Can the RBA thread the needle?

After hiking for the fourth consecutive month, the RBA’s tone has shifted to suggest a pause at the September meeting is possible, reflecting in part the troubling signals emanating from markets as the US teeters on the brink of recession and conditions continue to cool across the globe.

As lead indicators continue to flash red – consumer confidence remains at alarming levels and housing is rolling over – can Australia’s central bank successfully thread the needle and avoid an outright stalling of the Australian economy?

Darren Langer and I discuss this and more in episode 30 of The Rate Debate.

Transcript

Darren Langer (0:01): Hello and welcome to The Rate Debate. I'm Darren Langer Co-Head of Fixed Income at Yarra Capital. And joining me, as always, is my co-Portfolio Manager Chris Rands.

Chris Rands (0:09): Hello everyone.

Darren Langer (0:10): Well, it's the first Tuesday of August and that means the RBA has just met. And to coin a phrase or to steal a phrase, rather, I would suggest that that hike from the RBA of 50 basis points probably could be considered a little bit on the dovish side. Chris, what were your thoughts on the statement?

Chris Rands (0:27): I guess the idea of a dovish hike when they're hiking at the fastest pace that we've seen in 20 years is, is still a bit of a foreign idea to me. But certainly, some of the language that they used in the statement certainly is more dovish than the market expected. Previously, we saw a bit of a rally in the bonds. And so just some of the language that they use is now that they're not on a preset path, that they described the hike as normalization rather than a move from extraordinarily easy policy. And they spoke as well about the uncertainty and risks around what they're doing, which we hadn't completely seen over the past few meetings.

Darren Langer (1:04): There was one particular statement that seemed to be setting things up, at least the way I read it, that if they managed to thread the needle and we get a nice soft landing, it’s all the RBA’s doing but if things go pear-shaped and horribly wrong, it's offshore factors to blame. It was quite a negative start to the statement. And then they seemed to ease off as they went through about some of the more positive stuff. But certainly the opening part of the statement was more negative than I think we've seen from the RBA for a while.

Chris Rands (1:33): I personally think that makes sense. Because the cash rate is now above where we started kind of pre-pre-pandemic. So back in 2018, the cash rate was 1.5%, it's now risen up to 1.85%. So the idea that we're at super accommodative levels doesn't hold true anymore – we’re above where we started. And so you can look at it now and say, okay, how is the economy looking? How's it looking offshore? How can we move in the future? Because now we've moved, as I kind of said before, to a degree that we haven't seen since 1994, conditions probably should be starting to tighten up pretty soon.

Darren Langer (2:09): To me, the most important thing that was probably in the statement was the fact that they did mention that they're not on a preset path. We've had four rate hikes in a row. As far as I'm aware, that's probably the first time we've ever had four in a row. To me, that kind of says that perhaps a pause in September is at least possible or more on the consideration side. So maybe the RBA is thinking: do we pause? Or do we go 25 rather than another 50? What do you think about that?

Chris Rands (2:36): Certainly, my view of this is from the beginning, they should have been going slow and steady. So I think when you look at what's starting to occur offshore, there are signs now that they should be thinking about how they navigate from here. If you look at why they would want to pause, you don't need to look too far: you can see a potential recession forming in the US, you see the same circumstances potentially coming in Germany, China still seems to be slowing – they've got property problems – and you're now seeing Australian house prices start to fall at a relatively quick pace. There’s signs that US housing will be falling at a quick pace.

And that's all coming after very aggressive hikes. So certainly, I think that there's a pretty good case here that they should slow down, survey what they've done, and check what's going offshore. And if all of that clears up, and we come through unscathed, well, they've got the whole of next year to start hiking again if they need to. It's not like they're really kind of behind the curve now, which many people thought they were before. They've done enough hikes to get them ahead. The problem is just going to be that, as we've said, in the past, inflation is a lagging indicator so it's very hard to tell if you've done enough until you actually see it start to slow down.

Darren Langer (3:45): I think the other thing too, is that most of the positive statements from the RBA were around employment and around the potential for consumers to keep spending. As we've said before, employment tends to lag along with inflation, and spending is a little bit more difficult because most of the data that we've had so far has been probably prior to the last couple of hikes. So we haven't really got up-to-date data on that sort of thing. But, you know, our feeling is that between the inflated prices that people are paying for food and other goods, that it's likely to start denting discretionary spending as people move into having to pay more for discretionary goods. So it's really hard to see what else is positive out there. Most of the other things that are pretty negative.

Chris Rands (4:29): I think the flow on of what you said then reminded me, I've only really seen one or two of the increases in my mortgage rate so far. So the speed with which they've been increasing, it still hasn't even caught up to me the prior ones they've done. So there will be a bit of a lag with what they've done because of the speed that they're doing it as well. And how that hits the spending is still a little bit unknown, but certainly the drops that you're seeing in consumer confidence globally is pretty alarming still.

