Aussie Macro Moments

Dr Emanuel Derman's mysteries of macro...

2012-01-28T08:20:00.002+11:00

My old Goldman colleague poses this question over at his Reuters blog. He could have added that there is currency manipulation via QE too:

Mysteries of macro
By Emanuel Derman JANUARY 27, 2012

1. Consider two countries, America and China. Suppose (only suppose) China manipulates its currency to keep it low, thereby making exports cheaper and imports expensive, benefiting its balance of payments and mercantile ambitions, harming America’s.

2. Now consider America alone, with two subpopulations: borrowers and savers. Suppose someone at the top manipulates T-bill prices, keeping them high (i.e. keeping interest rates low), benefiting the borrowers and harming the savers.

My question:

Why is 1. often considered reprehensible and unfair, while 2. is merely business as usual and unremarkable, even praiseworthy? Is there something fundamentally different about 1. when compared with 2.? Are bonds fundamentally different from currencies, stocks, real-estate, other assets?

Or does it just depend on who you are?

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What is Terry McCrann up to?

2012-01-28T07:20:00.001+11:00

After being sensationally nuked twice by the RBA with his rate calls--ie, calling it confidently immediately before the event and then being wrong-footed by the outcome--Terry McCrann is back at it again for February.

A week and a half before the RBA Board has even had a chance to meet, and almost a week before the RBA's internal policy group meets to determine their own Board recommendation, McCrann is somehow confidently declaring that it is "almost certain" the RBA will cut rates. Not once but now twice in the Herald Sun and The Australian.

Now this is odd for a few reasons. First, McCrann is gun-shy and does not want to get it wrong again, as there are direct costs to his readership. He would not be swinging this hard without some basis to do so--ie, without someone wording him up.

Second, we know that there are a range of reasonable arguments that make the February decision iffy--we saw that in the financial market's reaction on the day, which dropped the probability of a hike from near 90 percent to mid 60s. We've seen the AFR's David Bassanese argue persuasively that there are sound grounds not to hike. Senior interest rate strategists have done the same.

Yet then we have also had the AFR's Alan Mitchell, who is regarded as another long-time RBA proxy, argue the case for a cut over the last couple of days.

A third weird thing is that both the Treasurer and Shadow Treasurer have broken protocol and actively pressured the supposedly politically independent RBA to reduce rates. Aside from being poor form, this is just not typical nor necessary. A potentially smart political move from Swan, who is focussing on the ALP's popularity. I am not so sure how lower rates benefit Joe Hockey.

A fourth oddity is that the nuking of McCrann, whose mutterings used to swing hundreds of millions, if not billions, of dollars of investment, has been widely regarded as the RBA bowing to calls from folks like myself to improve its governance and cease the practice of tipping off journalists about its recommendations prior to Board meetings (as used to happen with absurd regularity). This is actually an offense under the Corps Act and Public Service Act, and the RBA knows it.

Logically, there are a few candidate explanations. First, someone inside the RBA is going crazy-brave and ignoring all of the above, and simply cannot resist the temptation of continuing to tip off journos and thereby exercise influence. Frankly that sounds incredibly stupid to me, and a bit hard to believe. Especially around this meeting, where a cut would not be a surprise. So why do it?

Another explanation is a member of the RBA's Board is doing the tipping. This sounds a little more likely, as the private sector Board members and the Government's appointee all clearly have a strong bias towards lower rates right now. And it was interesting to see McCrann defend both the Board composition and its decision-making in today's column. He's done that a few times now, which might be a tell about his source.

The third alternative is that McCrann, and to a lesser extent Mitchell, are simply expressing their own opinions. But McCrann's certitude does not rest easily with this. Strong McCrann calls are normally tip-offs. To make such emphatic calls this far out from a Board meeting makes that more likely. To have Mitchell add to the case lends even greater weight to the notion that somebody is seeing to influence.

Personally, I don't really care either way. I have already documented my views at great length about the legality of RBA representatives giving price sensitive information to the media. I have also made plain my views about the RBA using a rate cut it knows the banks won't pass on in full as an exercise in bank margin expansion. There are far more effective tools if the banks are facing genuine funding problems than wasting scarce monetary policy ammo.

But if they do cut, and one way or another borrowers get more rate relief, that will be great for both equities and Australia's slowly recovering housing market. It will also, coincidentally, be great for the ALP's re-election prospects.

So If they do cut, we learn more about the RBA and its communications and decision-making processes. And if my personal fears about a medium-term inflation problem prove out, the RBA will be reluctantly forced to raise rates back up again, even if it does so reactively, and without sufficient vigour.

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Central banking humour...

