Going against consensus: Why the RBA will remain on hold
The bond market moves of last year caught most investors off guard, as many were expecting higher cash rates over the year. Currently, market expectations see the opposite outcome compared to 2019, with forecasts expecting lower cash rates from the RBA and an eventual start of a quantitative easing (QE) program.
While we have some sympathy for why this could be required, we think the case for that occurring in 2020 is nowhere near as clear cut as the market is currently forecasting. In fact, some lead indicators (such as housing and inflation) are beginning to point to 2020 being stronger than 2019, which would allow the RBA to hold some of their monetary policy ammunition in reserve.
Rather than focusing on the current narrative of a slow economy, we pose in our latest paper five big picture questions the RBA should be answering to land at our interest rate outlook and what it means for domestic bond yields in 2020. A summary of our views is below and the full PDF can be accessed here.
Q1: How should the RBA respond to change in the outlook for house prices?
The improved housing outlook for 2020, compared to the beginning of 2019, has the potential to create the “gentle turning” point the RBA has spoken of. While the recent housing related data has been sluggish, our indicators show that the economic data can take a few quarters to react. Hence, while the market has been impatient by wanting faster results, we think this may have been asking too much too soon.
To demonstrate this point, we show three key indicators that should show signs of improvement this year and that we believe will be important to watch in early 2020:
Household demand – The chart below shows that over the past 10 years household demand in these states has lagged house prices by approximately nine months, meaning house price conditions today will affect demand in 2 – 4 quarter’s time. It also means that it can take some time for the RBA’s actions to flow through to the real economy.
Chart 1 - NSW and Victoria household demand and house prices
Housing inflation - Over the past 10 years, housing inflation has been on a slow trend downwards, falling from ~6% p.a. growth to 20-year-lows of 1% p.a. Despite this downward trend, every time the RBA has cut interest rates housing inflation has risen by 0.5% to 3% over the subsequent 12 months. Given that the response in house prices so far has been similar to previous cuts, we think there is a good argument to be made that housing inflation will also follow the same pattern — providing an improved backdrop from last year.
Building approvals - The third improvement that we would expect to see is in the construction outlook for late 2020 — as building approvals typically follow house prices with a lag. The following chart shows that building approvals usually decline with house prices and a more positive outlook should give this some support.
Chart 2 - House prices and building approvals
Prices are set to rise
While not related to economic data, the final point to make on house prices is that the RBA will soon run into more aggressive housing headlines as prices reach all-time highs. The next chart shows that the current house price index is only 4% of its 2018 peak. Since prices have been increasing at over 1% per month, we should see prices set new highs in only a few months.
Chart 3 - Australian house price index
While none of these indicators say that the improvement in housing-related sectors are a certainty, they do suggest a far stronger outlook than what we saw at the beginning of 2019.
Q2: How strong will inflation and unemployment be in 2020?
The first signs of this improvement can be seen in inflation, as currently the indicators we pay attention to point towards a grind back into the low 2% territory in the first half of 2020. This is based off three key pieces of information, which were not in place this time last year.
Firstly, as noted above, housing inflation should bottom out as the housing market is showing strength. Over the past 10 years, each RBA cut brought with it higher housing inflation.
Secondly, Australian petrol prices had started rising and this has a very strong correlation with transportation inflation. If petrol prices remain at their current levels, this would imply transportation prices see mildly positive rises into the first quarter of this year— a small pickup compared to the 0% observed through 2019.
Prior to the outbreak of the coronavirus, oil prices had actually been showing large increases year-on-year, meaning if the market recovers from this shock we could be looking at higher transport-related inflation for the year.
The third reason to expect higher inflation figures is simply from the distribution of inflation outcomes. The table below shows the quarterly and yearly inflation figures over the past 24 months. The main reason that headline inflation dipped so low in 2019 was that the first quarter had an inflation print of 0% quarter-on-quarter, taking the consistent 1.8 – 2.0% inflation level into the low 1% range. Outside of this first quarter, the inflation figures had consistently remained in the 0.4% – 0.6% range.
Table 1 - Quarterly and yearly inflation figures - 24 months
Given we see more inflationary signs in the beginning of 2020 than we did in 2019, we suspect that in 1Q 2020 this zero outcome will be replaced with a higher quarterly figure, pulling inflation back towards 2% instead of 1%.
While the unemployment rate shifted slightly higher during the year, ending 2019 at 5.1%, this was only marginally higher than the 5.0% seen at the end of 2018. Additionally, the outright levels of employment are only marginally below the high point seen in 2007, as the employment to population ratio (an employment indicator which calculates what percentage of the population is working) saw an almost record high of 62.6% of the total population working.
Chart 4 – Australia: employment to population
It’s important to separate the narrative around employment from the facts. Yes, some forward looking indicators have started to slow (such as job advertisements and vacancies), but the NAB employment conditions have stabilised and the RBA has started providing support to the economy. We find the NAB business conditions is one of the better indicators at forecasting the unemployment rate in the near term, and this is suggesting that the unemployment rate should move sideways, i.e. ~5.0 – 5.2%, over the coming months.
Chart 5 - NAB employment conditions and unemployment rate change
This would suggest that not only was the narrative around employment misguided in 2019, but the near-term forecast should not be as bearish as the market currently insists.
Q3: Is global trade set to improve?
2019 proved to be a relatively weak year for global trade and, unsurprisingly, the Chinese trade statistics reflected this reality. However, there are some tentative signs that this could be slightly more positive for 2020.