Darren Langer (4:56): And talking about offshore, we saw this month the US GDP for the second quarter in a row has been negative. I think we mentioned in the last podcast that we've never actually seen the Fed hike while they've had negative growth. I know there is some argument again around the fact that US employment is still quite strong, and that it's not a technical recession. But there are good reasons to think that growth isn't likely to pick up from here; we're already starting to see prices paid components in some of the US numbers come off, which has been the main thing driving inflation. But worse, we're starting to see housing rollover, and certainly other things. I think it's enough to say that the US, if it was not in recession it's pretty close. But you know, the hardest thing for me is that I just can't see how they're not going to keep getting worse. There doesn’t seem to be a lot of positives there.

Chris Rands (5:47): When you look at the US, the lead indicators for them started falling probably three months ago. At that point in time, you had one or two indicators that were troubling. But now certainly when I looked through kind of our lead indicators, you see trouble brewing everywhere: manufacturing slowing, new home sales were down, housing starts were down, there are big build-ups in retail inventories.

There are enough things there that you kind of scratch your head, and you go, well if you're going to put rates up another 150 points from here, where do you think that growth is going to come from? So certainly, the first kind of move that we've seen over the past six months, it's only a relatively slow down, I think about 1.5% or something like that over six months – it’s not terrible. But the forecast from the Fed and most forecasters was that it was actually going to be positive. Certainly, when I looked through history, a move like this is signaling that a recession is coming. And you're seeing it from the curve. So I would look at that and I would say, what do we think is going to end it?

Darren Langer (6:47): One of the other things two has been interesting is that people seem to have accepted the fact that the US is in recession, and now we're looking through it to how do we get out of this sort of recessionary environment? Some of our more optimistic colleagues out there are pointing to the fact that US recessions, and in particular global recessions tend to be fairly shallow. And then we pull out of them relatively fast. And that it's not something that we should be too depressed about. I guess the thing we'd disagree with them is how recessions end, There's talk about growth picking up and the economy improving, but I think in reality we see that usually happens after they start cutting interest rates again.

Chris Rands (7:28): If you look back to about 1970, in every recession in the US rates fell by about 200-500 points, depending on the kind of when and how long it lasted. And there was no circumstance where rates were actually going up. So when you look at the thing that would generally bring you out of a recession is you cut rates, people start borrowing, the housing market picks up, all the things that you kind of expect, are rate sensitive, whereas at the moment you're actually seeing the housing market slow, because they're actively trying to slow it. You can put on top of that the fact that the US dollar’s rallying, that oil’s up, those things also generally constrict the economy as well.

My feeling coming into this year was the central banks don't want to see a recession, so they're going to be careful with rates and therefore not jag them up quickly. The thing that's made me very nervous is they're dragging them up quickly, it looks like the recession is almost here, and they're still saying that we've probably got another 200 left in us. So if they were to go that additional 200, I don't think it's going to be very good at all. And I think to really forecast this idea that the economy is going to turn around and there won't be a big recession is they need to stop and probably potentially even look at cutting, which is why you're seeing the futures market in the US inverted.

Darren Langer (8:39): I think one of the things that worry me is that if we do get back into a cutting cycle, you know, six, nine, 12 months later after the hike cycle, we just go back through the same churn and burn with asset prices. Again, nobody seems to have a solution to fixing some of the underlying causes, which are partly, as we've said before, demographic issues with aging populations, but also it seems very hard to get growth in an economy above what is trend. We get it up to sort of 3%, maybe 4% at times, and we end up back at 2%. I don't think there's any magic bullet.

And we've said before, perhaps we need to start accepting 2% growth as being normal. I don't think central banks and governments are willing to go there yet, but I guess what we don't really want to see is just a repeat of the last two years all over again. And then in 2025-26 we're back in the same boat where we're having to tighten aggressively to try and stop the excesses from cutting too far.

Chris Rands (9:44): Yeah, and I guess the follow on from that, and why probably the central banks didn't go down the path that I kind of described where you say ‘well, I can see a recession coming so I'm going to slow down’ is that asset prices still are super high. So maybe they think that they've got the ability to continue leaning on asset prices while growth still looks okay, and then maybe try and turn it around later. That feels dangerous to be doing that to me.

Certainly when you look in the RBA forecast, now, they're still saying a bit over 3% growth for this year and then dropping sub 2% for the next two years. So they seem to acknowledge that what they're doing will slow growth. But those forward forecasts that they make are not generally worth the paper they're written on, as we know from the past inflation forecasts they've made. So it does stand to reason I think that they are trying to slow down growth. And because of that, you need to be wary of what will come after.

Darren Langer (10:33): And certainly we've mentioned this before, inverted yield curves are telling you that something's not right. Usually that means that, at some point in time, they're likely to drive the economy into recession. We think we're already there in the US, but we're certainly not there in Australia yet. Australia does look to be in a slightly stronger position. When do you think we'll start to see the Aussie curve going inverted if we do keep tightening?

