Tag Archives: interest rates

Did RBA shoot own foot?

There was always a risk that the RBA would feel pressured into a cut on Tuesday by intolerable strength in the currency it issues.

So it was, it seems. Although sadly for the RBA, its decision to cut interest rates to take steam out of the AUD rally resulted in an AUD rally.

It has been widely asserted that the offending action was the lack of an explicit easing bias in the accompanying statement. For instance, from the SMH:

Failing to control the Aussie’s rise with its rate cut, the RBA “has lost all respectability – if there was any left to lose”

Cripes.

While I have to say I was surprised at this misstep by the RBA (which among other things contributed to a continuation in the brutal bank sell-off, which I lazily supposed would be halted by a cut), it’s probably reaching a bit far to heap opprobrium on the RBA in this instance. There’s been a vicious bond sell-off lately and yield plays (i.e. our financials-stacked sharemarket), have naturally been getting smacked around.

The market was also clearly looking for an excuse to buy AUDUSD. As I’ve detailed previously, most indicators have pointed to a mild improvement in Australia over the last couple of months, so much so that I found myself in the camp thinking a May cut might well have been off the table. In the end, the RBA met me half way, and markets moved on a tightening theme (or at least a no-more-easing theme, which is a sufficiently terrifying prospect for modern markets).

It will be a fairly short-lived, I feel. Iron ore has had a nice rebound from very oversold levels it reached in late March/early April. Chinese steel mills are replenishing inventories and there are signs of a thawing at the top tier of the property market. It’s not likely to last. As a reminder, here is the ongoing supply deluge:

IronOre2

All being dumped on contracting steel production.

I can’t say how long the restock will persist, but the next time iron ore slumps it’s very likely to print fresh lows, pushing another few juniors towards the abyss, before eventually coming for FMG.

Capture16

An interesting development that’s worth keeping an eye on is the large spike in futures volumes traded on the Dalian Exchange. From Reuters:

The volume of iron ore futures traded on the Dalian bourse reached 18.6 million contracts in April, equivalent to 1.86 billion tonnes, according to data on the exchange’s website. That was a monthly record, and far surpassed annual global sea-borne trade of around 1.4 billion tonnes.

An increase in volumes isn’t necessarily an issue, except that in this case market participants are obviously prone to leaping from one side of the boat to the other, and so we’re probably going to see more episodes of dizzying volatility this year.

The RBA is not done cutting interest rates yet.

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Australia’s extraordinary failure

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.

Iron ore

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.

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Sydney property prices

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?

The disease spreads

Back in August, when I began recording my thoughts on Australian interest rates in detail, institutional economic research teams were in unanimous agreement that we wouldn’t see the RBA cut interest rates any lower. In my impudence, I dissented.

Here were some of the forecasts for the first hike at the time:

  • AMP – Q1 2015
  • Barclays – Q1 2015
  • CBA – Q1 2015
  • Moody’s –  Late Q1 2015
  • St George – Q1 2015
  • StanChart – Q1 2015
  • TD Securities – Q1 2015
  • HSBC – H1 2015
  • Nomura – H1 2015
  • ANZ – Q2 2015
  • Citigroup – Q2 2015
  • UBS – Q2 2015
  • JP Morgan – Q3 2015
  • Westpac – Q3 2015
  • RBC Capital – Q4 2015
  • Goldman Sachs – Q4 2015
  • NAB – Q4 2015
  • Bank of America-Merrill Lynch – Q1 2016
  • Macquarie – Q1 2016
  • BNP-Paribas – 2016
  • Deutsche Bank – 2016

It therefore came as a small victory for this humble blogger when two of those shops abandoned their rate hike forecasts this week, and now expect cuts. Perhaps unsurprisingly, the two banks to catch my disease were among the least bullish on the timing of rate hikes.

Deutsche was first out of the gates, revealing they now expect 50bps of cuts next year, with the first in Q2:

Chief economist Adam Boyton believes the strength in the housing market that has been supporting the economy is easing.

“When we combine that with our expectations for the unemployment rate – which is that it will rise all the way through next year – all that suggests to us that there is scope for the RBA to cut rates further,” he told ABC News.

The call runs against most other economist forecasts.

Indeed it does. But perhaps not for long. Following poor national accounts data today, Goldman switched to cuts, with the first coming in March:

Goldman Sachs re-joined the bear pack on Wednesday, forecasting a 25 basis point cut in March and another in August.

“Although third-quarter GDP growth was consistent with our forecast . . . we are shifting our view on interest rates back to interest rate reduction in 2015,” the investment bank said.

“Nevertheless, revisions to the back data and the composition of the GDP data were sufficiently poor to tilt the balance of probabilities towards a rate cut in the first half of 2015 as our base case,” it said.

And NAB is leaving the window open:

National Australia Bank’s senior economist David de Garis said on Wednesday that if leading indicators for the current quarter prove erratic, the central bank might consider more easing.

