Shadow rates and the AUD

The Australian dollar has been stronger than expected given the ongoing weakness in key commodity prices and the emerging signs of softer momentum in key parts of the economy.  This may be explained in part by weaken "shadow" Fed funds rate, which suggests the short term yield advantage of the AUD has improved lately.

I've written about shadow rates  quite a bit on this blog, with some background in this post. It is basically an estimation of the effective Fed Funds rate if it could go negative, given information from the yield curve.

Relative policy rates are important when thinking about FX rates, but with the Fed funds rate at zero, this differential appears to be less meaningful for FX than it has been in the past.

But the picture is different when using shadow rates, which have actually been falling since the start of the year. With Australian rates on hold, this has served to widen interest rate differentials at the front end of the curve.

This is different to the long end of the curve, where differentials have narrowed more recently.  The relationship at the long-end of the yield curve and the AUD/USD is a shifting one, partly because there is a lot of co-movement between US and Australian debt markets.

Commodity prices continue to slide, with iron ore in particular now pretty close to the lows seen in 2012. Furthermore this weakness looks set to be more persistent.

The level of commodity prices is still high, although there are now more marginal commodity producing business now than there was back in 2006.  So prices don't have to sink to the same levels to cause more pain.

The stronger AUD is exacerbating this problem, with the widening differentials to shadow rates perhaps providing some explanation as to why this is the case.

Aus headline data are great, but big risks remain

Australian GDP growth jumped 1.1%QoQ and 3.5%YoY.  With the unemployment rate hovering at 5.8%, why all the concern about the economy?

While headline figures look great, not all is well. Wage growth, for example is very low, suggesting there is more weakness in the labour market than the headline unemployment rate would suggest. A continued fall in the terms of trade in the coming quarters will also erode nominal growth, which has been weak.

Furthermore, while the current composition of growth looks ok, momentum in key sectors appear to be fading or likely to fall faster in the coming year.

Looking at the quarterly contributions to activity its clear that the strong outturn was largely powered by exports.  Stronger iron ore and coal exports provided the base, with rural exports strong as well.

While exports should broadly be strong again in the coming quarters, the massive jump in grain exports, for example, is unlikely to be persistent.  This doesn't appear to be out of inventories.

Looking at the annual trends, we have seen net trade more than offset the fall in business investment.  To be sure, investment has proven to be more sticky than expected, partly thanks to the composition of big projects shifting from iron ore and coal to natural gas.

While the impulse from stronger exports should remain, the drag from investment should intensify.  That is the message from the most recent survey of capex intentions, which suggest a ~12% fall in investment in the next 12 months.

This is actually a bit better than when firms were asked 3 months ago.  While mining investment is will still fall and manufacturing investment intentions remain dreadful, other industries have shown decent signs of improvement.

This is important as investment intentions in this part of the economy tend to get revised higher to a greater degree through the year than it does for mining or manufacturing.  If the current pace of improvement is maintained, investment in the next 12 months may not be particularly weak.

One of the big drivers of this improvement as been the real estate industry, which accounted for around 50% of the uplift seen in this most recent estimate for FY15.  Greater investment from retailers is also providing meaningful support.

This follows the lift in consumption and dwelling investment we have seen over the last 9 or so months.

However, more recently we have seen a noticeable loss in momentum.

For example, dwelling approvals have fallen a decent way from their highs. Home loan approvals are also peaking, while house prices have shown some signs of weakness as well.  It would appear that the point of maximum impulse from lower interest rates is now passing.

Consumer confidence has also weakened quite a lot, with the most recent Federal budget accelerating the declines we have seen since the start of the year.  Retail sales have also lost momentum over the last couple of months.

The contractionary budget won't be providing much of an offset to weakening investment and slowing momentum seen elsewhere, with spending and investment growth remaining low.

So some of the more rosy aspects of the Australian economy look like they will be under more pressure in the coming quarters.  While real GDP growth has definitely held up better than many expect, many of the forward looking data suggests this is unlikely to last.

