Have Australian bond and currency markets got it wrong again

Matthew Peter, Chief Economist

Just as Federal Reserve (Fed) Chair Yellen tested the market’s faith in the Fed following a steady tightening path of US monetary policy, the Reserve Bank of Australia (RBA) dropped a hand grenade on markets in their minutes of the July Board meeting, which has blown the Australian dollar (AUD) towards US$0.80. The RBA hand grenade was in the form of an estimate of the neutral cash rate, which at 3.5% and  2 percentage points higher than the current cash rate, led markets to bring forward the expected timing of an RBA rate hike from August 2018 to May 2018 and sent the AUD into orbit.

What was the RBA thinking in revealing its neutral-rate estimate at this juncture, and has the market made the correct interpretation? In our view, the RBA has framed its neutral rate along the lines of the Fed’s long-run projection. That is, a rate towards which the cash rate will converge sometime (most likely beyond 2019) at which point the Australian economy will be close to equilibrium (i.e., full employment, inflation at target and no threats to financial stability). If we are correct in our interpretation, then market pricing prior to the release of the minutes was, in fact, confirming a cash rate of around 3.5% in four years’ time. Hence, it is understandable why the RBA may have felt comfortable in revealing their estimate in the minutes and perhaps why now, they may need to clarify further the interpretation of their concept of the neutral rate.

However, the RBA minutes have not been the only driver of higher Australian bond yields and a stronger currency over May and July. Another driver has been the flow of improved economic data, with labour market data being the most influential. Hence, it was with heightened anticipation that commentators awaited the release of the June employment data. The data confirmed the continuing growth in employment, if not at the same breakneck pace of the previous three months. Over June, the Australian economy added 14k jobs, with a strong surge in full time employment (+62k) partially offset be a fall in part-time jobs (-48k). A lift in the labour force participation rate meant that despite the positive jobs growth, the unemployment rate remained at 5.6%, revised up from 5.5% in May. Perhaps the upward revision to the unemployment rate dampened the market’s enthusiasm for the jobs data, as the AUD fell by around ½ US cent over the day.

Against this backdrop, the release of next week’s 2017Q2 inflation report has been pushed into the background. Nevertheless, the outlook for inflation remains a key driver of RBA policy, with significant price volatility likely over Q2 and Q3 as the competing effects of Cyclone Debbie, falls in petrol prices, surges in energy costs, rises in minimum wages and lifts in tobacco excise taxes blend together to form a muddy picture of the direction of inflation of the remainder of the year. QIC’s economists, Drew Klease and Nathan Cotton, expect the headline CPI increased by a tepid 0.4% in 2017Q2, with the annual rate of inflation remaining at 2.1%. While they expect a weak inflation print for Q2, prices are expected to jump a sharp 0.9% in 2017Q3 as a combination of higher energy costs and an increase in the tobacco excise lifts headline inflation.

The second half of 2017 is shaping up to be a watershed in RBA monetary policy. Markets, having come to expect an early tightening cycle by the RBA will now need to listen carefully to senior bank officials for the correct interpretation of their neutral rate. The market will also have to navigate swings in inflation. QIC maintains its long-held view that the RBA will wait until 2018Q3 before it begins its next tightening cycle. The correct interpretation of the RBA’s neutral rate is that is the rate that the RBA believes will hold when the Australian economy has fully transitioned from the mining and housing booms, which we estimate to be beyond 2019. With the RBA’s neutral rate estimate considered in that light, and given the still fragile underpinnings of Australian economic growth, our view is the RBA has no choice other than to wait before hiking rates.

Table 1: Financial market movements, 13 -20 July 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,473.5

1.0%

US

2.26%

-8.5 bps

US Dollar Index (DXY)

94.31

-1.5%

Nikkei 225

20,144.6

0.2%

Japan

0.08%

-0.6 bps

USD-JPY

111.91

-1.2%

FTSE 100

7,487.9

1.0%

UK

1.21%

-9.7 bps

GBP-USD

1.297

0.3%

DAX

12,447.3

-1.5%

Germany

0.53%

-7.3 bps

EUR-USD

1.163

2.0%

S&P/ASX 200

5,761.5

0.4%

Australia

2.74%

5.3 bps

AUD-USD

0.796

2.9%

Source: Bloomberg

Economic Update

United States

Subdued inflation complicates the case for rate rises in the US?

  • Inflation data continue to disappoint in the US, with monthly core CPI inflation remaining at a lacklustre 0.1% in June, the third month running. Year-ended growth in the core CPI, which excludes food and energy prices, was unchanged at 1.7% in the month, a noticeable loss of momentum from the start of the year when the measure was running over 2%. Headline inflation dropped to 1.6%y/y in June from 1.9%y/y in May with prices unchanged in monthly terms. This potentially makes life more difficult for the Fed, who have looked through the weak inflation readings when raising rates recently. Although the recent soft inflation reflects some transitory factors, Fed chair Janet Yellen acknowledged in her testimony to Congress last week that there could be more to it, and that the Fed were watching carefully for signs that short-term drags were not the only factors holding inflation back.
  • Retail sales fell in June for the second month, after the market had expected a small rebound. Headline retail sales were 0.2% lower in the month after a 0.1% fall in May, and ‘control’ retail sales (excluding sales at auto, gas, food services and building and supply stores), fell 0.1%. Year-ended growth of these measures remains positive, although growth has been steadily declining over recent months. In addition, preliminary results from the University of Michigan consumer survey showed consumer sentiment has fallen in July on declining consumer expectations of future economic prospects, suggesting some loss in consumer momentum heading into the third quarter.
  • On a brighter note, industrial production grew 0.4% in June on the back of strong mining and oil and gas output, adding to an upwardly revised 0.1% monthly growth in May. While this was slightly stronger than expected, growth in manufacturing output remained subdued, rising by only 0.2% in June.

Euro area / United Kingdom

Inflation rate falls unexpectedly in the UK

  • The UK’s annual headline inflation rate unexpectedly dropped to 2.6% in June, aided by lower oil prices. Year-ended core inflation also fell to 2.4% in June from 2.6% in May. After steadily increasing over the past year, the dip in inflation may ease pressure on the Bank of England to raise interest rates. 

China / Japan

Resilient growth in China confirmed in Q2 GDP figures

  • China’s economy grew at an annual rate of 6.9% in the second quarter, matching the first quarter’s growth rate and remaining comfortably above the government’s 2017 growth target of around 6.5%. This was higher than anticipated, and confirmed the strong economic picture that had been suggested by recent partial indicators and survey data. Year-ended growth in industrial production and retail sales increased in June, and growth in urban fixed-asset investment was unchanged after declining in recent months. 

Australia / New Zealand

Strong gains in full-time jobs continues in Australia 

  • The Australian economy added 14,000 jobs in June to keep the unemployment rate unchanged at 5.6%. This came as no surprise to the market, though the addition of 62,000 full-time jobs was a particularly strong result.
  • Inflation data for the second quarter will be released next week in Australia, with quarterly headline inflation expected to remain modest at 0.4% (nsa) as weak wage growth and lower petrol prices offset higher fruit and vegetable prices following Cyclone Debbie. We expect headline inflation rise to 0.9% in Q3, inflated by sharp gains in electricity and gas prices (+¼ppt) and the tobacco excise increase (+0.08ppt). Offsetting these gains are lower oil prices (petrol prices -0.125ppt) and the impact of the higher AUD.   


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