2012-01-27T10:48:00.002+11:00

A lot of my readers come from the Treasury, RBA, investment banks, media, hedge funds, and other global economics organisations, like the World Bank, IMF, OECD etc. Now I have never seen the ECB's domain hitting my blog before (it may have, although I have not noticed it). Today was then a first. So I was curious as to how they came across it. Drilling into the data, somebody at the ECB had gone to Google and entered in the following search string:

"Not all germans believe in god, but they all believe in the Bundesbank"

And they found me! It is especially amusing/ironic that this text was entered into Google by an ECB officer given (1) the ECB is about to take a circa EUR20 billion loss on Greek government bonds, which is tantamount to European taxpayers subsidising Greek taxpayers (UBS estimate), and (2) the ECB printed about half a trillion Euros of new money in December via their 3 year LTRO facility, which is very likely to be matched in size with another half trillion Euros in February (and is effectively European taxpayers bailing our private European bankers). The Bundesbank would do neither.

Barry Eisler on the risks of oligarchy

2012-01-27T10:30:00.000+11:00

Eisler studied law at Cornell, worked for the CIA in the Directorate of Operations for several years, then as a silicon valley lawyer, and is now an author. He writes:

"Overall, people seemed to want to understand perfidy as a problem with personalities, rather than as something insidious in their institutions."

Too true.

The Oz's brilliant Creighton calls on Swan to dump implicit bank guarantees

2012-01-27T08:18:00.001+11:00

Finally! I've been waiting for a business journalist that is truly unencumbered, truly able to sift through the noise, jawboning, lobbying and vested interests, and logically explain what is right and wrong. Not beholden to his or her relationships with the major banks, the RBA, Treasury or politicians. Truly independent.

Former RBA economist, Oxford graduate, Liberal Party speechwriter, and Spectator editorialist, Adam Creighton, might just fit the bill. And as you will see below, his political predispostions don't mean that he is reflexively prone to defending all things related to the status quo and establishment, as so many of his conservative peers in the commentariat are inclined to do.

In Creighton today we finally have a business journalist who says it as it is, echoing what I have argued here for years: the major banks benefit from enormously valuable implicit taxpayer guarantees (no different to Fannie and Freddie), which artificially raise their credit ratings two notches, artificially reduce their riskiness, allow them to source artificially lower cost funds, and yet they want to have their cake and eat it. They still want to generate supernormal, world-beating returns on equity, and they have lobbied furiously against the extra capital charges that are being required of the world's 30 largest banks in order to protect taxpayers from these too-big-to-fail behemoths.

To be clear: the fact that APRA, the RBA and Treasury have apparently supported them in these lobbying efforts, roundly rejected by the independent IMF, demonstrates that Australia suffers from a mild form of oligarchic capture (a subject that I have regularly highlighted here). The risk is that the dysfunction between policymakers and the banking cartel is deepened by post-GFC hubris (ie, the refusal to recognise that providence played the most important part in the Australian banking play).

Without going over too much old ground, I've argued we need to eliminate this moral hazard-inducing dysfunction, and price the guarantees. We should not, for example, use RBA monetary policy as a tool for bank margin expansion, as the RBA seems to be keen to do via a February rate cut that the banks will only partially pass-on. Creighton writes:

THE "strength" of Australia's banks now warrants routine mention whenever talk turns to the economy...But, as the IMF paper politely argued, the Australian authorities should "consider the merits" of mandating even more.

The merits are obvious: the status quo distorts the economy and is not fair. Australian taxpayers currently provide a valuable implicit guarantee, in effect for free, to the big four banks. Each of them is clearly too big to fail; their combined assets are about twice as much as Australia's GDP.

Short of breaking them up, the "too big to fail" problem is ineradicable. No democratic government, however hard-nosed, would tempt such an economic fate. And the fact Australia avoided a financial crisis last time says nothing about the probability we might yet have one next.

That means the major banks can borrow more cheaply than they otherwise could; lenders have little incentive to discipline them for becoming too leveraged or making poor investments. For instance, Australia's credit unions (which probably don't enjoy the implicit guarantee) cannot borrow as cheaply, even though their capital ratios are about 50 per cent higher.

The best way to mitigate the subsidy is to mandate extra capital to the point where the probability of taxpayers ever having to bail them out is close to zero."