And this is likely to keep the RBA biased towards keeping rates on hold or lowering the cash rat if the AUD fails to fall.

AUD frustration for Aus miners should end soon

The AUD has managed to remain at decent in the last few months, despite the decline in key commodity prices like steam and met coal and iron ore.

It is not unusual for commodity prices and the AUD to move in different directions over relatively short periods. But it does seem like that the AUD will move back into the 85-90cent range in the next 3 or so months.

The key wedge between commodities and the AUD the last few months has been an improvement in growth that is now flowing through to stronger employment and a somewhat lower unemployment rate. That has seen most forecasters and markets abandon expectations for further rate cuts from the RBA, will a growing number of analysts calling for hikes this year.

There are signs, however, that momentum in the non-mining parts of the economy will slow. In particular, it does appear that we are now past the point of maximum impulse from the cut in interest rates we saw over 2013.

For example, new home loans are still at a high level, but are no longer accelerating as they did in 2H13. This is already starting to take the edge off house prices in some areas.

And while the impulse from monetary policy is fading, fiscal policy is becoming contractionary, with the reduction in the deficit a little over 1% off GDP. Consumer confidence has also been impacted heavily over the past month or so.

In a traditional cycle, this wouldn't be such a big problem, as some of the lagging sectors of the economy would pick up the slack.  But this isn't a normal cycle for Australia, thanks to the long boom in mining investment that is coming to an end.

It has probably taken longer than expected for Australia to fall over the "capex cliff".  At the moment, investment expectations for 2014-15 look dreadfully low, although outcomes in the last few quarters have probably held up a bit better than previously thought.

It seems unlikely that the AUD will remain strong if key drivers of the recent recovery like housing start to cool and investment rolls over.  That may bring speculation of rate cuts back in play.

Aus economy still in muddy waters

The most recent economic data out of Australia suggest a muddy picture.  The consumer side of the economy is now responding strongly to low interest rates, with housing construction activity strengthening and retail sales lifting.  While the labour market data is ultimately a lagging indicator, it does point to weakness elsewhere.

For now, the cyclical improvement in the household side of the economy is doing enough to keep growth reasonable and the RBA cash rate at 2.5%.  But it is way to early to suggest that the next move in rates will be up any time soon and the Bank is likely to remain dovish.

It's extraordinary that the loss of jobs in the last 6 months has actually been larger than the first 6 months of 2009 at the height of the collapse of financial markets.  The unemployment rate jumped much quicker in that period, as many stayed in the workforce.  This time around, labour force participation has dropped by 0.6ppt.

There are signs from leading indicators of the labour market like job vacancies that conditions are stabilising, although there isn't a sign of a turnaround at this stage.

Monetary policy and rising asset prices have been able to offset the drop in employment from the consumption perspective, with retail sales lifting in the last 3-4 months.  Growth of ~3.8%YoY is hardly explosive, but is an improvement from mid-year.

Mortgage borrowing and house prices have been strengthening strongly for sometime, but this has taken another leg up in the last couple of months.  Investor interest in particular has exploded, although there is also a noticeable improvement in owner-occupied housing as well.

Thankfully this is also translating into stronger construction plans, rather than purely into higher house prices. Medium-density housing had been driving most of the gains, although in the last month there has been a noticeable increase in detached houses as well.

If this were a traditional cycle, it could be argued that monetary policy settings may need to be changed in the not too distant future.  In October 2009, the RBA raised rates after seeing a similar improvement in these indicators, although employment growth had been better then than it has been recently.

The problem this time around is that as the labour market data show, the end to the boom in business investment is proving to be more corrosive to labour markets than the financial crisis was.  Furthermore, end of the investment boom is likely to last much longer than the crisis, with the fiscal policy response also very different. With businesses assessment of conditions and investment plans still patchy, this still looks like a significant drag on activity.