“The RBA can take some comfort from recent indicators on the economy suggesting that the pace of growth has picked up to some extent,” he said.

“Should such indicators show signs of faltering, then the RBA would need to address whether the current stance of monetary policy is sufficient to aid the economy’s transitioning to higher domestic non-mining growth,” he said.

Late Q1 or early Q2 next year has been my forecast for the first cut (see here, here and here), so it’s a welcome change to have a few professional allies in what was becoming a fairly lonely position.

One by one, they’ll all come around. Though perhaps not Paul Bloxham of HSBC. The poor chap has been predicting rate hikes since 2011, shortly before the RBA started chopping away at the cash rate, taking it from 4.75% all the way down to its current 2.5%.

And it hasn’t stopped yet.

Strayan Rates – November Update

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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15bl-blkcomp

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.

Whitehaven

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.

Capture10

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):

Screen Shot 2014-11-25 at 6.07.56 pm

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.

Brent

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.

IOSpot

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.

OzTradeBalance

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.

AusToT

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).

Screen Shot 2014-11-26 at 5.28.34 pm

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Screen Shot 2014-11-26 at 5.29.49 pm

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):

China real estate prices

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.

Screen Shot 2014-11-26 at 6.58.19 pm

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:

Screen Shot 2014-11-26 at 7.59.34 pm

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.

RPDataHousePrices

RPDataMonthlyChange

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.

buildingapprovals

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.

BuildingApprovalsState

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.

ScreenHunter_5056-Nov.-18-12.55

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.

Screen Shot 2014-11-28 at 4.00.08 pm

CreditGrowth1

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.

RetailSales

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.

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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.

UETrend

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

StateUE1

StateUE2

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.

WageGrowth

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.

AUDUSD

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.

Welcome to the Ice Age?

ice-age-3-1

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.

US5001

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

US5004

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

10yeartreasuries1

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).

us10year1

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.

USCPI1

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

White-walker
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.

bankofjapan

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.)

USDJPY

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.

USDCNY

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.

EURJPY

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.)

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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.)

globalCA

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

US oil

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.

Japantradebalance

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.

Retail Details

It may not be apparent from its serene outer appearance, but a constant battle rages at Strayanomics between thoroughness and brevity. I would like any argument I make to be as well-supported as possible, but the detail this demands can be excessive. Unfortunately, attempts to keep a post as short and timely as possible risk inaccuracies, especially as this blog is a personal learning exercise as much as anything.

So it was with my shallow treatment of consumption spending in the interest rates update for October. In it, I wrote:

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.

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.

I based this observation on two pieces of evidence: the national savings rate and retail sales data, which at first glance wasn’t unreasonable. The savings rate remains elevated:

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And, notwithstanding a jump into Christmas last year, national retail sales growth has been notably weaker than in previous periods of strength in the housing sector (2001-2004, for instance). Momentum has also clearly been lost in 2014, despite ongoing strength in housing.

RetailSales

The problem was that I extrapolated out some mysterious shift consumer behaviour from these data, which wasn’t really justified.

I have highlighted a number of times that the housing boom has largely confined itself to Sydney and Melbourne.

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It should have come as little surprise then that consumption spending in NSW and Victoria has outpaced the nation as a whole. NSW has seen the largest increase by a long shot, mirroring the outperformance of house prices in Sydney.

RetailsSalesNSWVIC

In contrast, the mining states, along with perennial laggard, SA, have drifted below the national figure.

RetailSalesRest

If we take a longer-term view of spending in NSW, we can see that the housing boom in that state has indeed had the impact one would expect.

RetailSalesNSW

There really isn’t anything mysterious about the apparent frugality of Australian households, nor what looked like their reticence to spend out of rising housing wealth. The national figures merely mask regional differences. In states that are experiencing the winding down of the mining boom first-hand, households are considerably more sparing in their purchases. In NSW and to a lesser extent Victoria, the booming capital city housing markets are raising consumption spending, pretty much in line with what you’d expect. Thus, the reason the housing boom has not had “the wider economic impact one might have expected” is simply because the boom has not been especially wide

I might add, this doesn’t alter my narrative on interest rates, at least not at this stage. Firstly, it reinforces the picture of our bipolar economy (cyclical strength versus structural weakness, as outlined in the October rates post). Furthermore, it reminds us that low interest rates are critical to keeping Australia from sliding ever-closer to recession (or what will feel like a recession; substantially higher export volumes may shield us from recession in a technical sense). If the RBA hikes, we not only lose the momentum of housing construction, but we’re also likely to see growth in consumer spending cool materially as housing slows. Such is the bind our monetary technocrats find themselves in.

Was that it for volatility?

A couple of weeks ago I posted a piece which was mostly concerned with the re-emergence of volatility in markets.

