Capacity is not loosening to support rate cuts

May’s labour market data shows surprising strength beneath a weak headline. This suggests the Australian economy retains more capacity pressure than expected. We think there is scope for short-term yields to rise, especially relative to longer-term bond yields and are positioning for flattening of the yield curve.

The Australian labour market report for May was mixed. Headline employment surprised to the downside, falling by 2,500 over the month. However, compositionally, most of this was driven by part-time workers, with full-time employment rising. Importantly, aggregate hours worked rose by a strong 1.3% over the month, taking year-ended growth higher to 3.1% from 1.1%.

We think that the data has slightly hawkish implications for the Reserve Bank of Australia (RBA). If you think rates ought to be set equal to trend growth in aggregate hours worked plus core inflation, then you would be advocating rate hikes for the RBA, as the sum of the two components is 6%. However, we think that a better description of the way the RBA behaves is a "Taylor rule" where rates are set equal to a long-term neutral rate plus the size of the output gap (the deviation of output from supply-side potential). Our best real-time gauges now suggest the output gap is 0.3% of gross domestic product (GDP), while the neutral rate sits at 3.6%. Therefore, the optimal cash rate is at 3.9%, slightly above the current rate. 

Australian real-time output gap

Australian real unit labour costs and output gap

Australian 10-year bond yield and neutral rate 

RBA cash rate and “Taylor rule” prescription

There are many in the market who believe that the RBA is considering deep rate cuts. At time of writing, the money market is suggesting that the RBA will cut 75bps by the end of the year. However, we disagree. If anything, post-Liberation Day data suggest that the economy is resilient, and that the RBA needs to wind back it's dovishness. We think there is scope for short-term yields to rise, especially relative to longer-term bond yields and are positioning for flattening of the yield curve. 

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