Ep23: 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 and Chris discuss their views in the last episode of The Rate Debate for 2021.

Transcript

Speaker 1 0:02

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 as my co portfolio manager, Chris rans. Hello everyone. Well, what a year it's been the world completely underestimated the impact of 19 Delta variant, which, uh, 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 gonna, um, be happen again, 20, 22. 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?

Speaker 2 0:45

Chris? Not too much that we haven't heard before. So 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, the same as we knew before. Yeah.

Speaker 1 0:57

There was a little bit of, um, murmuring around the fact that they changed some of the language aren't, uh, dropping that 20, 23 sort of date, or at least not, not mentioning it quite as strongly. I think, you know, they, they probably were looking for something to change in a statement, as you said, that wasn't a lot different, you know, it sounds like February is really gonna be the, the next sort of major time we get any sort of information from them, but it seems to be, uh, BAU for the, uh, for the reserve bank now through to the end of the year.

Speaker 2 1:25

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

Speaker 1 1:36

It certainly that would be, you would assume the first thing is, are they gonna start unwinding quantitative E um, or at least certainly tapering it, hopefully they'll, uh, broadcast it and, and make a better job of it than what they do for taking YCC off. But, but that would be the most logical thing to expect will be the first announcement early on next year. Yeah, there's,

Speaker 2 1:56

There's kind of, I guess, two ways, certainly that, that I'm looking at this at the moment and we've kind of thought for a while that QE would be pretty quickly reduced next year. And that kind of, we'll probably talk about later with some of the, the calls that, that we put in the portfolio. But when you look at what the RBA said today, what they said is when they make their decision come February, they're gonna be looking at the same three things that they always have. And that is the actions of other central banks, how the Australian bond market is functioning and the actual and expected progress towards the full employment inflation targets. I kind of thought it was interesting when I read that statement, that the first thing that they listed there was the actions of other central banks, because certainly, you know, we've seen now the RB and that has stopped. We've seen the federal reserves starting to talk about stopping, and it kind of implies very strongly that the RBAs probably gonna be up next to, 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 kind of think at a minimum, they'll reduce it down to be purchasing only 30% of new issuance, such that they keep the balance sheets stable. So it's either I think gonna disappear or it's gonna be reduced kind of significantly so that they're not soaking up all the issuance.

Speaker 1 3:07

The reserve bank is certainly of the opinion that the stock of bonds, um, in their balance sheet is more important than the flow. I know we have a slightly different view of that given, uh, what we've seen happen overseas, but they are very much of, of the view that reaching a level I 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 by out 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, uh, the dollar will maintain its value rather than start to appreciate rapidly if the RBA was looking to tie in earlier, particularly the, the fed. Yeah.

Speaker 2 3:56

And so obviously there'll be a kind of, probably more volatility, those things end because typically currencies start to move around. Once you take a policy off, uh, interest rates start to move around and then probably semi-government spreads will start to move around as well, because they've, 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

Speaker 1 4:19

Months. And I guess that's a, a good, uh, segue into, into sort of what we've seen over the last 12 months and, and some of what we've seen unfold, I guess it's always hard to predict the future and no one does it very well, but I think we made a, a few sort of good calls this year, but unfortunately, you know, the, the volatility of the market makes you look really intelligent one day and, uh, extremely stupid the next. So it's been quite a, a frustrating year, but I, I think overall, you know, the things we sort of talked about 12 months ago were really that the market was probably getting itself a little bit too excited about interest rates happening sooner rather than later. I think that's still our view and, and probably somewhere we're we're we're butting heads with, with most of the market. I think the other one was that the COVID story still had water to play out. And I think, you know, that 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, and I think the other thing we sort of talked about really early on, even two years ago, the unwinding of, um, the yield curve control would end up being a lot more messy than the RBA expected. And, and I think that that sort of played out probably the, the really main thing though, that matters from the way we, we talk about and think about markets is that we had talked about flattening of yield curves, particular, you know, that 10 year part and longer. And we in significant flattening in most major G 10 and wider sort of bond markets. And I think, you know, to me, they're the main calls that I think were most important. Was there anything you sort of saw that, um, that I've forgotten

Speaker 2 5:55

There? No, I, I would kind of say probably the non consensus idea that we were using the most was that the long end, so kind of the 20, 20 plus 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 kind of lurched down to one 70 Andre. When I look at things like that, I think you really need to ask the question of, you know, what is going on here, if this is a truly inflationary environment, what is that actually saying? So it's interesting, I think, to, to have that one. Right. But it does kind of raise more questions about the future, which is probably something we'll talk about after as well. Yeah.

