Peter Rawson-Harris, Research Analyst, Macquarie
Friday 08 April 2016
Monthly economic commentary: March 2016
Peter Rawson-Harris, Research Analyst, Macquarie
Economic and market highlights
Australian labour force data remains weak despite an improvement in the unemployment rate from 6.0% to 5.8%, which is largely explained by a decline in the participation rate from 65.2% to 64.9%. Income growth remains weak at just 0.3% while Australia’s fourth quarter gross domestic product increased 3.0% year-on-year versus consensus expectations of 2.6%.
The United States Federal Reserve (Fed) left the target interest rate band unchanged at 0.25% to 0.5% and issued a slightly more dovish statement, causing considerable US dollar weakness. Unemployment was up slightly to 5.0% in March. This was a combination of continued strength in the numbers of jobs created (215,000) but also this strength coaxing people back into the workforce, hence the participation rate rose to 63%. Any remaining slack in the US labour market is diminishing, putting further upward pressure on wages and underlying measures of inflation. The Fed’s dot plot median estimate has fallen by 50 basis points by year-end 2016 and 2017 and represents a considerable revision to expectations. The dot plot diagram shows what each member of the Federal Open Market Committee (FOMC) thinks the federal funds rate will be by year end. Median expectations by FOMC members remain steeper than market pricing.
In Europe, money supply data suggests that the European Central Bank’s expansionary monetary policy is working by facilitating access to credit. Loan flows to the private sector in February grew at the strongest monthly pace since 2008. Despite this steady improvement in lending, the recovery in business investment remains anaemic and will depend on sustained growth in aggregate demand to support it. Chinese New Year and a weaker US dollar have produced a large decline in China’s net financial flows data, temporarily allaying fears over China’s foreign exchange reserves, which have been used by the People’s Bank of China to protect the renminbi from a rapid and disorderly decline.
The risk-on sentiment fuelling the early March rally in yields subsided into the close of the month as the US Federal Reserve adopted a decidedly more dovish tone in their most recent Statement of Monetary Policy. After starting the month at 1.74% and reaching a high of 1.99%, US 10-year yields slumped on comments from Janet Yellen, Chair of the US Federal Reserve, finishing up a modest three basis points at 1.77%. Australian 10-year bond yields followed a similar path, though 10-year yields picked up nine basis points to 2.49%. In Japan, yields move further into negative territory, falling from -0.5% to -0.7%. Yields on German 10-year bonds rallied five basis points, although at mid-month, they were 21 basis points higher. Most bond markets appear to be paying very close attention to Fed sound bites.
Emerging markets outperformed developed markets as the US dollar weakened, with the MSCI Emerging Markets price index rallying 13.0% in US dollar terms. In local currency terms, Australian equities lifted 4.1% in March, while the S&P500 added 6.6%. In Europe, the German DAX improved 5.0%, but speculation over the fortunes of British businesses under a Brexit scenario continued to weigh on UK equities, with the FTSE100 gaining only 1.3%.
US dollar weakness was broad-based after increasingly dovish communications from the Fed in March. The Euro (+4.9%), Canadian dollar (+4.9%) and Pound Sterling (+3.1%) were all stronger, while the Yen added only 0.4%. The Australian dollar, which has been highly correlated with iron ore prices, gained 7.7%.
Iron ore’s dramatic surge
A two-month rally in the price of iron ore culminated in March with a 20% gain in a single day, the largest ever recorded since the introduction of iron ore spot pricing in 2008. Some interesting explanations have been put forth as to the cause of the rally. One is that it was caused by the restocking of inventories after Chinese New Year. Another refers to approaching “construction season” with the surge in iron ore being the result of accumulation of steel stockpiles. Neither seem particularly plausible on their own given the rally began back in mid-January and the fact that these cyclical factors have never in the past produced such a strong price response. The most interesting explanation appears to be a flower expo in the heavily polluted city of Tangshan, Hebei province. For six months, Tangshan steel mills, which at one point produced more steel than the United States, face a shutdown for a flower show, allowing the smog which permanently blankets the city to clear. As a result, steel mills have brought production forward ahead of the six-month enforced closure. A similar scenario played out last year when the government ordered steel mills in the vicinity of Beijing to curb production lest the skies be polluted during an important military parade. This is obviously a transient driver of price and the strength of the iron ore rally is unlikely to last.
