The reopening trade to determine economic growth in 2022

One of the key factors that will make or break the case for the RBA tightening in 2022 will be the reopening trade. Will consumers start spending heavily as is forecast, or will the threat of inflation and a rise in interest rates scare them off? Darren Langer and I discuss our views in the last episode of The Rate Debate for 2021.

Edited transcript

Darren

Hello, and thanks for tuning into the final episode of the rate debate for 2021, a year I'm sure most of us will be happy to see the back of. I'm Darren Langer, Head of Fixed Income at Yara Capital and joining me is my co portfolio manager, Chris Rands.

Chris

Hello everyone.

Darren

Well, what a year it's been. The world completely underestimated the impact of the COVID-19 Delta variant, which sent most of the world into lockdown and economies into hibernation. These events put enormous pressure on the RBA to continue to prop up the economy. In this episode, we'll have a look back on some of our calls and how they turned out and then have a look at perhaps what we think is going to be happening in 2022. But before that, it, it is the first Tuesday of December. That means the RBA has just met. What did we hear from them today Chris?

Chris

Not too much that we haven't heard before. Basically they'll be keeping the cash rate at 0.1 and continuing their bond purchase program through to February next year. Apart from that, it's the same as we knew before.

Darren

There was a little bit of murmuring around the fact that they changed some of the language around dropping that 2023 date, or at least not mentioning it quite as strongly. I think they were probably looking for something to change in a statement, but as you said, that wasn't a lot different. It sounds like February is really going to be the next major time we get any sort of information from them, but it seems to be BAU for the for the reserve bank now through to the end of the year.

Chris

I guess that raises the bigger question that probably the market will start contemplating next. And that's do they end their program come February next year?

Darren

It certainly that would be, you would assume, the first thing they are going to start unwinding quantitative easing or at least tapering it. Hopefully they'll broadcast it and make a better job of it than what they did for taking YCC off. But that would be the most logical thing to expect, the first announcement early on next year.

Chris

There’s two ways that I'm looking at this at the moment, and we've thought for a while that QE would be quickly reduced next year. We'll talk about that later with some of the calls that we put in the portfolio. But when you look at the RBA, they said when they make their decision come February, they're going to be looking at the same three things that they always have.

1. the actions of other central banks,

2. how the Australian bond market is functioning and

3. the actual and expected progress towards the full employment inflation targets.

I thought it was interesting when I read that statement, that the first thing that they listed there was the actions of other central banks. We've seen now the RBNZ has stopped, the Federal Reserve’s starting to talk about stopping, and it implies very strongly that the RBA is probably going to be next to talk about the stopping of their program. And at a bare minimum, if you look at the amount of bonds that they've bought, they own about 30% of the bond market, that's now in line with offshore. So I think at a minimum they'll reduce it down to purchasing only 30% of new issuance, such that they keep the balance sheets stable. So I think its either going to disappear or it's going to be reduced significantly so that they're not soaking up all the issuance.

Darren

The reserve bank is certainly of the opinion that the stock of bonds in their balance sheet is more important than the flow. I know we have a slightly different view of that given what we've seen happen overseas, but they are very much of the view that reaching a level is more important than continuing to buy, and that would certainly make sense. As you say too, we've always thought that quantitative easing was more around trying to maintain the level of the currency relative to other countries, more so than necessarily being purely about interest rates. And I think the nod to the offshore central banks starting to wind back policy is probably that they're more comfortable that the dollar will maintain its value rather than start to appreciate rapidly if the RBA was looking to tighten earlier, particularly the Fed.

Chris.

There will probably more volatility as those things end because typically currencies start to move around once you take a policy off, interest rates start to move around and then probably semi-government spreads will start to move around as well, because that's the three places that it's probably had the biggest effect. So if they do remove QE, you probably expect there to be more volatility next year, than what we've seen over the past 12 months.

Daren

I guess that's a good segue into what we've seen over the last 12 months and some of what we've seen unfold, It's always hard to predict the future and no one does it very well, but I think we made a few good calls this year, but unfortunately the volatility of the market makes you look really intelligent one day and extremely stupid the next. So it's been quite a frustrating year, but I think overall, the things we talked about 12 months ago were really that the market was getting itself a little bit too excited about interest rates happening sooner rather than later. I think that's still our view and probably somewhere we're butting heads with most of the market.

I think the other one was that the COVID story still had water to play out. And that certainly became true. That one may have been more luck and good management, but it certainly was always something that was a big risk factor in markets. And the other thing we talked about really early on, even two years ago, the unwinding of the yield curve control would end up being a lot more messy than the RBA expected. And I think that that played out.