Speaker 1 6:31

And I think, you know, just to, to balance it out, you know, there's been a few things we've been a little bit disappointed in, you know, we, 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, the large movement in, um, swap spreads. Um, 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, and various other things. But I think, you know, there're two of the areas where we probably got a little bit wrong, but it's been a year where, as I said, you know, it's, it's been so up and down. I mean, we've seen movements in bond returns that are, you would expect over a year and we're seeing in often in a, in a month or for month, it's been really volatile. I think that's, that's the word more so than transitory for this year? I,

Speaker 2 7:24

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 gonna go like this, you know, for there to be basically whenever I'm writing the monthly report reporting and I'm talking about fee 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, I

Speaker 1 7:53

Guess then sort of starting to think about some of the ramifications of what we've seen over over the last, um, 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, you know, has the R B actually started to already tighten tighten rates. And the fact that, you know, we're also now talking about quantitative easing coming maybe early next year, you know, how, how much tightening do you think the RBA has to do to be able to, you know, before they're gonna be happy that they've taken enough stimulus out of the system?

Speaker 2 8:27

Yeah, it, that's a pretty good comment. I think the, one of the problems that, that certainly I have with the way that the market looks at unconventional policies is they, they kind of look at the policies and say, they're not doing anything. So just get rid of them and will be, don't worry about it. I take the opinion that these unconventional policies are actually doing something. And, you know, it's a pretty good way to look at what's happened with yield curve control. The, the exit was very messy, but if you look at, you know, three year fixed rate at the moment they've moved up from about 30 basis points up to be over 1%. And because of that, what you've seen is a pretty 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 gonna have an effect. You kind of 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 ons 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 that, how fast that flows through and what the actual effect is, I think will take a bit of time to see, but it, it does, I think reduce the sub can cash moves that they need to make after that. Yeah.

Speaker 1 9:37

And that, that's one of the really big, um, things, I guess, looking into 20, 22 and further out, which is again, always dangerous, but how high can cash rates go? It's one of the things, I guess again, where we are a little bit different to, to many economists and certainly a lot of market strategists that, you know, they're talking about rate it's considerable magnitude higher than what we think can be sustained, given their levels of debt and things like that out in the market. You you've been warming up the crystal ball, uh, in doing your sort of forecast for next year. You know, where do you think cash rates will get to once they start to tighten and given that the we've already had so much stimulus taken

Speaker 2 10:14

Out, I think when we split up and we look at kind of the outlook for next year and what we're thinking about, certainly I would say that I don't think that the RBA is gonna be hiking cash rates next year. I think what they're gonna be doing is removing QE and then waiting to see how that affects the economy. So when we think about cash rate moves, I, I don't think we're gonna see too much next year. And then that kind of brings you into, I think, forecasting a period where when you're getting kind of 12, 18 months out, it becomes murky at best. When I look at the cash rate though, I kind of 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 kind started this process that have cash rate at about 1%. And so my feeling is that when this is all said and done, we, we probably see a cash rate close to that rate rather than a cash rate of, you know, two, two and a half, simply because of this huge debt build up, you know, home prices that are 20, 30% higher, it becomes incredibly difficult to push cash rate up 2% and not expect that you're gonna to affect the housing market at some stage.

Speaker 1 11:19

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

Speaker 2 11:47

I think is gonna 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, you know, if you kind of think that oil prices go sideways from here, then, then that kind of inflationary pulse disappears. And, 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 normalize, which then means the RBA is gonna 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, you know, 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 gonna 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 on top

Speaker 1 12:54

Of the, the obvious things about interest rates in, in inflation. What do you think is gonna be one of the biggest factors next year that will either make or break the case for a tightening in 2023?

Speaker 2 13:06

I would probably think that it's just a question of what the reopening trade looks like. If, you know, the reopening looks similar to the start of this year, where everything will at 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 cases they're gonna be spending pretty strongly. It's just, if they don't that it would probably knock that idea off its course.

Speaker 1 13:51

So I pose a question to you if we had to put hand on hard and say was the main driver of that, uh, I guess that spending pulse, is it monetary policy and, and lower interest rates or has it just been the, the largest of government spending and, um, fiscal policy?

