, and so cushion the blow to public finances from falling commodity prices. If large and persistent (and not offset by higher nominal wages), a fall in the AUD would in time revive weak business investment outside the resource sector. All this ought to support employment. While a lower currency is not a silver bullet for all Australia’s challenges (it would make our over-inflated house prices even harder to justify, for instance), in reducing the drag on the economy from various structural weaknesses, it would reduce the likelihood of rate cuts.

As you can see on the chart below, the AUDUSD had tumbled below support at .9200 and was trading around .8900 at the time of my last Strayan rates post. Since then, it has fallen further but stalled once it hit strong support at the previous low of .8660, set in January this year.

The bears have mounted a concerted effort to break this support on no less than three occasions since the end of September, and failed each time.

Plainly, this support is going to be harder to break than it appeared to me a couple of weeks ago. The picture is has grown a murkier due to the sharp decline in US interest rates last week. Lower interest rates reduce the attractiveness of holding a currency, and so tend to see its value decline. (charts courtesy of ForexLive).

Bonds have settled down after the craziness of last week, but all eyes are now on US inflation data later tonight. Should those data undershoot expectations, and I would say that is a distinct possibility, then US yields would likely come under further pressure, which would of course favour the AUD.

As I argued in my last rates post, I would be looking for the AUDUSD to head towards .8000 before concluding that the case for a rate cut had significantly weakened. Much depends on US data, and at the risk of impeccably bad timing with the US CPI just around the corner, I’ll say that .8660 looks safe for now.

Conclusion

Evidently, the cyclical factors I highlighted at the beginning of this post are under-delivering relative to their historical performance. The most energetic phase of the housing boom has been and gone, without inducing a sustained spending response from households. This has meant that the impact on labour markets has been insufficient to reverse the uptrend in the national unemployment rate. Inflation is benign. China continues to offer a window of possibility that maybe the government will ride to the rescue again, but circumstances have not changed in the Middle Kingdom enough to alter my view that the structural weaknesses bearing down on the Australian economy will lead the RBA to cut rates the next time it adjusts the cash rate.

For now I’m going with Q2 2015.

Data and charts sourced from the RBA’s monthly chart pack, the Bureau of Resources and Energy Economics’ (BREE) latest quarterly report, the Australian Bureau of Statistics, China’s National Bureau of Statistics, and IGMarkets.

Straya T’day 1/10/2014

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National Day brings peace and quiet…

…unless you happen to be occupying Central, in which case you’re embroiled in the thick chaos of rebellion.

For Aussies at least, China’s National Day holiday week offers a welcome respite from the daily torment inflicted on us by the Chinese commodities exchanges.

So no iron ore or steel news today; for once this Straya T’day post will be all-Strayan.

Retail sales miss

Retail sales for August came in lower than expected, printing a 0.1% seasonally-adjusted gain over July, on expectations of +0.4%. Retail turnover was 5.1% higher than August last year. The respective trend figures were +0.2% and +5%.

The yearly gain in sales still looks fairly healthy. (Both charts use trend data.)

However much of this strength reflects the surge in the latter half of last year, which is still ‘passing through the snake’.

Monthly figures have been subdued for most of this year.

The budget didn’t do much for consumer sentiment, and this has no doubt been a key factor in households’ reluctance to loosen the purse strings. It may also be a function of the deteriorating outlook for iron ore, which has been reported more widely and with an increasing acceptance that the situation is not likely to improve materially in the foreseeable future, other than perhaps a tepid restock in Q4.

Manufacturing PMI surprises

In fairness, Australia’s manufacturing PMI surprises me with every release, since its very existence implies that manufacturing has survived another month.

It’s pretty bleak reading, although that’s nothing out of the ordinary. Until Australia’s real exchange rate significantly devalues, there’s little hope of a broad-based revival in business expenditure in the manufacturing sector.

Mining capex unwind is upon us

Along with retail sales, the ABS released quarterly data today on engineering construction work, which is an important measure of mining investment activity. Combined with the flagging terms of trade, the downturn in mining investment is the chief headwind facing the Australian economy over the next couple of years.

