Pain trade will persist

Notwithstanding this column’s preternatural optimism, there is, regrettably, more bad news to deliver. The latest data on Aussie inflation shows that it accelerated, rather than decelerated, in May and is not slowing in trend terms as fast as the Reserve Bank of Australia had projected. It is no wonder that financial markets are pricing in a 50 per cent chance the RBA lifts rates again in July (before the inflation data, this probability was priced at sub 30 per cent).

This worryingly echoes a broader dynamic that is evident both domestically and overseas: it is proving much tougher than anyone expected for tight monetary policy to destroy demand, kill bad businesses and generate the increase in slack and unemployment required to snuff out the nascent wage/price spiral that is brewing in Australia, the UK, Europe and the US, among others.

On Thursday the Aussie retail trade data surprised economists with its strength, rising 0.7 per cent in May. In trend terms, annualised monthly retail sales growth has picked up to about 6.5 per cent, its fastest clip since mid-2022 (when the RBA started lifting rates).

Coolabah chief macro strategist Kieran Davies comments that, “at the margin, the rebound in retail sales counts towards higher interest rates because the RBA is banking on weaker demand as one of the factors to help contain inflation”.

Overnight German inflation data surprised on the high side, printing at 6.8 per cent over the year to June, as did US economic growth, which rose at a revised 2 per cent annual rate in the first quarter of 2023 compared with consensus forecasts for a 1.4 per cent increase. This was partly driven by a beat on consumer spending, which expanded by 4.2 per cent in the March quarter (economists projected a 3.8 per cent increase).

In the US there was also a positive surprise on jobless claims, which were lower than the market predicted. This powered a jump in US and German 10-year government bond yields, which climbed by 14 basis points and 10 basis points, respectively. Since this was less than the move in short-term interest rates, the US yield curve inverted further. An inverted yield curve, whereby shorter-dated rates are above long-term rates, is typically a good predictor of a looming recession.

In Australia this week we discovered that underlying (or core) consumer price inflation had actually accelerated to 0.5 per cent in May, up from 0.2 per cent growth in April. This was a contrast with the more widely reported deceleration in annual headline inflation that head-faked a few participants. (Note that the headline rate is very volatile and there are massive price hikes slated for electricity in July.)

Pressure on rates

On a rolling three-month basis, core inflation in Australia is expanding at 5.2 per cent a year, which is not, unfortunately, improving at the rate the RBA had assumed. “Interpolating the RBA’s forecasts for quarterly core inflation, they imply annualised growth should have been around 4.5 per cent in May in trend terms,” Davies says. “This suggests that the RBA will likely nudge up its near-term forecasts for underlying inflation in the August Statement on Monetary Policy.

“Uncomfortably high underlying inflation places pressure on the RBA to hike again in July, particularly given the RBA’s belated concern about upside risks to inflation and where monetary policy is only slightly restrictive, with the RBA lagging its peers by a large margin.”

The RBA estimates that the “neutral” (or normal) cash rate is 3.8 per cent, which means that the current cash rate of 4.1 per cent is only slightly restrictive, according to its internal modelling.

Peer central bank policy rates continue to climb and are conspicuously higher than the RBA’s benchmark. (The US is at 5-5.25 per cent, the UK is at 5 per cent, New Zealand is at 5.5 per cent, and Canada is at 4.75 per cent.)

This is rather awkward given that the RBA’s cash rate is typically 1.6 percentage points above the US equivalent rate, which may explain why the Aussie dollar is so low (and has been falling of late).

The multitrillion-dollar question is how far the RBA has to go. If we look at every hiking cycle since 1994, the RBA has, on average, lifted its cash rate about 1.6 percentage points above the estimate of the neutral cash rate. (If we include the 1988-89 hiking cycle, the median peak rate rises to 2 percentage points above neutral.) The last hiking cycle in 2009-10 appears something of an anomaly with the cash rate only going 0.6 percentage points above neutral. We are only 0.3 percentage points through the RBA’s revised estimate of neutral, which is disconcerting if this neutral number is right.

How far to go

One of the challenges for RBA governor Phil Lowe – and his imminent successor – is that we just don’t know how tight policy needs to go. There is a raft of data suggesting that the huge cash buffers consumers saved during the pandemic have made them much more resistant to rate hikes.

The recent reacceleration of national house price growth in Australia after a 10 per cent peak-to-trough drawdown (using daily data, or circa 15 per cent in inflation-adjusted terms) is another canary in the coal mine that argues in favour of policy doing more heavy lifting.

While business insolvencies are increasing, they are still below the average of the post-2008 period. In May, 868 Aussie businesses went bust, which was the highest reading since 2015. But this is really just the beginning of what will be a long and painful default cycle as central banks engage in their multiyear battle against an inflation crisis that is being fuelled by a demand-side wage/price spiral.

RBA leadership

The RBA’s task is not helped by debate over its leadership. There is much chatter about the prospect of the current Treasury secretary, Steve Kennedy, who is also a serving RBA board member, being appointed the next governor.

While Kennedy is regarded by both sides of politics as an outstanding adviser and policymaker, he has appeared dovish on inflation and wages, providing the federal government with cover on the 8.6 per cent increase to the national minimum wage and the 5.75 per cent rise in award wages, which will flow through to affect about one in four workers.

Both of the two front runners – Kennedy and RBA deputy governor Michele Bullock – could be excellent future leaders of Australia’s central bank. Former Treasury Secretary Bernie Fraser was arguably the best governor the RBA has ever had. And if these two individuals are the only viable options, having an outsider like Kennedy reform the RBA’s culture would perhaps, at the margin, be superior to appointing a long-standing insider (although it should be noted that as an RBA board member, Kennedy is also a de facto insider).

But bringing in a demonstrable dove in the middle of the toughest hiking cycle in decades could badly damage the RBA’s global credibility, especially with the financial market participants the RBA has to convince to price interest rates in line with its policy if the latter is to be effective.

If Treasurer Jim Chalmers is desperate to emulate the approach of his hero, Paul Keating, who appointed Fraser as governor, one option might be to give Lowe a short extension of, say, 12 months to allow him to complete whatever needs to be done in this tightening cycle. This would in turn provide Kennedy with a clean policy slate.

All of this is bad news for any growth or risky asset classes, including equities and property. Morgan Stanley’s strategists point out that the US equity risk premium – which is the extra return you get above risk-free 10-year government bonds – is much lower than it has been in a very long time. It is about 1.5 per cent compared with its average level since 2008 of 4-5 per cent. Morgan Stanley’s “fair value” estimate for the S&P 500 is 30 per cent below its current level. While Morgan Stanley warns of the risk of a sharp equities correction, it is just as likely investors could endure many years of weak returns.

This cycle will be elongated and iterative. Our brains have been hard-wired for hedonistic quick fixes care of the ultra-low interest rate policies common in the post-2008 period. Given extraordinary inflation, cheap money is not an option. Accordingly, you should prepare for long-term pain trades in risky (and especially illiquid) asset classes that could take years to adjust to the new normal of very high risk-free cash rates.

Find out about Coolabah's new Floating-Rate High Yield Fund here. First published in the AFR here.