Speaker 2 14:06

I mean, clearly it's probably a mix. 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 sin 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 the, there was no reduction coming from kind of a lack of employment or a lack, 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, you know, that's kind of 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, you know, they're, they're spending on the types of things that you feel 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,

Speaker 1 15:08

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

Speaker 2 15:18

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

Speaker 1 16:18

Yeah. One of the things that sits in the back of my mind is that, um, we keep talking about the highest amount of disposable income. Then people say we also need further wage hikes, things like that. Okay. We can assume that the wage hikes need to come to replace the, the government spending that, that that's a given, but it's probably not gonna come to the same level. I mean, the, the fiscal spending we've seen put into the economy is quite large, probably more so than what wage rises would be. But I think also a lot of that sort of comfort has been that, uh, housing, equities and other sort of 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 gonna go sideways a little bit. We just can't keep making higher and higher highs all the time. Markets just don't work that way unless you, we really see incomes and profits increase dramatically from here as well. Which again, that would infer another step I've in spending that is above what we're already seeing now. So I, I wonder, you know, are we gonna be in a situation where we get 12 months down the track, all the ducks are lined up to need to type interest rates and then suddenly gonna get repricing in asset markets, or at least some of that impulse taken out that sort of makes everyone take a step back and go, oh, hang on a minute. Maybe we shouldn't be doing this now. What are your thoughts on that?

Speaker 2 17:45

Well, certainly something that I've been thinking about kind of, of how we deal with QE ending kind of fits into that narrative. Because 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 aggress. And we didn't see the fed kind of 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. So it's kind of the feeling that I have is 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, you know, who's borrowed to much the key difference this time. If you wanted to think about it separately though, 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. You know, 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 so something that you couldn't have foreseen kind of six months

Speaker 1 18:52

Before. Yeah. I think one of the other things that sits in the back of my mind is as a risk, the things that are positive are, 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, is going to deal with their slow down and growth. We have seen them sort of 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, um, housing and, and building market anytime soon, particularly with still, you know, ever grand hanging around in the background and the rest of the, the property, my market in China, still looking a little bit dicey. The last thing they wanna do is, is stick a torch, uh, to that flame. So I, I guess, you know, China, how they deal with their problems will probably dictate the direction, um, of Western markets because we rely so much O on the, um, the good flow coming from, from that economy. Um, the other thing I guess, that sits in the back of my mind is that, you know, politics in general finds new ways to create problems for itself. And there's been a fair amount of saber at Ling going on not only in relation to China, but to Russia, a and just in general, uh, across the globe, there seems to be a, a lot less willingness for cooperation, various things. And then further down the track, we also have the problem with what do we do about global warming, a and some of those problems that have been put on the back burner because of the, the pandemic. So it's really hard to sort of just project the things we'll just get better and better and better going forward, and that none of these risks are ever gonna derail the outcome. Uh, that's, that's the thing I find hardest, uh, to accept with a lot of these really blue sky forecasts that nothing will ever go wrong ever again.

Speaker 2 20:37

Yeah. And I, I think when I look at that, you know, sometimes we probably come off pretty negative with the, the things that we talk about and what we look at, but you kind of need to look at this and say, the RBA is going to have exited the yield curve control. And probably at the start of the year, they're gonna be ready to exit QE as well. So if 24 months ago, as we kind of 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 pretty positive outcome. So to be out of the, out of those kind of 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 kind of how wages and inflation involves, 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, a pretty bad place to be. That seems to be where the UK, the Canada and us have been for basically the past 10 years. And it's just Australia joining that party.

Speaker 1 21:32

That's very true. Like interest rates going up is probably a sign that the, the economy's in a good place. It's not, it's not the world ending event probably is to bond manager just cuz it it's, 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, a left field event or, 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, uh, left field event sort of derail things. But that would certainly be a, a good outcome. And it would be a nice way to, I I guess, finish the finish the year, uh, if that ended up being the case, but we'll, we'll see, I guess<laugh> well, that's it for the year. Uh, we'll be back in February 20, 22, ready to debate the issues that are facing markets around the world. And remember if you ever want to suggest topics or discuss anything further with Chris and myself, we can be contacted@therightaboutatyaracm.com, Chris and I would like to thank you all for your listening throughout the year. And we really appreciate the support that we've got. We hope that you find time to catch up with family and friends and to take a moment to reflect on the year that was until we meet again in 2022, stay safe, Chris. And I would like to wish you all a Merry Christmas and a happy new year.

Speaker 3 22:50

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