Over the past week or so a few warning signs have appeared relating to the outlook for interest rates and Australia’s relative economic performance. In essence it seems that the sharp lift in global bond yields over the past couple of months still has some way to go over the next few months. As global bond yields continue to rise, the RBA may also find itself in a position where it might want to try and influence a reduction in Australian bank lending interest rates by cutting the cash rate, but lenders respond by leaving lending interest rates unchanged. There is a real risk that for a period the RBA will be powerless to ease monetary policy even if it decides that a policy easing is necessary.
Taking first the warnings relating to global bond markets. Over the past two months or so signs of a lift in global growth driven by stronger than expected economic data from the US in particular, but also to a lesser degree from China and Europe too indicated that bond yields had fallen much too low. At the same time, policymakers around the world were starting to question whether very easy monetary conditions were proving to be counter-productive and actively reducing growth prospects especially when extended in to the strange world of negative interest rates making it harder for commercial banks to lend profitably. The focus among policymakers was turning towards the relative benefits of fiscal expansion which seemed to hold more promise than monetary expansion in lifting growth.
Investors in many cases were positioned for a lower-interest-rate-for-longer world, a world of persistently low economic growth and very low inflation. Investors until mid-2016 were cautious about the prospects of growth assets underweighting shares in their portfolios while building up cash balances and holding more bonds. The rebound in share markets and the sell-off in bonds has been driven largely by investors caught wrongly positioned and adjusting their portfolios to signs of better global economic growth and the hope that growth can be underpinned further by changing policy mixes with more emphasis on fiscal expansion. The surprise election of President-Elect Trump added hope that the US might change the mix of its policies too.
It is unlikely that this quite major asset allocation shift by investors towards shares and away from cash and bonds has run its course just yet. Just since the end of September the asset allocation shift has pushed up the US 10-year bond yield by 88bps to 2.47% and the Australian 10-year bond yield has moved up 97bps to 2.87%, and even if there were no other factors in play investors look set to continue to sell bonds to fund greater investment in risk assets for a little while yet.
Other factors that might provide even greater impetus for bond yields to rise are starting to show. Even as signs of global growth have improved there was still a sense that inflation was well contained helping to provide some cap on the rise in global bond yields. Two potentially inflationary factors have emerged over the past week or so. The first is the unexpected agreement among OPEC oil producers to restrict global oil supplies reinforced over the weekend by non-OPEC producers promising to restrict supply too. There is a real risk that the oil price could rise up through $US60 a barrel over the next few months pushing up the retail prices of energy internationally. Another important and potentially inflationary shift has come from the World’s favourite producer of manufactured goods, China. In early 2016 China’s producer prices were falling at close to 5% y-o-y and had been continuously falling for the previous three years and more. Through mid-2016 the pace of fall in China’s producer prices moderated and turned to minor gain three months ago. The most recent producer prices release for November was +3.3% y-o-y up from +1.2% y-o-y in October. The swing through 2016 from China exporting deflation to exporting rising inflation has been pronounced but has hardly been factored in to views about the inflation outlook elsewhere around the world, including the US and Australia.
If investors start to react to signs that inflation risk is rising, global bond yields may rise more over the next few months than they have risen since September. This would represent a world where funding costs for Australian lenders continue to move upwards and regardless of anything that the RBA may do with its cash rate to try and offset the pressure. This would be an environment where the RBA would be powerless to influence lending interest rates in Australia, an environment where a cash rate cut would be ignored by lenders.
One problem is that Australia was the odd-man-out economy in Q3 experiencing a sharp decline in economic growth while others were mostly experiencing better growth. It is true that there were a number of anomalies and one-offs in Australia’s surprising -0.5% q-o-q GDP growth rate in Q3 that saw annual growth clatter down from 3.1% y-o-y in Q2 to 1.9% in Q3. Real GDP growth was negative but nominal growth was positive, +0.5% q-o-q. In terms of real growth it was also an unusual quarter where government spending, housing and net exports all contributed negatively. All three could and probably will make positive contributions to growth in Q4. Australia is not on the brink of recession (two consecutive negative growth quarters) in our view, but it is highly vulnerable to a period of soft growth simply because household debt is so high that any lift in lending interest rates by financial institutions will stretch household budgets and limit growth in household spending.
The warning signs from the rest of the world, travelling better than Australia for the time being, is that the upward pressure on interest rates internationally (and Australian financial institutions’ funding costs) still has some way to go. Recent signs that oil prices may rise and that China’s producer prices are rising fast may add to upward pressure on global interest rates and Australian borrowers should expect repeats of the recent round of “out-of-cycle” increases in home loan interest rates over coming months.