Why Bill Evans is wrong this time

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In his weekly address, Australia’s leading interest rates prognosticator, Bill Evans, argued that the interest rate doves have it wrong:

The balance of partial indicators suggest that growth momentum in the Australian economy has slowed markedly over the last three months since the lead up to the federal budget.

Because most high frequency data is around the consumer and housing, most evidence in that regard can be found in that sector. House price inflation (6-month annualised) has slowed markedly in all of the major cities – Sydney (17 per cent (to March)) to 12 per cent (to June)); Melbourne (13 per cent to 8 per cent); Brisbane (6 per cent to 4 per cent); and Perth (6 per cent to flat). New housing finance approvals have slowed from 33 per cent in February to 2.2 per cent in May (6-month annualised growth rate).

Between March and May, nominal retail sales actually contracted by 0.5 per cent. We estimate that the 6-month annualised growth rate for retail sales will slow from 6.5 per cent in March to 2 per cent in June (based on a reasonable estimate for retail sales in June).

In the three months to March, we added 91,000 jobs, while in the last three months only 20,000 new jobs were added.

Not surprisingly, market pricing around the Reserve Bank’s potential action has changed markedly. In late April, before the budget was released and before the market became aware of the lost momentum in the data, market pricing pointed to a 75 per cent probability of a rate hike by mid 2015 and a near 100 per cent probability of two rate hikes by year’s end.

Now markets are pricing in a 50 per cent probability of a rate cut by mid 2015 and a zero probability of a rate hike by end 2015.

Current pricing stands in sharp contrast with our own expectations of rates firmly on hold over the next 12 months, with two rate hikes in August and November next year. This view is predicated on a number of key observations on the state of the economy.

On housing investment, a distinction needs to be made between marginal momentum and the absolute level of activity. After rapid growth through 2013, annualised dwelling approvals are at a high level relative to history, just below 200,000. As this activity comes on line, it will provide critical support to activity and the labour market, most notably in key eastern states. On the labour market, forward indicators remain more positive than the labour force survey; the implication here is that more robust employment growth is anticipated in coming months. While it will likely not be enough to arrest the slow rise in the unemployment rate until year end, stronger jobs growth will support household incomes and affirm their expectations over the labour market. Coupled with continued house price growth, greater confidence in the labour market should be a positive for household demand through 2014 and into 2015.

This will provide a broadening of the demand base for Australian businesses. Australian firms have remained more sanguine on the outlook following the budget than consumers; and, as at June, conditions and confidence were both modestly above long-run average levels, according to the NAB business survey. To further reinforce the outlook for the consumer, we need to see the recent improvement in trading conditions and profitability translate into stronger employment demand. Global conditions should become increasingly supportive of this trend going forward. Currently, we anticipate world growth will strengthen from 3.0 per cent in 2014 to 3.7 per cent in 2015. This improvement will be a function of stronger developed world demand as well as stronger momentum in China, key for both the price level and volume demand of Australian exports.

This then leaves us to consider the likely longevity of the apparent confidence impact of the federal budget, arguably the key risk to the outlook.

1. By recent historical standards, the 2 per cent lift in confidence since the 7 per cent fall post budget has been modest. In 2013, the 7 per cent fall following the budget was largely offset by a 5 per cent lift in June. The index was back above the pre-budget level by August. In 2010, controversy around the mining tax and the carbon tax sparked a 7 per cent fall in confidence, with a near full recovery by July. Of course, the results of both those years were complicated by imminent elections and changes in the stance of policy (rate hikes in 2010 and cuts in 2013).

2. Households have been overestimating the near term severity of this budget. Total savings in the first 3 years of the budget are expected to be around 1 per cent of GDP compared to 3 per cent of GDP in savings from the first Howard-Costello budget. Surprisingly, confidence only fell by 0.3 per cent in the wake of that budget.

3. Media estimates suggest that the new Senate will oppose around $24bn of the $36bn (over 4 years) in budget savings. Of course, these policies include most of the less popular initiatives, including the $7 co-payment for visits to the doctor.

…On balance, we favour a gradual improvement in confidence and an associated recovery in marginal momentum for the consumer and housing. We expect households will look through the political turmoil whilst also appreciating that the severity of the Budget measures has been overestimated.

We expect that the Reserve Bank will be similarly patient, expecting the consumer to gradually lift its confidence and restore a more solid pace of spending, including a lagged boost to housing.

Readers will recall that is was Bill Evans that first broke ranks with the economic clique in 2011 and forecast rate cuts. This time, however, he is wrong for three reasons. In effect, Bill is arguing the opposite of what I did this morning, that firm business confidence will ultimately win out over weak consumer confidence. You can read my take on that elsewhere but the reverse is the likely case.

Second, the budget’s weight on consumers is not fleeting. It will ease for few months but only in time for another round of austerity in December with the MYEFO. By then the budget deficit will be wider than forecast (perhaps considerably) on senate interference, the high dollar and the terms of trade crash. The one thing the Abbott government can’t abide now is a wider deficit than forecast. It is the lynch-pin of its credibility and more austerity will flow. The budget is now a permanent problem for confidence.

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Third, it is now quite clear that the RBA oil tanker is beginning to turn. It may be that Tim Toohey and MB are ahead of the curve in seeing rate cuts in September and October this year respectively but even so, the RBA is now supporting macroprudential moves, APRA will tighten the screws behind the scenes, housing will slow and, after another dour MYEFO in December rains upon Christmas, the odds of a new year cut are good. A forward looking central bank will have already cut.

Today markets are beginning to price it with the Cs1Y hitting a new low of 13bps of cuts in the next year and on a quite convincing downtrend:

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.