Chris Rands (11:00): The Aussie curve, I think is a little bit harder to forecast because commodity prices are still relatively high. So that's going to give us a boost. And I think that's probably the reason people lean in to say, you know, while it does look like recession’s coming in Germany in the US, maybe we can avoid it here in Australia. If the RBA slows down, and they start talking 25 basis point hikes, or maybe even pausing, then I would probably think that we could avoid curve inversion, mostly because we've been lagging the US by six months. So hopefully we get the signal that something's gone wrong in the US, and then we can kind of avoid it because we've been six months delayed. When you look at the US though, there are a few things that kind of concern me as I see it.

So if you look at 2s and 10s, so the difference between the two-year bond and the 10-year yield, it actually first inverted in April. Typically, when you look at the timing between curve inversion and recession, it's about 12 months. So you know, we've kind of rolled forward six now, and it already looks like the data is softening and that curve inversion was correct.

At the time, what the Federal Reserve said was, don't worry about that, we prefer to use the three months versus the 10 years, which is very similar. But because it's a shorter-dated bond, that kind of takes a little bit longer to invert, and over the past kind of month and a half that's flattened from about 150 points down to nine. Typically, once you get the cash rate above the 10-year bond yield, it's game over, you're looking at the bond market saying we don't think you can keep moving cash like this because otherwise the 10 year should be 2% higher. The breakdown of all of that is certainly what you're seeing in the US is very concerning. And what you're seeing in Australia kind of suggests we might be able to skate through if we're lucky enough.

Darren Langer (12:38): Yeah, it certainly looks like I guess, to some extent, the world's pain is Australia's gain. Because we are so commodity rich, we're a food producer, we're producing all the things that people have to pay extra for at the moment. So income-wise, we're probably going to be okay. The big question is whether we can withstand a global recession and remain on our own.

And just to steal the RBA’s second paragraph, they mentioned global uncertainty as being one of the biggest risks to the outlook at the moment. You have, obviously, gas supply issues in Europe, we still have COVID floating around – that certainly hasn't gone away and it's fairly pronounced in Australia and New Zealand but elsewhere in the world. And I guess you've got China starting to slow, and now you've got the US with Nancy Pelosi talking about going to Taiwan, I guess, thumbing their nose a little bit at the Chinese. And whether it's calling their bluff on certain things or not, I don't know, but it seems to be maybe an unnecessary thing. But it doesn't seem to be a positive in the scheme of things, at the moment, to help the global economy recover. Are there other things out there that you're sort of seeing that are worrying you?

Chris Rands (13:55):I feel like we're always kind of describing something that worries us. Certainly the ongoing disruptions from food and commodities still coming from Russia and Ukraine is, I think, causing the biggest problems in the market. The oil price has been coming off a little bit, which should help the inflation backdrop. If you could see the oil price kind of drop – I think it's about $92 now – if you could see that drop into the low $80s we probably should see some negative month-on-month prints in inflation which gives the RBA, the Fed, the Bank of England and the Bank of Canada and all the other central banks just moment to kind of say: ‘we've hiked 200, now we've got some negative month-on-months, let's just sit on our hands.’ So I don't think that from a rates perspective, it's all bad. It just certainly feels like every time there's a time to rest, there's some other geopolitical thing popping up that that just throws a spanner in the works.

Darren Langer (14:50):I think that probably one of the main themes we've seen out of the central banks is that they're still talking quite aggressive on rates, but they have opened the door now to easing off or pausing to see what's actually happening. And I think that that was probably the first sign that think they're getting closer to what they think is neutral. It's obviously a little bit higher than what we think is neutral, it's certainly a long way. I mean, we had three-year bond yields at over 4% not that long ago. We’re now back down below 3%, well below 3%. So we've seen rates markets move quite aggressively over the last few months, and I think the last few months have probably been some of the most volatile that I've ever experienced. I hope that if central banks are getting to that point, perhaps we'll start to see some more calm markets in the next couple of months.

Chris Rands (15:48): Yeah, I guess the positive that I see with respect to that as well is that three-month tenure in the US when it's inverted in the past, that's been the end of the hiking cycle. And so it's always very hard beforehand to figure out exactly where they're going to stop, but the curve – once it starts inverting – is a very good signal that you're at least close to the end. And I think that says maybe the Fed gets as close to 3% but it feels like they're going to stop closer to 3% than they do to 4%.

Darren Langer (16:19):Well, that's it for this month. If you ever want to suggest topics or discuss further things with Chris and me, we can be contacted at theratedebate@yarracm.com. Tune in next month when we deliver our latest thoughts on the RBA's September rate decision and provide an update on what's been happening in markets. Until next time, stay safe.

Tune in next time

So, that's it for the month. If you ever want to suggest topics or discuss further anything with Darren or I, we can be contacted at theratedebate@yarracm.com.

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