AUD update

Since the last update on the AUD in this post, the Aussie has retraced back towards the lows seen in earlier in the year of ~US0.89 cents.  In general, the rationale for the expected decline largely played out into year end, with the currency getting a further downward push via some strong jawboning from the RBA.

At US0.89, there is much less of a case to be particularly bearish on the AUD without some kind of new catalyst. The impact of tapering on US bond yields has largely already happened, with it unlikely that a decision by the FOMC to further pare back purchases unlikely to tip yields higher than the current ~3% level. So its unlikely to come from here.

On the Australian domestic front, things remain mixed, although there are signs that the current monetary policy settings are doing enough to keep things stable at slower growth.  Interest rate sensitive sectors like housing and consumption continue to be strong, although not drastically so given the monetary easing to date.  Confidence remains patchy for both consumers and businesses.  There continues to be a lot of focus on house price growth, although this is largely a function of investor activity in Sydney.

The "capex cliff" created by weakening mining investment has, so far, not been as bad as it could have been, with stronger exports so far providing a major offset.  But that impulse will fade as the rate of export growth slows and investment retraces much faster. So the picture is still for pretty soggy activity, but not dramatically lower than many are expecting.

The biggest source of downside risk seems to be emanating from Australia's largest trading partner in China, where growth appears to be slowing a bit faster than many expected. High-frequency indicators like coal burn and steel production look noticeably weaker in December, while spiky SHIBOR rates and slower credit growth do not bode well for headline indicators.

Net speculative positioning in the AUD is fairly short, although still below the levels seen earlier in the year. So there is some room for more short interest to come into play.

That said, I'm not so sure there is a huge compelling catalyst for more shorts to come in.  Domestic data might be a little soggy and China a bit weaker, but it would be a surprise if that moved the AUD sharply lower from here.

So it probably still pays to be on the short side of the AUD at these levels, although the case for it is not as compelling as a couple of months ago.

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AUS investment pipeline less bad in Q3

The latest round of estimates for Australian business investment, which are critical to the outlook for the A$ and interest rates, weren't as bad as expected. The most recent expectation was down 2% from the same time last year, much better than the 10%YoY decline seen last quarter.

We also received data for Q3 showing private capex was pretty strong in the quarter.  It is important to remember that only the machinery and equipment component feeds into the Q3 GDP data, which fell 1.5%QoQ.

The construction component in this survey was up a huge 6.3%QoQ, although this is not included in GDP.  Rather, the Construction Work Done data released yesterday feeds into the national accounts, and this rose at 2.7%QoQ.  This means business investment should add ~0.2ppt to quarterly growth.

The improvement in the outlook for capex isn't so much due to the oft mentioned rebalancing of investment, but rather the outlook for mining investment appearing to be a bit more resilient.

As the chart left shows, the latest gauge of 2013/14 capex spend is a little better than last quarter.  It seems likely that actual spend will be lower than 2012/13, but this reading suggests it won't be drastically lower.

For me, the risks to this number are too the downside.  All mining related projects are under pressure to reduce costs given a much more uncertain commodity price outlook, be it iron ore or LNG prices, where prices are currently good, to coal and gold prices which are very weak.  Pressure from shareholders to cut capex and shelve major projects is also intense.  Other business surveys, like those from NAB, point to greater weakness than seen in these data.

The chart on the left comes from the most recent BREE assessment of major mining and energy projects, which doesn't have as large coverage as the ABS data, but does provide more detail on specific projects. The report can be found here.

This gels with the ABS outlook, with spending for next year around on part with 2013 if most of the likely projects go ahead.  The "possible projects" seem remote at this stage with the report noting that all the projects in feasibility stage 6 months ago have not reached FID stage.

Outside of the mining sector, growth investment intentions was stable, showing small gains compared to the same estimate last year.

In some ways, this is concerning as it suggests that monetary easing seen to date has yet had a huge impact of investment intentions outside of the mining sector.