Overall, the value of work completed declined 2.2% in the June quarter from March. The value of work completed by the private sector declined 1.9% to $23,130m.

So far the descent has been fairly smooth, however this is set to steepen rapidly over the next 6 to 12 months.

Of course, all this investment is going towards substantial increases in Australia’s export capacity, primarily in LNG. So will the decline in investment give way to a boom in exports, such that the net impact on the economy is benign?

Not quite.

It’s important to remember that Australia’s mining boom over the last decade has been enriching beyond precedent because it was a boom in profits. So despite the vast majority of Australia’s mineral resources being owned by foreign interests, the profits generated by these firms greatly increased company tax receipts and royalties revenue, much of which was then passed on to households in the form of tax cuts and transfers. Booming profits also saw wages in these industries skyrocket, providing another conduit for the windfall to flow into the Australian economy.

The ‘boom’ in LNG exports after the investment phase passes and supply ramps up will be quite different. These mega-projects in Queensland, WA and the NT are going to be about the most expensive sources of LNG on the planet, placing them at the other end of the ‘cost curve’ to Australia’s iron ore majors (see below). This means that current LNG prices aren’t going to deliver the massive profit margins that characterised the mining boom. So although Australia’s export volumes will surge, supporting GDP growth by improving the trade balance, the income effect on Australia will be negligible when compared to the iron ore and coal booms of the last decade.

The gas has mostly been sold on long-term contracts. However, what happens to spot prices once the gas starts flowing remains to be seen. There was already a mini-crash in spot prices this year during the northern summer…

…and yet the ramp-up in Australia’s LNG exports has barely begun.

If spot prices do fall significantly below contract prices, there will be immense pressure on suppliers to renegotiate those agreements.

Here’s where Australia’s LNG projects sit on the cost curve (in orange).

Clearly, if spot prices drop much below the levels they did during the northern summer, and stay there for any length of time, a lot of these projects are going to face serious trouble as buyers attempt to wriggle free of contractual obligations.

Yet another reason why we’re fervently cheering the Australian dollar lower!

Straya T’day 26/9/2014

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Memo to RBA from former self

Former RBA senior economist Jeremy Lawson has delivered a gentle rap across the knuckles of his previous employer for the state of housing, albeit with the insistence that it wasn’t mendacity but rather an underestimation of the ‘investor pulse’ in Australia that led the RBA to sit by while housing market inflated. I have covered the rise of the Australian property investor here, so it goes without saying that I mostly agree with his appraisal.

Much has been written this week about Stevens’ ‘backflip’ on macpru regulation, centred on his somewhat flippant description of these tools as an international ‘fad’, just last month. What he actually said was;

As for what one does about (the boom in property investment in Sydney and to a lesser degree Melbourne), apart from just warning—and the warning is probably ignored—I think the next step is to then press through the supervisory mechanism for the lenders to know who they are lending to, take care, keep giving the message about leverage and take a close look at standards of lending. APRA already has been communicating with banks about those types of issues, and I imagine we can probably step up that scrutiny and make it a little bit more targeted if it is appropriate to do so over time. The strongest step would be the dreaded macro prudential tools—they are the latest fad, internationally. And I have said that I do not rule out the use of those or asking if APRA will use them, if needed. That would remain on the table as a possibility as well.

His choice of words was unfortunate. He wasn’t wrong that macpru policies have gained popularity in the international policymaking community in the wake of the GFC, however this was a necessary response to the catastrophic failure of conventional thinking on central banking and macroeconomic management that resulted in the crisis. So macpru is no fad, at least I certainly hope it’s not. But despite his seemingly dismissive tone, Stevens clearly had not ruled out the dreaded macroprudential tools.