Probably the main thing that matters from the way we talk and think about markets is that we had talked about the flattening of yield curves, particular that 10 year part and longer. And we’ve seen significant flattening in most major G10 and wider bond markets. And I think to me, they're the main calls that were most important. Was there anything you sort of saw that that I've forgotten there?

Chris

I would say probably the non-consensus idea that we were using the most was that the long end, so the 20, 20+ year bonds would probably not go as far as the market thought. And that's probably been one of the better calls that we made. And certainly when you look at the US 30 year at the moment, it's lurched down to 1 70 and when I look at things like that, I think you really need to ask the question of “what is going on here?” If this is a truly inflationary environment, what is that actually saying? So it's interesting, I think to have that one right. But it does raise more questions about the future, which is probably something we'll talk about after as well.

Darren

Just to balance it out, there's been a few things we've been a little bit disappointed in. We had a fairly strong view that semi-government spreads would probably widen over the latter part of this year. And we really haven't seen that, if anything, they've continued to be quite strong for reasons that still remain a little bit cloudy to us. And I think the other thing has really been the large movement in swap spreads. We've seen quite a, a widening of swap spreads probably a little bit more aggressive than you would've expected just from changes in interest rates and various other things. There're two of the areas where we probably got a little wrong, but it's been a year where it's been so up and down. We've seen movements in bond returns that you would expect over a year and we're seeing in often in a month or half for month. It's been really volatile, and I think that's the word, more so than transitory for this year?

Chris

I think as well, just to add to that, certainly the thing that has frustrated me through this period is that while we thought rates would move higher, we really didn't think they were going to go like this, you know, for there to be basically whenever I'm writing the monthly reporting and I'm talking about 50 point moves every third month. This isn't really what we had envisioned when we said the rates could move a bit higher. I kind of think the Aussie tens up kind of one and a half percent is somewhere that makes sense. And so for them to push through 2% was a, a bit of a kind of move that we weren't expecting. I would think

Darren

Starting to think about some of the ramifications of what we've seen over the last couple of months, one of the things we've talked about on and off is this whole idea about, was yield curve control an actual tightening of policy and has the RBA started to already tighten rates. And the fact that we're also now talking about quantitative easing coming early next year, how much tightening do you think the RBA has to do before they're going to be happy that they've taken enough stimulus out of the system?

Chris

That's a good comment. I think one of the problems that certainly I have with the way that the market looks at unconventional policies is they look at the policies and say, they're not doing anything, so just get rid of them and we’ll be fine don't worry about it. I take the opinion that these unconventional policies are actually doing something. And it's a good way to look at what's happened with yield curve control. The exit was very messy, but if you look at, three year fixed rates at the moment have moved up from about 30 basis points to be over 1%. And because of that, what you've seen is a fairly quick tightening of fixed rate mortgages in the Australian market. And now given that 50% of housing lending was being done in fixed rates, that's clearly going to have an effect. You can't look at that and say it's done nothing

From the research that we've talked about in the past, basically every 10% of bonds in GDP that the RBA buys that's good for about 1% of cash rate cuts. So if they were to end QE and never remove white yield curve control, I would probably think of that as the first 50 basis points to a hundred basis points of hikes. Now how fast that flows through and what the actual effect is, I think will take a bit of time to see, but it does I think reduce the subsequent cash moves that they need to make after that.

Darren

And that's one of the really big things looking into 2022 and further out which again is always dangerous, but how high can cash rates go? It's one of the things where we are a little bit different to many economists, and certainly a lot of market strategists. They're talking about rates being considerable magnitudes higher than what we think can be sustained given their levels of debt out in the market. You have been warming up the crystal ball in doing your forecast for next year. Where do you think cash rates will get to once they start to tighten given we've already had so much stimulus taken?

Chris

When we look at the outlook for next year and what we're thinking about, I don't think that the RBA is going to be hiking cash rates next year. I think what they're going to be doing is removing QE and then waiting to see how that affects the economy. And then that brings you into forecasting a period where you're getting 12, 18 months out and it becomes murky at best. When I look at the cash rate though, I think that the debt buildup that we've seen over the past two years is going to make it incredibly difficult to push the cash rate back through from where we started it.