The perils of offshore expansion

2012-01-27T07:35:00.000+11:00

A month or so ago NAB was forced to inject $600m into one of its UK banks, sucking capital away from that which would otherwise be used to protect Australian depositors. As with most other case studies of Australia's taxpayer-backed major banks trying to expand overseas, the moral of this story is that they are not very good at doing it, and appear to have no durable comparative advantage. Just ask ANZ what return on equity it is generating from its Asian operations--less than what they get in Australia, remarkably. Today Banking Day reports:

NAB fills another pension deficit at Clydesdale
27 January 2012 7:05am

The pension scheme at Clydesdale Bank continues to suck up capital from National Australia Bank. Scotland's The Herald newspaper reports that Clydesdale has tipped £130 million into its pension scheme. This is around a third of the additional capital subscribed by NAB to Clydesdale earlier this month. NAB is seeking to curb its wage bill in the UK by phasing out contributions to the older of its two pension schemes for half the staff working at Clydesdale Bank.

ANZ: Small business sector sales healthy

2012-01-27T06:39:00.000+11:00

More good news:

"ANZ today released its monthly Small Business Sales Trends report which showed sales increased by 3.3% year on year (y/y) in December 2011. This is the eighth consecutive month of positive annual growth in sales for small businesses, driven by growth in the mining states as well as non-retail and services sectors.

ANZ General Manager Small Business Nick Reade said: “The December figures reflect a reasonable Christmas trading period overall, with sales up 3.3% y/y and 1.9% year-to-date.

“A better than initially expected Christmas period was also seen in general by retail-related small businesses, with sales growth of 1.8% y/y. Anecdotal reports suggest retailers still had to discount strongly to achieve this growth rate and clear their stock."

Good morning friends...

2012-01-27T06:19:00.001+11:00

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Australia's best economic forecaster thinks they hold, but will they really?

2012-01-26T08:38:00.001+11:00

Ricardian Ambivalence, who, based on his track-record, looks to be the best market forecaster in Australia, has just put up a very good post on why he thinks the RBA will hold in February. His logic is impeccable: by the RBA's own analysis, economic conditions have improved since its last meeting in December (ie, the downside scenarios have not materialised); the RBA does not need to cut rates to boost the banks' net interest margins (based on only 1 basis point of NIM compression thus far); and the RBA cannot control the currency with policy.

But with the AUD/USD cross currently at US1.06 (some commentators called an AUD short at much lower levels!!), and many developed world central banks ditching their inflation targets and expanding their money printing programs, I think the market has reasonable grounds for pricing in a good probability of a cut in February. To be clear, I don't think it is the correct policy decision, but, just like in December, I think we are going to learn an enormous amount about the RBA's decision-making process, and how potentially basic and prone to public pressure that process may be.

Imagine if the AUD falls to sub-parity, and Q1 core inflation bounces even higher than Q4 (and we get more upward revisions to past data)? What does the RBA do then? Quickly start raising the cash rate again? While I think the decision should actually be very simple--exercising the option to wait has enormous logical appeal--I have a sneaking suspicion the RBA is going to make life very complex for itself.

Anywho, here is some of RA's thinking:

Last night’s EU PMI data (which suggests EU growth may have hit the nadir in Nov) and today’s Q4 AUD CPI numbers make a fairly good case for the RBA to hold their key policy rate at 4.25% at their 7 February 2012 Board meeting...

The global backdrop is better now than in Dec (US picking up, China isn’t hard-landing, EU growth pulse is quickening and credit crunch receding), the domestic growth data remains around trend, and abstracting from shocks, CPI looks to have been running at around 2.5%y/y for the best part of six quarters (H1 CPI was biased up, and H2 was biased down).

So, the RBA has the economy pretty much where they want it – and it’s also pretty much as they expected. The unemployment rate has been steady at ~5.25% for some time now, growth has been around trend (I think a touch sub-trend, but their assessment was ‘basically in line with trend’ at their Dec meeting), and it looks to me that asset prices are starting to stabilise / rise (equities up, houses look about flat).

Given these factors, the RBA will probably not downgrade their growth forecasts or lower their inflation forecasts in the Q1 SOMP (released on 10 Feb, following their 7 Feb Board meeting). With no downgrades, i cannot see how they can go from describing the Dec move as a close call (‘this did not suggest any strong need to cut interest rates’) to cutting in February...

Finally, there are three rate cut memes that i want to address:

1/ the RBA will cut to help the banks — the NIM loss from debt issued at recent wide spreads is ~1bps so far; the RBA has time to wait and see if funding margins stay permanently wide before they need to step in and protect major bank NIMs.