This isn't a huge threat to the RBA's forecasts at the moment because the mining part of the equation is ok.  But it is proving difficult to turn the rest of the economy around despite very low interest rates.

If the mining investment outlook were to weaken more aggressively in the next 6 months, which is still a very possible risk, its not clear that policymakers will get instant traction elsewhere in the economy if rates are cut further.

So at face value, these data paint a picture of muddle through for Australian GDP rather than something worse.  But for me, the risks are still to the downside.

AUD to keep getting that sinking feeling

Since the last post on the AUD, it has sunk a little further to under US0.95. I think the news in the last few days has reinforced the downside risks, although the bigger catalysts from a domestic perspective are yet to come.

As I've outlined previously, there were a couple of key factors which helped move the AUD from being the worst performing currency earlier in the year to one of the best.  First was the change in domestic data from mostly disappointing to some better activity readings.  Second was the realisation that China was not heading towards a hard landing and was in fact strengthening. The final point was the rapid rise in US yields was mitigated by the FOMC decision on hold course with current policy.

On the first point, the Australian domestic data continues to be a bit better.  But the big problem is that we are currently getting a lot of visibility on sectors of the economy that are required to improve in order to ensure that growth doesn't slip further.

For example, retail sales have picked up and building approvals have lifted sharply as shown in the chart on the left.

But what we haven't got as much visibility on is business investment, which is shaping up as the critical drag on activity heading into 2014.  While business confidence has lifted, businesses assessment of conditions and capacity utilisation remain very poor, suggesting this remains a huge risk to growth forecasts.

As the chart on the left shows, stronger consumption and housing construction is no guarantee that growth will not be weaker in 2014. I think that business investment will be enough of a drag on growth next year that on average growth should be around ~2%.

This is below the consensus outlook and the recently revised RBA forecasts of ~2.5%.  To be sure, the most recent RBA statement on monetary policy was probably on the dovish side, with the uncertainty about the path of business investment the key issue driving whether they may need to cut rates further.

And for my money, markets are too confident about the prospect of the next move in the cash rate being up next year.  If anything it will either be unchanged or a bit lower.

Labour market data is a lagging indicator, but it is released relatively early in the data cycle and is probably the single most important indicator for policymakers.

The poor growth in Australian employment, which has slipped over the past few months, suggests things are soggy enough to remain concerned.  Indeed, those who are hawkish should note its unlikely that the RBA will hike until there is a solid indication of much better employment growth coming through the pipeline.

The outlook for China continues to be pretty stable.  There are no demons in the activity data, with the latest reading on steel production looking strong.  Crude steel output should rise by ~7.5%YoY when the official statistics are released, which is probably even still much better than anyone expected.

From a policy perspective, there seems to be mostly positive commentary coming out about the 3rd Plenum meetings which are underway, although major reforms are unlikely.

It should also be noted that SHIBOR rates have fallen again, although looks to be moving in a new, higher band, which would represent a small tightening of monetary policy.  But this is not worth panicking about.

There does appear to be a more meaningful, change in the outlook for policy in the US following the most recent data and statement from the FOMC.  This makes tapering of asset purchases likely in the next couple of meetings.

The most recent employment data were strong, with non-farm payrolls now averaging over 200kt over the last 3 months (with big revisions to August data).  This has previously been suggested as a threshold for tapering.

GDP data were mixed and ISM surveys strong, but more important is the FOMCs assessment of higher interest rates on housing market activity. As I posted here, they are not so alarmed and are probably comfortable with 10-year rates at 2.5-2.75%.

This should change the direction of relative AUD/USD yields, which are influential on FX movements. Although as the chart on the left shows, its not 100% consistent over time.

I think there were a couple of factors that drove the currency so much lower in April when yields dropped compared to the preceding 12months.

First was the element of surprise from the RBA, with the rate cut in April not expected.

Second was the overlay of a huge amount of concern about a hard landing in China, which is now off the cards for now.