And so if you think back to pre-COVID, the RBA was already cutting to give the economy a bit of a kick. And so we started this process that had the cash rate at about 1%. My feeling is that when this is all said and done, we probably see a cash rate close to that rate rather than a cash rate of two, two and a half, simply because of this huge debt build up. With home prices that are 20-30% higher, it becomes incredibly difficult to push the cash rate up 2% and not expect that you are going to affect the housing market at some stage.

Darren

And given that sort of forecast, people seem to be very worried about inflation. Again, there are certain elements of the inflation that we're seeing that are probably more sticky than others. Energy prices are obviously the one swing factor that monetary policy can't really do a lot of, but we are seeing a lot of costs coming through from housing. So if housing starts to decline, how quickly do you think that starts to impact inflation?

Chris

This I think is going to be a bit of a mix. If you look at the RBAs chart pack at the moment, they've got a great chart in there where they show that two thirds of the current inflation impulse is coming from housing construction and oil prices. And so, if you think that oil prices go sideways from here, then that inflationary pulse disappears, and you're left with the housing impulse. And we know that fixed rates are up, we know that building approvals are starting to fall. And so that would also implies sometime in the back half of next year, you probably see some of those building costs start to normalise, which then means the RBA is going to have to see inflation come through a different set of measures, whether it's the goods that we're seeing offshore, whether supply shocks or something like that, maybe wages arising.

This is just what makes it so hard. And the RBA mentioned it today. The Australian inflation rate is not doing what the offshore economies are doing. And so for us to really, I think, lean into this idea that it's going to be a big inflationary shock here. I think you need to start to see those other goods, those other things that have been lagging start to pick up, and there's just no sign of it yet. So it might come next year. But if, to me, if it just remains as construction costs of oil, I would be very skeptical of the RBA wanting to hike into that.

Darren

What do you think is going to be one of the biggest factors next year that will either make or break the case for a tightening in 2023?

Chris

I would probably think that it's just a question of what the reopening trade looks like. If the reopening looks similar to the start of this year, where everything went gangbusters, then clearly the market is going to be forecasting very strong growth for 2022, that inflation forecast to pick up at the second half of the year, and then the RBA to move in 2023. If for whatever reason people don't get out and spend the way that they did at the start of this year. I think that would make the outlook a little bit more confusing. Certainly in the US, you're starting to see some sign that consumers are not quite as confident as they were before. So there's the potential for that to be there. But given the amount of savings that's built up, given the amount of fiscal impulse that's still coming through the economies, I think the base case is they're going to be spending quite strongly. It's just if they don't, that would probably knock that idea off its course.

Darren

So I pose a question to you. If we had to put hand on heart and say what was the main driver of that spending pulse, is it monetary policy and lower interest rates or has it just been the large government spending and fiscal policy?

Chris

Clearly it's a mix of the two. If you look at the GDP print from last quarter, this quarter that we just went past, the ABS stated that it was the largest increase in household disposable income since 2008. So that's kind of quite interesting from the perspective of we've all been locked down, but we actually have more money to spend now than at any point since 2008 in terms of that growth perspective. So when they showed the breakdown, what they were showing is a large chunk of that came from government spending, which was the support as the economies were locked down. But on top of that, not as many jobs were lost. So there was no reduction coming from a lack of employment or a lack of wages. And that really sets us up to go next year from the perspective of people just go straight back to work with that money in their back pockets, ready to spend. So that's the first thing that you can think about.

And then the second thing is that the housing market's up 30%. And typically when you look at the housing market running, people are buying furniture, they're spending on the types of things that you fill your house. So I would say there's also been a huge rates impulse sitting in there as well. And it's the mix of those two that have just sent good spending so high.

Darren

I guess then everyone listening to that is probably is thinking the same thing. So why don't we think interest rates are going up next year, when there's so much stimulus still coming through?

Chris

My simple response to that is when you look at the economy prior to 2020, we were basically moving sideways. The RBA tells us that wages growth while they've picked up, they're back at about 2% pa. So if you're expecting people to keep spending the way that they have been over the past 12 months, then it's clearly going to have to come from somewhere else over this period. So typically when I look at these things, I think you need to sometimes try and look through a little bit of the huge numbers that can come from the fiscal spending and the stimulus, because once they start to run out of the numbers, you go back to that steady state that you're in before. And that's what makes this so hard to sit on the position that we're sitting on at the moment, because there's a lot of evidence that points to a lot of spending coming, but at the same time in the back of my head, I think about what it was like in 2019. And there wasn't a lot of wages growth to propel us to new highs every year. So as the housing market starts to cool as that fiscal spending starts to come out of the economy, can we keep spending the way that the economists and the market strategists want to see over the next two years?