Returning to Lawson’s comments, the one criticism I think can be fairly levelled at the RBA over its lackadaisical approach to housing is the failure to learn from recent history both here and abroad. As I have detailed previously, the past two decades have deeply implanted the notion in many Australians that property speculation is a low-risk, high return investment strategy, and understandably so. There have been persistent warnings of the dangers of leveraged property bets, and none of these ‘doom-mongering’ exhortations have been vindicated (remembering, of course, why this has been the case). Therefore, as the RBA pushed the real cash rate into negative territory, it should have been acutely aware of the high probability that this would ignite another investor surge in the property sector. It would have been entirely appropriate to deploy some manner of macpru tools before the cash rate was dropped as low as it was. Whether these would have worked, we do not know. But as Stevens has belated accepted, there was little downside in trying.

Shining lights in the darkness

Michael Pascoe and Adam Carr have both come out swinging as a mood of foreboding supposedly descends upon the nation. Carr is sounding increasingly unhinged as he lambasts everyone from ‘property doomsters’ to our esteemed policymakers. What can you say? Anybody who declares property investment a no-brainer under any and all circumstances has obviously done their credibility a disservice (remembering the extreme historical anomaly that Australia’s experience with property have been over the past two decades).

Both commentators are chiefly concerned with the ‘Hanrahan chorus’ wailing about imminent collapse. The point being, either Australian property is heading for a US subprime-style meltdown, or it’s fine. Reality is a little more nuanced than this simple bifurcation implies. As the RBA’s Financial Stability Review showed, Australian banks are not engaging in the scale of risky lending that has characterised other property bubbles. So the risk of a complete systemic meltdown seems remote. But this doesn’t mean that having a property market in which median prices are over 8 times incomes and investors account for over half of mortgage issuance, as in Sydney today, is a good idea. You can still seek to optimise economic policy outside periods of imminent doom.

Moreover, there are considerations regarding property that go beyond the threat to financial stability. Australia is in the grip of the most serious downturn in national disposable income in at least three decades, perhaps much longer. The household debt-to-income ratio is stable but high (having risen slightly in the past couple of years). This situation can easily deteriorate as incomes fall, however, either through loss of purchasing power if the nominal exchange rate keeps falling, or rising unemployment if it does not. So it ought not to be too controversial to highlight that it’s undesirable to have a seriously stretched residential housing market at this point in our economic cycle.

Macpru is therefore an eminently sensible option. If it totally fails, and if the housing market continues to march inexorably higher, then we may have to countenance higher rates. But the hurdle is very high for higher rates, since as I have mentioned a number of times, nothing else aside from the speculative end of the property market argues for them.

Bounce in steel, iron ore to end the week

Better news in the steel-ore complex today, with futures up in China; a welcome end to another dour week.

Ugliest of all this week was news that growth in crude Chinese steel consumption in has ground a halt this year, for the first time since 2000. The mantra in the iron ore industry is that the 2014 rout has been a supply-side phenomenon; demand is fine. However, the assumption driving higher iron ore output was that Chinese steel consumption had much further to rise. So flat steel consumption, and therefore relatively weak growth in seaborne iron ore demand, is what has made the iron ore supply ramp-up into a problem.

Unless spot stages an almighty rally today, this will mark the 7th straight week of declines. China’s National Day ‘Golden Week’ holidays begin on Wednesday, running to the following Tuesday. There’s a fair chance we see a bit of restocking activity once that’s out of the way, but unless the government the signals a meaningful shift in policy that will reinvigorate demand for steel, the Q4 rebound is likely to be underwhelming this year.

Friday Muzak

Because econ can wear you down after a while…

Straya T’day 25/9/2014

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Cheer up!

John Edwards, a member of RBA board, today delivered a pointed rebuttal to the doom-mongers talking down the economy. (We have nothing to fear but fear itself, my friends!)

The gist is:

The boom was not as big as is widely thought; it has on the whole been sensibly handled; and in any case it is not yet over.

Edwards has of course never heard of Strayanomics, but his arguments are recognizable in their opposition to most of what has been written on this site in its brief history.

The gist of Strayanomics:

The boom was very big, the biggest in Australia’s history; it has not been handled in anything like an ideal fashion; it will, of course, not end overnight, but it is unequivocally in the process of ending.