So even though I expect yield differentials to narrow, would I expect the current to drop back to where it was? I tend to think it might be a bit harder to knock over to sub-90 levels, because the China part of the equation is much better at present.

But that said, I would still be short the AUD.

Still more thermal coal in the Aus production pipeline

Australian coal exports look to have been a little weaker in September,  but in the year to date have risen by ~14mt.  This is a very strong performance in the context of very weak prices.

Perhaps growth in Q4 will slow a little given we are now lapping a period where several mine expansions and productivity improvements already started to take hold.  Nevertheless, it seems likely that full year shipments will be close to 190mt.

Furthermore, it seem likely that growth in 2014 will again be solid.  This growth is likely to be concentrated at the producers that contributed to the strength in shipments this year, bringing 2014 close to ~200mt.

Taking a look at production/sales from major producers in the year to date, the bulk of the gains in exports has been concentrated in three producers.  GlencoreXstrata(GX) and Rio Tinto have dominated the supply increases with over 5mt each, while Whitehaven has also lifted exports by ~3mt with the introduction of production from the Narrabri longwall coming into the mix.

Looking at next years production, it seems unlikely that Rio Tinto will record much growth.  Most of the gains this year has come from brownfield expansion at its Hunter Valley operations, which has in part been about replacing some of the lost volumes from the Coal and Allied days.

GX is a different story, with expansions at Ulan West and Ravensworth North still to ramp towards nameplate capacity of ~8mtpa for each mine.  This should lift GX's Australian thermal exports by 5-6mt in 2014

Whitehaven should also see some gains, although 2015 looks to be much more important as its large Maules Creek operation is expected to start to move tonnes.  This operation has significant flexibility between thermal and semi-soft coals, depending on pricing. Idemitsu's Boggabri expansion is also expected to shift tonnes next year.

So still looks like exports will record decent growth in the next couple of years, albeit at a slower pace than seen recently.  I'd imagine the project pipeline to slow markedly beyond that, with mega-projects in the Surat basin likely to be delayed until they can get the infrastructure costs down.  But for those looking for supply cuts given the current surge in seaborne supply, its unlikely to come anytime soon.

SHIBOR jump sinks AUD

Markets sank today as news out of China perhaps reignited the spark of concern about the state of the banking system.  Not only did the largest banks triple the amount of bad debt write downs, but the SHIBOR rate also spiked over the day by the largest amount since June.

As the chart on the left shows, the rise today is almost imperceptible compared to what we saw mid-year.  So the prospect of more bad loans isn't causing the same kind of stress that the rumours surrounding China Everbright did back then.

Perhaps this has gathered more notice than it otherwise would, given the vacuum of news for markets left by the resolution to the deadlock in the US Congress and the prospect of tapering by the Fed currently being pushed back.

But the reaction to this news is informative of where the risks are concentrated if the news from China did turn more negative.  As I posted here, this is the looming risk to the current status quo.

On of the more interesting reactions was from the Australian dollar.  Earlier in the day, the key Q3 CPI data surprised to the upside.  While any action on policy rates by the RBA in the immediate term was pretty low, this data means that it is essentially zero barring some kind of catastrophic event.

This initially sent the AUD higher, which has rocketed in the past few weeks.  But these gains were unwound on the emerging stories on Chinese debt write-downs and the SHIBOR hike.

So along with some commodities like copper in particular, perhaps it is the AUD that has the most to loose from a change in tack in China, by virtue of it being so strong of late.  To be sure, not only is the China risk a big headwind to the AUD, but also changes elsewhere globally and domestically.

For example, US Treasuries have rallied a lot since the last Fed meeting which caught markets off guard.  While the taper looks to have been put away for sometime, it will perhaps come into play sometime in late Q1 given leading indicators suggests things should improve.

On the domestic front, the recent data has been a bit better, but not enough to think the end of the rate cutting cycle is over.  While house prices in some states have shot higher, the reaction since the RBA started cutting rates is still relatively muted.  More importantly, there still appears to be considerable downside risk to forecasts not withstanding the small improvement in confidence.