Darren

One of the things that sits in the back of my mind is that we keep talking about the highest amount of disposable income, then people say we also need further wage hikes. We can assume that the wage hikes need to come to replace the government spending, that's a given, but it's probably not going to come to the same level. I mean, the fiscal spending we've seen put into the economy is quite large, probably more than what wage rises would be. But I think a lot of that comfort has been that housing, equities and other assets have all risen quite significantly, probably to points where it's really hard to see them pushing significantly higher, at least for a little while. It doesn't mean they have to suddenly come screaming off, but they're probably going to go sideways for a little bit.

We just can't keep making higher and higher highs all the time. Markets just don't work that way unless we see incomes and profits increase dramatically from here, which again, would infer another step up in spending that is above what we're already seeing now. So I wonder, are we going to be in a situation where we get 12 months down the track, all the ducks are lined up to hike interest rates and then suddenly we get repricing in asset markets, or at least some of that impulse taken out that makes everyone take a step back and think hang on a minute, maybe we shouldn't be doing this now. What are your thoughts on that?

Chris

Well, certainly something that I've been thinking about is how we deal with QE ending. If you look at the two times the Federal Reserve has tried to stop its QE spending over the past 10 years, both of them have been very problematic. So in 2014 when they stopped QE, the oil market tanked instantly. And because of that, the ECB had to start easing more aggressively and we didn't see the Fed hike their rates meaningfully for another three years after that The other period when they really stopped QE was 2011, and basically as soon as they stopped, the European debt crisis kicked off. Everything feels very good when there's this free stimulus coming into the economy, and the second that it stops, that's where you find out who's borrowed too much. The key difference this time, if you wanted to think about it separately, is there's still huge fiscal spending coming from the government. So perhaps ending QE won't be quite as problematic because there's more fiscal spending to come. That's just a guess, but certainly the thing that I think about is every time we seem to try to take these programs off, something goes wrong and it's always something that you couldn't have foreseen six months before.

Darren

One of the other things that sits in the back of my mind is as a risk, the things that are positive are quite obvious and up front, but some of the times the risks are much harder to see. One of those we've talked about last podcast was around how China is going to deal with their slow down in growth. We have seen them start to ease policy a little bit again, but it's really hard to see the Chinese government in particular, wanting to re kickstart all of the problems in their housing and building market anytime soon, particularly with evergrande hanging around in the background and the rest of the property in China still looking a little bit dicey. The last thing they want to do is stick a torch to that flame. How they deal with their problems will probably dictate the direction of Western markets because we rely so much on the good flow coming from that economy.

The other thing that sits in the back of my mind is that politics in general finds new ways to create problems for itself. And there's been a fair amount of sabering going on not only in relation to China, but to Russia, and just in general across the globe. There seems to be a lot less willingness for cooperation on various things. And then further down the track, we also have the problem with what do we do about global warming and some of those problems that have been put on the back burner because of the pandemic. So it's really hard to sort of just project that things will just get better and better and better going forward, and that none of these risks are ever going to derail the outcome. That's the thing I find hardest to accept with a lot of these really blue sky forecasts that nothing will ever go wrong ever again.

Chris

Sometimes we probably come off pretty negative with the things we talk about and what we look at. But you need to look at this and say, the RBA is going to have exited their yield curve control and probably at the start of the year, they're going to be ready to exit QE as well. So if 24 months ago, as we came into this crisis, you told me that the RBA is going to be out of QE and have removed that yield curve control policy in only 18 months, I would've thought at that time that that's a positive outcome. So to be out of those unconventional policies that make people feel uncomfortable is probably a good place to be. And then we wait to see if the consumption comes back, we wait to see how wages and inflation evolves, and if we're ready to go, then they can start moving the cash rate in 2023. To me personally, that doesn't feel like a bad place to be. That seems to be where the UK, Canada and the US have been for basically the past 10 years. And it's just Australia joining that party.

Darren

That's very true. Interest rates going up is probably a sign that the economy is in a good place. It's not a world ending event, well it probably is to bond managers just because it makes our life harder, but it's not a world ending event. It would probably be a really good outcome for the global economy. So if we're wrong in our view that we don't get a left field event or some of these other things don't slow things down, it's probably not a bad outcome. I still think that it's very rare given the last 10 years that we've gone more than three or four years without having some left field event derail things, but that would certainly be a good outcome. And it would be a nice way to finish the year if that ended up being the case, but we'll see I guess.