US inflation the key for next market rally

In the AFR I write that in an age of record household debt, the Reserve Bank of Australia’s monetary policy transmission mechanism is a beast to behold. When the RBA dumped its 0.1 per cent interest rate target for the 2024 government bond in November, it sent private sector rates soaring: repayments on NAB’s new 3-year fixed-rate mortgages leapt from 1.98 per cent to 4.50 per cent. 

These hikes triggered the initial turning point in the east coast housing market, which typically leads the rest of the land. They have been amplified by the RBA’s inaugural variable-rate hike in May. Sydney house prices are now falling quickly, having lost 1.74 per cent since their peak a few months ago according to CoreLogic. Melbourne prices are following, off 0.74 per cent from their highs. After booming last year, Brisbane dwelling values are similarly flat-lining.

There is now a big disconnect between variable and fixed-rate home loan pricing: whereas variable rates are around 2.50 per cent, 3-year fixed-rates are two percentage points higher. Leading brokers say the share of borrowers taking out variable-rate loans has surged from about 25 per cent of all new approvals last year to north of 90 per cent currently.

For the time being, markets are still pricing in the prospect of the RBA boosting its cash rate to 2.5 per cent by the end of 2022, and to 3.25 per cent within 12 months. There are, however, factors that could attenuate the RBA’s hiking profile.

The first is that both non-bank and bank funding costs have increased materially, and lenders may pass-on these charges to customers via higher borrowing rates. This could do some of the heavy-lifting for the RBA.

A second consideration is the heightened sensitivity of household balance-sheets to interest rate changes, which implies that the RBA may not have to lift rates as far as it has in the past. During the week, Assistant Governor Luci Ellis was at pains to stress that Martin Place cannot know with any conviction where the real “neutral” cash rate is notwithstanding suggestions that it would rail-road its way straight to 2.5 per cent.

[Note this article was published by the AFR on Friday, following which US core inflation printed at 0.3% and the S&P500 jumped 2.5%]

A similar debate is playing out in US markets, where equities and fixed-rate bonds (or interest rate duration) are rallying in correlated unison despite the post-GFC dynamic whereby duration tended to be negatively correlated to stocks.

Having fallen almost 20 per cent on a peak-to-trough basis, the S&P500 index has bounced 6.7 per cent. Concurrently, the US 10-year government bond yield has slumped from a recent peak of 3.20 per cent to just 2.76 per cent, which means bond prices have risen.

US investors now hope the Fed will only lift rates to its own “neutral” estimate of circa 2.8 per cent, avoiding the need to tighten policy to a point that would tip the economy into recession. This is predicated on the presumption that core inflation is rolling over.

While month-on-month core inflation according to the CPI index remained stubbornly high at 0.6 per cent in April, the Fed’s preferred measure—the core PCE index—is expected to print at a benign 0.3 per cent on Friday night. This would represent the third consecutive month of 0.3 per cent core PCE inflation, which annualises at a much more acceptable 3.6 per cent. It would also mean that the year-on-year core PCE inflation rate had dropped from its peak of 5.3 per cent to 4.9 per cent, or less, setting the stage for a risk rally founded on the belief that the world’s most important central bank will engineer a soft-landing.

The alternative is an upside surprise with core PCE inflation running at 0.4 to 0.5 per cent, signalling a year-on-year pace at 5.0 per cent or higher. This would raise the spectre of the Fed having to get restrictive, crushing aggregate demand sufficiently to push the US economy into recession in 2023. Using equity and bond market data, our modelling suggests this is a very plausible scenario. Our analysis also highlights that S&P500 earnings are extremely elevated relative to their historical trend, with a real risk of further large draw-downs in stocks as earnings mean-revert. This will be amplified if the Fed needs to get restrictive with policy.

Subject to the question of where the RBA takes interest rates, Australia should remain the “wonder down under” care of a cheap Aussie dollar, elevated commodity prices, robust consumer spending, a resurgence in business investment, and a rebound in both unskilled and skilled migration.

The road ahead nevertheless remains a complex one for our new federal government, led by Prime Minister Anthony Albanese. At the margin, markets expect more stimulus from incoming Treasurer Jim Chalmers relative to the counter-factual, which could mean the RBA has more wood to chop.

Labor is blessed with some outstanding economic talent, which it should harness. The single-best economic brain in parliament is unambiguously Dr Andrew Leigh, a celebrated Harvard PhD who was a professor of economics at ANU. Labor would be mad not to leverage off his world-class capabilities, which have focussed on innovating empirically-tested policy ideas.

Chalmers also has access to the Yale PhD, Dr Daniel Mulino, who has spent much of his career rendering valuable economic advice. And then there is the ambitious new member for Paramatta, Dr Andrew Charlton, who completed a PhD at Oxford, and played a crucial role in the Rudd government’s response to the global financial crisis. This included developing unprecedented policy measures, such as purchasing more than $10 billion worth of residential mortgage-backed securities during the crisis, which saved many smaller bank and non-bank lenders while making a return for taxpayers.

Dr Leigh, Dr Mulino, and DR Charlton could play an important role in buttressing what is otherwise a skinny parliamentary bench.