2/ the RBA will ease because of the AUD — the currency is too volatile a reason to act; doing so raises the risk that you’ll have to unwind the action (note, i’m explicitly leaving open that it’s a good reason to defer action). The AUD averaged 1.0619 (TWI 77.47) in Q2’11; 1.0492 (75.85 TWI) in Q3, 1.0118 (74.83 TWI) in Q4, and has averaged 1.0348 (76.84) in Jan’12. It’s in a range folks …

3/ The RBA will cut and say that they are now on hold — the RBA tends to try and avoid commitments about the future. So i think they’d sooner stay on hold at 4.25% and say that they are ready to ease if required than cut and say that they are on hold (this is another manifestation of the point i made w.r.t. the AUD, above … it’s easier to wait and see than to undo something).

McCrann and Bassanese conflict about what RBA will do in February

2012-01-26T08:24:00.000+11:00

Boy, I don't envy the RBA right now. The Fed has announced a 2% core inflation target over the medium term, consistent with most other central banks. Core inflation in Australia is currently running at 2.6% per annum with nontrivial upside risks. If you listen to Terry McCrann, the RBA is "almost certain" to cut rates in February because it is not worried about inflation and wants to protect the major banks' net interest margins. Apparently the RBA wants to also cut rates because of the high Australian dollar. Ironic given the currency is where it has been for 12 months, and was previously regarded as an important brake on inflation. This is not a matter of opinion: the only reason core inflation has stayed at 2.6% per annum is because of our imported and tradables deflation. Also ironic because the RBA has previously argued that you cannot control currencies with policy. So then we go to David Bassanese, who has published a truly terrific article on the RBA's dilemma over at the AFR. In fact, I think its probably the best article I have ever read of his. In conflict with McCrann, Bassanese posits:

"Sadly for interest rate watchers, the underlying consumer price inflation results for the December quarter were not low enough to make a rate cut by the RBA next month a done deal...

[T]he case for a third consecutive interest rate cut is to date far from strong – and certainly not as high as the 80 per cent probability priced in by financial markets ahead of this week’s CPI release.

After all, if anything, economic risks in Europe have been gradually receding since the RBA last cut interest rates in early December. European bond yields are down, and equity prices are up. Greece is still killing itself trying to stay in the euro zone.

The Chinese and US economies, moreover, are holding up well. Locally, business and consumer confidence have recovered from their slumps in August last year – which in turn followed the sharp fall in world equity markets. Local confidence is far from buoyant, but at worst it’s probably only a little below average."

The really interesting aspect of Bass's analysis is his parsing of the inflation data:

"Low inflation owes thanks in large part to the strength of the Australian dollar, which is holding down import costs. Indeed, in trade-weighted terms, the $A is up by more than 40 per cent in the past three years.

Domestically generated inflation – especially in the services sector – is far from benign...

Indeed, it’s worth noting that despite the apparent softness in the economy, annual service sector inflation has accelerated in recent quarters, and ended the year at a relatively uncomfortable 4.4 per cent. Annual inflation in those sectors relatively sheltered from international competition (the non-tradable sector) has also accelerated, ending the year at 3.9 per cent.

It’s just as well that annual inflation in both the goods and tradable sectors is running at a relatively low 2 per cent, or else inflation would not be so benign.

All up, Australia appears to have an intractable service sector inflation problem, which likely reflects the underlying strength in the labour market, poor labour productivity growth and a lack of effective price competition – especially in the utilities, health and education sectors. This is being masked by weak import prices, which also won’t be so benign once the already high Australian dollar stops rising.

Against this background, it strikes me that there’s only so much insurance the RBA can take out against a European-led implosion in the global economy. While most forecasters – most recently the World Bank and the International Monetary – concede there are large downside risks to the global economy, the fact remains that so far at least the worst-case scenario has not been borne out."

Swannie: Banks can pass on rate cuts because of world-beating return on equity

2012-01-26T07:08:00.000+11:00

According to Business Spectator:

But Mr Swan made it clear on Wednesday that he will be on their profitable backs again should the Reserve Bank of Australia (RBA) cut rates after its board meeting on February 7.

"I'm sorry, they are at record levels of profitability," he said in Brisbane after the release of benign quarterly inflation figures.

"They have a return on equity which is virtually unequalled by any other bank in the world."

Mr Swan said while the banks argued their future funding needs would cost more, their net interest margins - or profits on lending - were about the same level as they were prior to the global financial crisis.

He also pointed out the banks were raising more funding locally through domestic deposits and were less dependent on offshore funding because of initiatives such as covered bonds.

"There would be a lot of people out there in Australia who will judge them harshly if they take actions that they deem to be unreasonable in the current environment when they are so profitable," Mr Swan said.

"But at the end of the day the government doesn't regulate these rates. What I can do is speak up about it, outline the facts, and make the system more competitive so that if people are unhappy with their banks they can walk down the road and get a better deal."

