US Inflation Key to Next Market Rally – Christopher Joye
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 look at. When the RBA gave up its 0.1 percent interest rate target for the 2024 Treasury in November, it sent private sector rates soaring: Repayments on NAB’s new 3-year fixed-rate mortgages rose from 1.98 percent to 4.50 Percent.
These hikes triggered the initial turning point in the East Coast housing market, which usually leads the rest of the country. They were reinforced by the RBA’s first rate hike in May. Sydney property prices are now falling rapidly after falling 1.74 percent from their peak a few months ago, according to CoreLogic. Melbourne prices follow, falling 0.74 percent from their highs. After last year’s boom, home values in Brisbane are similarly flat.
There is now a big disparity between home loan prices at variable and fixed rates: while variable rates are around 2.50 percent, 3-year fixed rates are two percentage points higher. Leading brokers say the proportion of borrowers taking out adjustable-rate loans has risen from about 25 percent of all new approvals last year to more than 90 percent now.
For now, markets are pricing in the prospect of the RBA raising interest rates to 2.5 percent by the end of 2022 and to 3.25 percent within 12 months. However, there are factors that could weaken the RBA’s walking profile.
First, funding costs have increased significantly for both non-banks and banks, and lenders are able to pass these costs on to customers via higher lending rates. This could take a toll on the RBA.
A second consideration is the heightened sensitivity of household balance sheets to interest rate changes, meaning the RBA may not need to raise rates as much as it has in the past. During the week, Deputy Governor Luci Ellis stressed that Martin Place cannot know with certainty where the true “neutral” interest rate lies, despite suggestions that it would move straight to 2.5 percent.
[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 income (or interest rate duration) have risen in unison, despite the momentum following the global financial crisis, where duration has tended to be negatively correlated with equities.
After falling nearly 20 percent from peak to trough, the S&P500 index is up 6.7 percent. At the same time, the 10-year US Treasury yield has fallen from a recent high of 3.20 percent to just 2.76 percent, meaning bond prices have risen.
US investors are now hoping the Fed will only hike rates to its own “neutral” estimate of about 2.8 percent to avoid the need to tighten policy to a point that would plunge the economy into recession would. This is based on the assumption that core inflation will be rolled over.
While monthly core inflation according to the CPI index remained stubbornly high at 0.6 percent in April, the Fed’s preferred gauge — the core PCE index — is expected to trade at a benign 0.3 percent on Friday night. This would be the third straight month of core PCE inflation at 0.3 percent, which is a much more acceptable 3.6 percent on an annualized basis. It would also mean that the PCE core inflation rate would have fallen to 4.9 percent or less year-on-year from its peak of 5.3 percent, setting the stage for a risk rally based on belief that the world’s main central bank is… World will perform a soft landing.
The alternative is a surprise to the upside as core PCE inflation comes in at 0.4-0.5 percent, signaling a pace of 5.0 percent or higher yoy. This would raise the specter that the Fed must turn hawkish and dampen aggregate demand enough to push the US economy into recession in 2023. Our modeling using stock and bond market data suggests this is a very plausible scenario. Our analysis also shows that S&P500 earnings are extremely large compared to their historical trend, with a real risk of further large pullbacks for stocks if earnings revert to the mean. This will be exacerbated if the Fed has to become more hawkish in its policy.
Subject to the question of where the RBA is getting interest rates from, Australia should remain the “Miracle from Down Under” which is made up of a cheap Australian dollar, increased commodity prices, resilient consumer spending, a resurgence in business investment and a rebound in both the unskilled and the skilled people care about migration.
However, the road ahead remains complex for our new federal government led by Prime Minister Anthony Albanese. On a side note, markets are anticipating more stimulus from new Treasurer Jim Chalmers versus the counterfactual, which could mean the RBA has more wood to chop.
Labor is blessed with some outstanding economic talent that it should capitalize on. By far the best economic brain in Parliament is clearly Dr. Andrew Leigh, an acclaimed Harvard graduate student who was an economics professor at ANU. Labor would be insane not to use its world-class skills, which have focused on innovating empirically tested policy ideas.
Chalmers also has access to Dr. Yale’s Daniel Mulino, PhD, who has spent much of his career providing valuable economic advice. And then there’s the ambitious new member for Paramatta, Dr. Andrew Charlton, who received his PhD from Oxford and played a key role in the Rudd government’s response to the global financial crisis. This included the development of unprecedented policies such as the purchase of more than $10 billion worth of mortgage-backed securities during the crisis, which bailed out many smaller bank and non-bank lenders while generating a return for taxpayers.
dr Leigh, Dr. Mulino and DR Charlton could play an important role in propping up an otherwise tenuous parliamentary bench.