The big widening in bond spreads in the last month or so at the shorter end of the curve has largely been driven by a sell off in Aussie bonds. But this is not something it that will be persistent if China is more inclined to slow than strengthen.

Weak economy outweighs house price surge for RBA

The economic debate in Australia has changed dramatically in the last few months as house prices have jumped dramatically in Sydney, Melbourne and Perth.  This has raised alarms that overheating property market is posing new financial risks to the Australian economy and this will change the course of RBA policy.

In terms of managing the cycle, the big jump in house prices suggests the RBA has a little time to monitor other variables, but I think they are still likely to have to cut rates given the weakening growth outlook.

From a financial risk perspective it also seems that the RBA has time up its sleeve given the big changes in household borrowing behaviour since the financial crisis.

It remains to be seen whether low interest rates can generate a problematic house price bubble when the rest of the economy is weak.

The high level of household indebtedness means, the RBA will probably be more willing to normalise interest rates when the general economy starts to turn than they were prior to financial crisis.

But that point still seems far away, with the risks to growth still high.

While house prices have jumped sharply in the last couple of months, other key indicators have not been alarmingly strong.  Housing loan approvals have risen steadily over the past few months, but this rise has been much more gradual than previous years.

Overall credit growth is also relatively modest. Gone are the days of 20%+ rates of housing credit growth as those with debts are paying down principal a lot faster than they used too.

Perhaps we are just on the cusp of a rapid acceleration of these variables given the leap in house prices.  But is is also equally plausible at this stage that the recent strength in house prices will run out of steam given risks to the rest of the economy.

Problematically for real activity is that stronger loan growth has not translated in particularly strong housing construction at this stage.  Building approvals remain relatively subdued, with high-density construction so far leading the way against detached housing.

Elsewhere there have also been scarce signs of improvement.  For example, retail sales over the last few months have been bad, not withstanding a rise in August.  At this stage it looks like household consumption won't be adding much to growth in Q3.

The spectre of much weaker business investment is also a huge potential drag on growth.  To be sure, we get much less high frequency data on business than we do on housing and consumer activity, but the recent information has been weak.

The prime example of this is the NAB Business Survey.  Confidence actually jumped quite a bit last month, although that could be just relief that the Federal election was finally over

Business conditions, which actually match activity and investment intentions much better, remains very weak along with capacity utilisation. This bodes poorly for investment, which is so critical to growth in the next 12 months given the slow growth elsewhere.

So overall activity still looks sub-trend, with growth likely to move from the current 2.5% growth rate to below 2% next year.

This should see the unemployment rate rise further and probably a bit more quickly, with jobs growth likely to slow as many of the leading indicators are pointing too

Against that backdrop, I think the RBA will probably be inclined to cut rates a little further, with the weak economy taking precedence over bubble concerns at this point.

There has been some discussion as to whether the RBA, along with bank regulator APRA, should implement other tools to help manage some of the risks from sharply rising house prices and more importantly from loosening of lending standards.

In particular, it could implement limits on LVRs akin to the recent move by the RBNZ.

This is not necessarily a bad idea, although I don't see this as hugely complementary to the setting of policy rates, which remains the key but crude tool in managing the economic cycle.

House prices are likely to rise if interest rates are low even with curbs on some types of very risky lending.  To be sure, what is probably more important is not letting house prices rise in the first place, which is necessary to boost things like home building, but to ensure you can tame frothy activity once the broader economy is in better shape.

Prior to 2008, this proved to be problematic given the global credit boom and policymakers lax attitudes towards the risks.  But the post 2008 experience shows that both policymakers and households are much more cautious, with housing market activity proving to be much more cyclical as policy and market interest rates move.

So macro-prudential tools are useful to help tame some of the bad lending risks in banks, but probably don't help you manage the cycle any better if you don't get the cash rate settings right.