Chinese trade statistics
The first positive sign for global trade is that Chinese trade statistics have shown signs of life after being consistently weak for the past 12 months. Importantly for global trade, Chinese imports lead the global cycle by approximately 12 months and in the back end of 2019, saw a relatively large rise. This means that as long as the coronavirus does not considerably alter the momentum of the global economy, then come mid-2020 we should see signs that global trade is beginning to improve and potentially pick up dramatically in the back end of 2020.
World trade and Chinese imports
Source: Bloomberg, World Trade Organisation
Reflecting this positive import outcome, the Chinese PMI figures saw new export orders rise above 50 the first time since the middle of 2018. This is off the back of positive outcomes between China and the US on trade talks, potentially signaling that companies are becoming more positive on the future trade environment.
Additionally, South Korean and Taiwanese exports — two economies which are traditionally thought of as the canary in the coal mine of global trade — started improving. Both countries had negative outcomes through 2019, which have started turning and could signal that the pickup is more widespread than simply China.
If this is true, the Australian economy should benefit from the improved environment which will give the RBA less urgency to move rates.
The caveat to this improvement is that these statistics have been occurring through the December and January data. Whether this improvement can continue in the face of the coronovirus is yet to be a seen and poses a large risk to global trade. This is addressed in a separate question below.
Q4: Where is the Tail Risk – The known unknowns?
While we don’t cover the US–China trade war (as enough ink has already been spilled on this topic) or the deterioration in relationship between Iran and the US in this outlook, it is worthwhile pointing out the risk that could come from the coronavirus, which appears to have originated in China.
At the time of writing, the facts surrounding this disease are murky as the number of cases and deaths rise by the day. However, from the information available the market is so far looking at it in a similar nature as the SARS outbreak of 2003, although it seems to be less deadly (i.e. a lower mortality rate) but more contagious.
It is hard to determine just how many people will contract the disease and how long the epidemic will last, so we’re unable to forecast just how large the effect will be on international conditions. More specifically though, the fact that the Chinese government has quarantined multiple cities, with a combined population in the tens of millions of people, it means there will likely be a hit to Chinese GDP as, among the numerous other effects, consumption will be lower and tourism down. Additionally, the timing of the event over Chinese New Year means the effects will be larger than if this had of occurred at a different time of the year.
From this perspective, the total effect is currently unknown, but we do know that it will not be positive. The offset to this is that the Chinese government could (and likely will) introduce easier fiscal policy to offset the weaker conditions that their containment policies have created. Depending on the actions that they take, this could potentially see a slowdown in GDP for the first half of the year, which is followed by an acceleration in the second half.
Chinese demand and tourism
Whether these risks are enough to cause the RBA to cut or not are a key question that they will need to answer this year. Slower Chinese demand and weaker travel from Chinese tourists, which represent the greatest number of outbound tourists in the world, would be a key risk for the Australian economy, coming at a time when GDP is weak. While we think that the RBA should not overact to this information, and wait to see how global trade evolves over the next three months, it does create a story that naturally feeds into easier rates and will cause the RBA to become more dovish if it persists for some time.
Q5: How will the RBA respond to the widespread bushfires?
While the total financial cost from the fires is unknown at the time of writing, most estimates have put the effect on GDP in the short term at a drag of around 0.2% – 0.5%. While this is by no means enough to cause a recession, it has come at a time when GDP is at its weakest in 10 years. If the RBA was negative enough on the conditions, it could be seen as just one more reason to move rates. However, while there is a short-term impact, If past natural disasters are anything to go by we should see this be a positive for GDP in the next few quarters as higher investment will occur across the regions that have been hit by the bushfires (refer to Chart 19).
On top of this we see a fiscal response to the affected regions as the more appropriate policy measure as it means the help required will land where it is needed most, rather than lower rates benefitting the country at large.
As such, we think that the RBA should not react to the fires, as the medium term effects will be limited and it is more appropriate for a fiscal (rather than monetary) policy response.
The other consideration here is whether the RBA should be responding to these events and what that would say about the future for potential policy action. If the RBA simply cuts interest rates every time a national disaster occurs, it has the potential to shirk the responsibilities of the government in addressing the effects of the rising temperatures and will potentially go around democratic process if voters demand environmental action. While it remains up to the RBA as to how they react to this outcome, the future forecasts for Australia’s weather could mean that cutting in the face of a natural disaster potentially sets them up for additionally easier policy in the future — a slippery slope if these conditions occur more frequently.
Putting it together
Overall, we believe there is a higher probability that the RBA will be able to remain on hold this year, rather than cut rates. Yes, there are still near-term risks and the economic data is currently soft, but the employment indicators have been strong, inflation is more likely to be higher in 2020 than 2019, the Chinese trade situation has shown signs of improving, and the housing outlook is positive.
While we can see why the market is forecasting additional rate cuts, it is beginning to look like they are pricing in far more action from the RBA than will be warranted in 2020,and there are improving odds that the RBA will end up on hold.
Want to learn more?
The above wire was a summary of our recent white paper "5 big questions the RBA needs to answer". You can read the full version by clicking on the pdf below.
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Chris is responsible for portfolio management, including portfolio construction and trading for various Australian fixed income portfolios including the Nikko AM Australian Bond Fund at Yarra Capital Management (Nikko AM was acquired by Yarra...