The RBA WILL be forced to follow the RBNZ

Via Damien Boey at Credit Suisse:

The RBNZ has surprised, by cutting rates 50bps at its meeting today. Further, Governor Orr has given some fairly dovish guidance, mentioning that the Bank has done its homework on unconventional easing measures, such as outright asset purchases. The AUD and Australian bond yields are following the NZD and New Zealand lower, as if to say that the RBNZ is leading the way.

We can understand why investors are looking for guidance, even from the central bank of a smaller economy. Bonds are rallying frenetically, cornering central banks into easing. Indeed bond yields everywhere are now undershooting long-term neutral rates by such a big margin, that the “term risk premium” concept is losing meaning. Part of the reason why we are seeing the undershooting is technical – inverted yield curves, with backwardated bond volatility surfaces encourage fixed income investors to short volatility to buy short duration bonds. Part of the reason is fundamental. Investors sense that rate cuts might not be that effective in stimulating credit creation and asset price inflation, nor that effective in driving competitive currency devaluation if everyone else is trying to do the same thing.

But it is a dangerous exercise to extrapolate the RBNZ’s thinking to the RBA. RBNZ Governor Orr has a very different economic model in mind to RBA Governor Lowe. In the first instance, Orr is prepared to set rates in such a way as to err more on the side of generating strong GDP and employment growth than on the side of being macro-prudential. This is the case even after allowing for the recent shift in the RBA’s balancing act between competing considerations. Secondly, Orr is prepared to ease financial conditions explicitly via currency to obtain an export competitiveness advantage in third markets. In contrast, the RBA still has the view that it ultimately does not want to intervene in foreign exchange markets, even though it is happy to take the short-term benefit of currency undershooting.

In terms of impact on Australian financial conditions, the RBNZ decision and commentary have caused significant flattening (inversion) of the yield curve, and weakness in the AUD/USD. The flatter curve represents a tightening of financial conditions in the sense that the bond market is telling the RBA that the cash rate is unsuitably high. But the weaker AUD/USD represents a net easing of financial conditions, especially when we consider that fundamentals (commodity prices, rate differentials, currency scarcity) support a currency closer to 69c. These factors have largely offset each other. Indeed, if we account for the hidden factor driving bond yields lower, weakening global growth expectations embedded in falling US bond yields and stock prices, we could even argue that AUD/USD undershooting is overshadowing the flattening of the curve caused by the RBNZ. In other words, perhaps the RBNZ is doing the RBA’s job for it via the currency channel. On balance, our assessment of financial conditions is that they are loosening, historically consistent with positive per capita real GDP growth. Should the population grow by around 1.8% in the year ahead, we should see real GDP growth of around 2.75%, more or less in line with the RBA’s current forecasts. And even if we allow for undershooting, it is very unlikely that the economy will enter recession outright.

Updating our proprietary duration appetite index, we find that bonds are now at their most overbought since the early 1990s recession. This is a remarkable feat considering that back then, the economy had an inflation problem to deal with. But it does not have such a problem today. Unless we think that the economy is going into imminent recession, it is very hard to justify the speed, and arguably, extent of the rally we have just seen in bonds.

From here, the likelihood is that the RBA will respond to the bond market’s guidance by cutting rates further. But bonds are pricing in near zero rates over the forecast horizon even though financial conditions are loosening, and recent RBA rate cuts have been surprisingly effective. The risks are that the curve steepens, unless there is a very large global shock for the RBA to contend with. But even then, currency should be a major shock absorber.

Overall, we can clearly see undershooting in the Australian economy right now, given the softness of partial indicators and PMIs. Some undershooting should be expected given the overshooting that occurred from 2012-2016 on the back of Chinese inflows to the property market, and then, an infrastructure boom. But ultimately, recession is still not the likely outcome given how financial conditions are evolving.

I disagree. There is every chance of recession. Nor is that the right parameter. This is now the problem:

We’re entering a GFC scale income shock that is going to gut the Budget outlook and add WA and QLD austerity to NSW and VIC. Given government spending is all we have driving growth and jobs, this is manifest in rising unemployment and dreadfully weak wages growth.

The RBA will be forced to cut as deeply as it can.

Then go deeper.

Houses and Holes

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 fouding 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.

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