Firstly, let me make it plain that what is happening in the US economy in the first few months of the year is absolutely no surprise. The first quarter of each year of the past four has been the best and I expect the same this year. My forecast since the year began has been for 2.6% or so growth this year and I have not changed that at all.
The pattern of the past four years has been some combination of the global inventory cycle associated with Christmas, the timing of monetary policy interventions and its amplification of Christmas stock market Christmas. The pattern is most howlingly obvious in US employment numbers:
That is not to say that beneath this cycle the US is not moving towards some kind of virtuous cycle (escape velocity if you like) that will accelerate both growth and monetary tightening. But we aren’t there yet in my view.
There is, nonetheless, increasing hoopla about this “accelerating” recovery and concomitant repricing of various markets.
The AFR has a report today on the return of the Australian yield curve to a more normal pattern:
Bond traders are rapidly paring back their expectations of cuts to the official cash rate as global stocks surge and the US economic recovery gathers pace.
On Monday, the three-year bond yield rose above the Reserve Bank of Australia’s overnight cash rate, now at 3 per cent, for the first time since July 2011. Another rise in bond yields on Tuesday implied bond traders were predicting the cash rate was unlikely to be cut by even 25 basis points.
The three-year rate, which hit 3.03 per cent Tuesday, has risen by more than 100 basis points off its low of 1.96 per cent in June 2012 as investors dump their bonds. The rise has produced a “more normal”, positively sloping yield curve, which bodes well for the economy.
“Given the front end of the yield curve was inverted for most of 2012, the fact that it is positively sloping again is a sign that the economic outlook is improving,” said Tim Carleton of hedge fund Auscap Asset Management.
Well…maybe. But to determine that we must first determine how the US economy matters to Australia. The channels include:
- stock market risk premiums are set in New York, we follow;
- US monetary and fiscal settings determine the value of the US dollar. This in turn effects the price of commodities and the Australian dollar. A rising USD will damage commodity price, espeically if the AUD stays strong;
- the trade channel is small, representing only 3.7% of export value, the US consumes only small amounts of bulk commodities;
- however, the US is very large importer of Chinese goods so there is a positive flow effect to Australia in better Chinese growth.
So, the vast majority of the channels via which the US can effect Australia are in the financial not real economy. The corollary is that if you think we’re in for some kind financialised recovery, as the stock market currently does, then the US is about to launch us all into a fabulous new cycle.
If, however, you think that the real economy is what matters these days, as I do, then the US recovery and any effects it is having upon market pricing, are going to be temporary.
This is a rather long-winded way of saying that the US recovery, such as it is, does not change my view that Australia faces a bull trap in the next twelve months. That is, even as assets increase in value on the back of rising US risk tolerance, Australia still confronts a mining investment cliff and declining terms of trade. The attempt by the RBA to rebalance Australian economy growth drivers back towards asset inflation and dwelling construction is certainly being assisted by the US recovery, such as it is.
But in truth, these days the real economy is yoked completely to just one oxen: China. If the terms of trade continue to fall, which is my base case, then the US recovery is only going to mitigate the real economic downside that comes with falling mining investment.
Yet, for the first time in many months, local interest rate markets are close to pricing rate cuts out completely and the yield curve has finally righted after twelve months of inversion:
At best, these markets are ahead of real economic prospects and may in fact be approaching dislocation.