Readers are at liberty to explore my reasons for these positions on the blog. Or they could turn to the RBA itself, since, as Leith van Onselen of Macrobusiness noted in his takedown of ‘Mr Rainbow’ this morning, the RBA’s own research contradicts Edwards’ message.

No sense of occasion

Displaying scant regard for the timing of Edwards’ feel-good riposte to the merchants of doom, the slide in steel and iron ore futures continued on its merry way today. Here’s the daily piece from Reuters. No sign of a turnaround yet.

And here’s what spot looks like.

As I never tire of repeating, Australia’s immediate economic fortunes are massively dependent on the decisions taken by a few men in Beijing. If the Chinese leadership presses ahead with reform efforts, more pain lies ahead. If they baulk at the task and revert back to fixed asset investment and loose credit, we’ll enjoy a reprieve. (But note that in due course the pain will eventually arrive; credit booms are inherently unstable, the longer they run, the more tottering they become.)

As such, any indication of wavering resolve is cause for excitement. There was one such indication yesterday when the Wall Street Journal reported that pressure was mounting to replace the reform-minded chief of the People’s Bank of China (China’s central bank). If true, it could usher in a more accommodative monetary policy stance, which should support China’s economy and its demand for raw materials. The PBoC has denied this, for what’s worth, but the situation should be watched closely.

Chinese stocks greeted the news with some enthusiasm, however sadly the same cannot be said of the steel and iron ore.

On steel, Bloomberg has a fascinating story today which provides a neat follow-on from a point I made earlier in the week. The September HSBC PMI showed considerable buoyancy in exports, which I suggested may partially reflect the accelarating offloading of unwanted steel products on to global markets by Chinese mills, which seems to be gathering speed as domestic prices collapse.

From Bloomies:

After the Chinese steel industry expanded by 50 percent since 2010 to keep up with surging demand, mills can produce 210 million metric tons more than the market needs and a quarter of capacity sits idle, according to data compiled by Bloomberg Intelligence. With economic growth slowing, producers are reluctant to close plants, forcing a record pace of sales overseas, where competitors accuse China of dumping.

China, which produces almost half the world’s steel, shipped 52.4 million tons in the first eight months of this year, up 36 percent from a year earlier and more than the 42.5 million exported over the same period in 2007, when sales were at an all-time high, government data show. By year-end, the 2014 total may reach 85 million tons, according to Hu Yanping, an analyst at custeel.com, a researcher in Beijing. That’s 44 percent more than the 2007 record of 59 million tons.

…

More of the surplus is heading to other countries. In the U.S., the sixth-largest buyer of Chinese steel, hot-rolled coil imports cost about $683 a ton on Sept. 19, the most since June 2012, according to data from Metal Bulletin. That compares with $487.50 for Chinese hot rolled coil exported on a free-on-board basis, the lowest since November 2009, the data show. The premium of about $196 is the biggest since December 2008.

As the premium collapses, the calls for protection from Chinese imports will grow louder, and rightly so. What is left of the US steel industry has no obligation to bail out beleaguered Chinese mills who’ve wrecked their margins after years of capacity over-investment.

As the article notes:

The country won’t be able to increase exports next year “without encountering resistance,” said Shi Shengwu, a manager at the international trade unit of Wuhan Iron & Steel Co., a producer based in Wuhan. “It’s a very touchy issue.”

Indeed. China is set to produce a bit above 800 million tonnes of steel this year. Australia’s iron ore expansions have been undertaken on the assumption that this rises to a billion tonnes by 2020. As it stands, this looks very unlikely to transpire without absolutely eviscerating the world price (forcing some production to idle and therefore preventing the increase in output).

Deficit yawns

The Final Budget Outcome for 2013-2014 is out and showed a substantial deterioration from 2012-2013, roughly in line with the government’s expectations in May. Unfortunately, although the iron ore price slid throughout the last half of FY2014, it is looking like being much lower this coming financial year (see above spot price chart), setting Hockey up for an even worse 2014-2015 budget. Those who thought the Treasurer was low-balling forecasts to engineer a unexpected improvement will be disappointed (for instance).

Still, they’ll always have John Edwards to turn to if things get really glum.