Source: Bloomberg, FactSet, MWM Research, April 2016
The Australian dollar follows iron ore
The unprecedented strength of the Australian dollar which persisted through much of the China boom, until early 2013, choked other parts of the economy while resource exports flourished. When China’s demand began to fade, so too did the strength of the currency and the prices of all commodities. Large miners increased scale of production in the face of declining prices. Over time, this response beget a vicious circle of lower prices leading to increased production leading to even lower prices, and so on.
For the first time in two years, iron ore prices have been trending in a different direction- upwards. Combined with the firmer GDP growth outcome, and diminished expectations for rates cuts from the Reserve Bank of Australia (RBA) has resulted in upward pressure on the Australian dollar. The currency has been nudging $US0.77, giving the RBA a collective headache as they try to stimulate the non-mining components of the economy. Almost certainly, other catalysts will be required for interest rate cuts to follow. Should consumer price inflation fall below forecast levels and more slack emerge in the labour market, in addition to the persistent currency strength we have been seeing, then the chances of interest rates cuts will be dramatically higher.
Source: FactSet, Reserve Bank of Australia, MWM Research, April 2016
We remain of the view that the RBA will deliver further monetary policy easing in 2016, and our commodity forecasts imply some retracement of iron ore prices back below $US50/t. However, more modest market expectations of both Fed hikes and RBA cuts is likely to add upward pressure on the Australian dollar in the near term. Getting to the $US0.60-0.65 zone desired by the RBA to hasten the economy’s transition from mining to non-mining activity will require a combination of RBA rate cut and Fed rate hike, while a delay on either will prolong the current upward pressure on the Australian dollar and dampen the economy’s transition.
The mysterious falling Fed forecasts
In a press conference held after the March meeting of the FOMC members, Janet Yellen commented that “most committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time”.
Source: Bloomberg, MWM Research, April 2016
This represents a continuation of the softening stance by the Fed against further interest rate rises as they make liberal use of a technique they have been practicing since the early 2000s called forward guidance. FOMC members now expect only two rate hikes this year, down from four. With the market tumult earlier in the year, the tone of communications from the Fed has become increasingly dovish and suggests greater emphasis will be placed on global economic and financial risks. The dovish stance has been reinforced by diminishing economic projections for gross domestic product growth and inflation. Expectations have shifted somewhat and Fed members now see the US economy growing at a maximum pace of 2.3% in 2016 and 2017, with core inflation forecast at 1.7% in 2016, lifting to 2.0% next year. However, the present rate of core inflation as measure by Core Personal Consumption Expenditures is already 1.7%, and on a rather steep ascent. Should the current trajectory not diminish, inflation could very well overshoot.
Yellen also commented on the topic of monetary policy divergence, which is the increasing gap between the trajectory of interest rates in the US and the rest of the world. While the position of the Fed is that their actions in relation to setting interest rates are independent of other central banks, it is not possible to ignore the potential spill-over effects, such as currency volatility. Changes in US dollar exchange rates have an impact on local economic activity, so, despite the declaration of central banking independence by the Federal Reserve, they remain in a catch-22. The catch is that the Fed’s tendency towards dovish rhetoric in recent times has weakened the US dollar, and strengthened foreign currencies. Since the monetary policy statement of January, the Australian dollar has rallied from $US 0.71 to $US 0.77. This is undesirable from an economic perspective, as the RBA has been at pains to point out: a weaker Australian dollar is desirable and necessary to restore balance in the economy and facilitate the transition from mining to non-mining activity. At the moment, the currency is doing us no favours. US dollar weakness is also hurting other economies, impeding growth.