In it, I noted that the S&P500 had breached what was surely the most-watched trend line in the world, and looked poised for a deeper sell-off.

sandpLT

A deeper sell-off we got, but a prolonged one we certainly did not.

S&P500

That violent whipsaw has seen S&P reclaim the trend, if only just. The VIX has accordingly been smacked down just as quickly as it rose (though it remains elevated relative to recent extreme lows).

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So, was that the little vol episode over and done with? Can we get on with the smooth rally again now?

We shouldn’t be quite so hasty. As you can see on these charts from Elliot Clarke of Westpac, the aftermath of the previous conclusions of QE ushered in significant volatility.

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The title of that second chart, I might add, speaks a most important truth. Quantitive easing is colloquially known as money printing. For something to be considered money, it requires certain attributes, most commonly that it’s a store of value, a unit of account and a medium of exchange. The last of those is where the QE hits a snag. The Fed cannot legally create money and exchange it for anything other than financial assets; it creates liquidity and uses it to purchase government bonds and asset-backed securities from commercial banks. In so doing, those banks see a decline in bonds on their balance sheet and an increase in reserves. The Fed would like those commercial banks to then lend those reserves out into the economy and stimulate economic activity, but for the most part they have not.

Much of this new ‘money’ being created by the Fed through its QE programs is therefore sitting idly in its virtual vaults. That being so, how does QE affect asset prices aside from those that the Fed is actively transacting in? (Government bonds and ABS.)

The main channel is the suppression of volatility. Through its Permanent Open Market Operations (QE), the Fed becomes a giant, regimented provider of liquidity in bond markets, thereby reducing interest rate volatility. This naturally then flows into other markets. Part of this process is direct, by virtue of the Fed’s participation in markets, and part of it occurs as a result of the general shift in market psychology: participants believe that the QE lowers volatility, meaning they transact less, driving down volatility further. Participants believe that others believe this, and so on and so forth.

In my view, it is the decline in volatility that is the critical channel through which QE supports asset prices, especially equities; more so that lower yields. Risk is not confined to the variance of returns, but that is a key measure used in the market. Lower variance of returns encourages risk-taking, driving up risk assets such as equities. (The steady rally in equities is of course itself reflected by even lower volatility, so the process is self-reinforcing. This works in reverse when volatility starts to rise.)

The key now is whether the S&P can hold on the trend line, and carry global equities in the process. Recommending equities this time around is that the US economy is in unquestionably better sharp than it was at the end of either of the last two programs, and that the fed funds rate isn’t actually going to rise for some time yet. Nevertheless, rather than signalling an abrupt end to this latest volatility episode, I’m still of the view that major asset markets will experience significant ructions over the next few months, unless the Fed surprises on Thursday by delaying the end of its bond buying program or substantively prolonging the expected timing of its first rate hike. Likewise, a big surprise from the ECB with respect to its own QE program would also be supportive of more relaxed market conditions.

A bond bear market or a dollar bull market?

There was one other thing I wanted to discuss, which is the likely trade-off between a bear market in bonds and a bull market in the USD. The former was widely expected to arrive with the end of QE, the strengthening of the US economy and the eventual normalisation of short-term US interest rates. The Fed buys US government bonds as part of its QE program, thus the providing demand. When this demand is removed from the market, so the common view held, bond prices would decline and yields rise. Supporting this view was the violent sell-off in bonds that accompanied the announcement last year that the Fed would ‘taper’ its bond-buying program (in late May).

US_10year

Alas, this year, and in spite of clear indications of economic improvement in the US, especially in the labour market, yields have been trending down. In the last couple of months this movement was especially pronounced. The chart above significantly understates the intraday volatility the week before last, since it only captures daily closes. At one point, yields fell below 1.9% as bond bears stopped out en masse.

Part of the reason for this slump in yields (rally in bond prices) has been the ongoing absence of inflationary pressures globally, which if anything seem to be abating further. Economic recoveries are typically associated with rising inflation, which makes bonds less attractive. Tepid inflation has therefore supported bonds. Europe is flirting with deflation, Japan is battling to maintain what little inflationary momentum was generated by its sizeable currency depreciation, and China’s chronic overcapacity encourages to its ongoing export of ‘disinflationary’ pressures (see steel, for instance). Adding to this has been the sharp decline in oil prices, which is inherently disinflationary, although not of the sort that demands a monetary response.

Throw a strong USD into this mix and the US is going to find it extremely hard to lift inflation into a range that warrants ‘normal’ interest rate settings. So if the USD continues to rally, I find it very hard to see a trending bear market in bonds. The only thing I can really imagine that would facilitate a simultaneous USD bull market and bond bear market would be another credit boom, to support US demand and prices (particularly wages, which are more or less flat real terms), to such a degree that the strong dollar does not completely quash inflation.

There’s probably something I haven’t considered there, but it’s an interesting scenario to ponder, I reckon.