The success of vaccine tests ; Australia’s current strong growth story; and pivots around monetary policy are highly relevant to the market outlook.
The approach to monetary policy in Australia is changing. In his speech last Monday, the Governor neatly set out the four aspects of current policy.
- The nature of forward guidance – “we have now moved to place much more weight on actual outcomes rather than forecast outcomes”. A reasonable interpretation here is that particularly due to the combination of globalisation and technology the functioning of labour markets has changed and the need to be pre-emptive with policy has dissipated. It is now appropriate to wait to see inflation firmly within the 2–3% band AND high wages growth, requiring a return to a tight labour market. Arguably he is making the “tight labour market” a necessary condition so, if for example a spike in inflation resulted from a supply shock then that would be an insufficient condition to raise rates.
- Consistent with the above view he emphasises the RBA’s mandate – price stability; full employment; and economic welfare. He confirms the sentiment in 1) by emphasising the need to reduce spare capacity in the labour market – jobs are the central focus and success with jobs will lead to progress on the inflation front.
- He discusses “the gravitational pull of low global interest rates” – if that pull, which reflects the global excess of savings over investment, is overlooked developments around the exchange rate and the economy would be adverse. However, in the Q&A he again describes negative rates as “extraordinarily unlikely” since they make it “harder for banks to lend” although he does accept that the gravitational pull represented by any future decision of the US Federal Reserve to go negative would cause a rethink.
We are now in the world where quantities, not just prices, matter. The RBA’s QE program affects the economy through boosting the liquidity of the banking system, lowering rates, and forcing a reallocation of private sector portfolios away from bonds to other private assets – boosting asset prices. By lowering rates, foreign investors are discouraged from buying AUD assets, lowering the value of the exchange rate.
So, the themes are clear – the elevation of the labour market over the inflation priority; sensitivity to a rising exchange rate; and the benefits of rising asset prices.
In the Q&A he was asked about excessive froth in the housing market – his own view is that it is unlikely, given the collapse in population growth; rising vacancy rates in Sydney and Melbourne; and falling rents. However, he made it clear that the authorities have a successful track record in cooling housing markets through macro prudential policies as we particularly saw in 2015 and 2017/18. There would certainly be no need to direct interest rates at any asset bubble. As we move into 2021 and beyond the disintermediation of the banks will be an issue for the effectiveness of macro prudential tools.
On Thursday the market was shocked by the Employment Report which printed 178,800 new jobs compared to expectations of minus 30,000. With that type of volatility and policy focussed on the labour market there is little doubt that markets will be feeling edgy.
However we do expect that economic conditions in 2021 will not indicate a continuation of the apparent rapid recovery in the labour market. Spare capacity in the economy is not captured just by jobs growth.
Since the beginning of the year hours worked have contracted by 3.3% compared to a 1.6% contraction in number employed. Earlier in the week the Wage Price Index printed annual growth of only 1.4% while RBA’s recent liaison points to more than half the respondents adopting a wage freeze. Wages growth is likely to slow to 1% in 2021.
When in July, other forecasters were predicting damage from the fiscal cliff leading to negative growth in the third quarter and modest growth in the December quarter Westpac forecast very strong growth in the September (1.8%) and the December quarters (2.2%) – that implied 8% annualised growth over the second half of 2020!
However we do not expect that economic conditions in 2021 will sustain anything like the forecast momentum and the associated boom in jobs that is gaining traction in the market.
Next year we are forecasting a broadly unchanged
unemployment rate over the course of the year. Growth in the market will be absorbed by hours worked; the participation rate; and the need to absorb the job losses associated with looming headwinds. And in the middle quarters of 2021 the economy is likely to experience a “soft patch”.
We differentiate between the growth surge associated with the reopening over the September–March quarters and the return to more challenging conditions that is likely to emerge in the June/ September quarters of 2021.
The headwinds to growth in 2021 will come from a number of sources apart from the collapse in population growth. These will include the resolution of the deferred loans outstanding which are reported to have plummeted by 67% for both mortgages and SME’s – so far so good.
But there are still likely to be difficulties once banks reach that core of loans related to individuals and industries in most distress. Associated with this issue will be a lift in insolvencies, once the moratorium expires (currently formally the end of December) while the expiry of the JobKeeper policies (end March) will also release workers into a much less vibrant market than we are experiencing at present.
While the financial markets are likely to be encouraged by the current economic developments we are comfortable that the unemployment rate will be broadly stable in the 7–7.5% range in 2021.
Furthermore, measures of spare capacity, including wages growth will signal that the RBA has little fear that it has misjudged its current policy approach.
Therefore, our view on the RBA’s 3 year bond rate target is unchanged – that it will not need to be adjusted until mid-2022.
But markets will be focusing on whether this adjustment needs to be brought forward by extrapolating recent developments and pricing in much more rapid progress in reducing the spare capacity in the labour market than we currently expect.
The announcement of the progress on vaccines will also impact markets but mainly from the perspective of demand and risk in the US and Europe.
However that is likely to have a significantly more important impact on assessments of domestic demand in the US and Europe than in Australia. The recent issues in South Australia with hotel quarantines will keep the Australian authorities cautious about opening foreign borders in spite of progress with vaccines.
Markets have responded somewhat to the Pfizer and Moderna news.
US yields lifted recently (0.75% to 0.95% for the ten years) partly in response to the news around the vaccines; markets will be closely watching the progress of the vaccines.
In the near term this higher rate has already been buffeted by the immediate disturbing news around new cases and possible shutdowns, particularly in the US.
Nevertheless we think the vaccine developments are “game changers” for the US economy and US markets.
Our forecasts have been for a fairly “steady” profile for US Treasuries through 2021 as markets were uncertain about the recovery outlook in the face of competing “forces” – prospects of a vaccine and the sharp lift in case loads.
These earlier and more convincing than expected results on the vaccines (with others still actively developing their Stage 3 testing), in our view, point to markets favouring the improving vaccine outlook over the immediate threat from rising case-loads. And as we move through 2021 that dynamic will become more apparent.
Up till now our forecast profile for US 10 year Treasuries through 2021 had been to remain in a 0.65% – 0.75% range through to the end of the year, before lifting to 1.1% through 2022.
We have now brought that rate profile in 2022 forward to 2021 with the 10 year bond rate rising from 0.80% in December through to 1.2% by end 2021. We accept that the Federal Reserve may remain active in the QE space through 2021 but feel that the optimism associated with the successful distribution of vaccines through 2021 will be the dominant market force, while providing the Fed with some scope to ease back on support.
The RBA is projected to hold around 17% of the bonds on issue when it completes its QE program by June next year. The Board has indicated that it is prepared to extend the program.
Compared to the US Federal Reserve (22% now) and RBNZ (36%, projected) the RBA’s share of outstanding AGS is modest; the prospect that the RBA will extend its QE program beyond June seems realistic although we expect that AUD bonds will continue to trade at a slight premium over USD bonds.
Consequently, the expected rise in US bond rates can be expected to lift AUD bond rates, steepening the yield curve. Despite lifting our long bond forecasts we remain comfortable with the estimated timing of the revision to the three year bond rate target remaining at around mid–2022, but, as discussed, markets may be less patient.