RBS: RBA to keep rates on hold in February (+ big revisions to CPI data)

2012-01-25T15:25:00.000+11:00

The RBS team are top-notch:

We favour no change in rates in February.

Barring a worsening in Europe or indirect signalling by the Reserve Bank, we still hold the minority view that the Bank will leave the cash rate unchanged at 4.25% on 7 February. We think that there is not enough new information to justify another back-to-back rate cut. Globally, Europe is in recession, but is not quite as bad as had been feared, the US has improved and China has slowed in line with expectations. Locally, employment has disappointed, but unemployment has been stable at 5.2% and the Q4 CPI seems unlikely to trigger revisions to the Bank's forecast profile for ex-carbon tax underlying inflation in February's Statement on Monetary Policy. That said, banks are complaining about higher funding costs, although we are not sure whether the Bank feels the need to respond to this with a rate cut.

Recent revisions have lifted underlying inflation.

Following changes introduced last year, the Bureau of Statistics now seasonally adjusts most of the CPI and seasonally reanalyses the data each quarter. As a result, the seasonally adjusted CPI and estimates of underlying inflation have been revised over time, by more than we would have expected. In particular, the average of the weighted median and trimmed mean CPIs have seen notable revisions. For example, average Q2 inflation was initially estimated at 0.9% on the 15th series basis and then revised to 0.6% on the 16th series basis using the new seasonal adjustment methodology before being revised again to 0.8%. For Q3 inflation, it initially printed at 0.3% and has now been revised to 0.4%. If further revisions are similarly biased, then this would raise doubts over the real-time estimation of underlying inflation using the Bureau's new techniques.

UBS: February rate cut "close call"--market underpricing RBA holds

2012-01-25T14:13:00.000+11:00

From UBS's rates strategist Matt Johnson, who has a pretty amazing inflation forecasting track-record, and pinged today, right on the money:

"Feb is a close call for the RBA...With CPI around the RBA’s forecast, the market is under-pricing the risk that the RBA is on hold at their 7 February board meeting. The prior two rate cuts (-25bps per meeting in Nov and Dec) were close calls, and February may be even closer."

Koukoulas: Financial markets "wrong" about "highish" inflation

2012-01-25T13:58:00.001+11:00

In response to today's 2.6% underlying inflation result for the 2011 year, my old sparring partner Stephen Koukoulas has tweeted:

"Mkt looking at 2.6% y/y underlying reading as a highish result - AUD up: This looks to be wrong interpretation"

On his new blog, Koukie prepared a media release before the CPI results as to what he thought should be reported. It seems he was forecasting a 2011 year result of 2.3% (versus the 2.6% we got) driven by a "stunningly low" Q4 result, and, further, that financial markets would then price-up a 100% probability of a 25bps rate cut in February (vs. the substantially scaled-back 68% probability right now). As I have said too many times to count, forecasting is a very tough gig that is almost impossible to get consistently right. Notwithstanding our sparring, I've always found Koukie to be a lovely guy. Here is the media release he prepared before the CPI...

WEDNESDAY 25 JANUARY 2012:

Today’s consumer price index confirmed that Australia’s inflation rate remained around its lowest level in a decade. In underlying terms, the CPI rose by 2.3% in the year to the December quarter to remain in the lower part of the target range of the RBA...

The low inflation rate has money markets pricing in further interest rate cuts in the near term. According to market pricing, the RBA is expected to cut the official cash rate by a further percentage point over the next 6 months with a 25 basis point cut priced into the market for next week’s meeting of the RBA Board...

The stunningly low inflation result is a further embarrassment for the Liberal Party, which had policy settings in place in 2006 and 2007 that spurred underlying inflation to a 15 year high of 5.0%.

TD Securities: "Higher underlying CPI rattles confidence in a February cut"

2012-01-25T13:37:00.001+11:00

TD Securities always-excellent Annette Beacher comments after today's inflation data:

Higher underlying CPI rattles confidence in a February cut. Core inflation stickier than expected...

A higher than expected underlying CPI report for end 2011 takes some of the certainty out of our forecast 25bp rate cut for the February RBA Board meeting. The AUD firmed to $US1.05 and 3yr bond yields added 10bp after its release...

We still expect a cash rate reduction of -25bp to 4% at the February 7 RBA Board meeting. Had underlying inflation softened to the extent that we anticipated, we had a near-100% conviction of this view. Now with inflation a little sticker than we expected, we have a 70% conviction, and co-incidentally the OIS probability of -25bp is also closer to 68% [from nearly 90% before].

Westpac index confirms economy currently growing "at trend"

2012-01-25T13:28:00.000+11:00

From Westpac today:

"The annualised growth rate of the Coincident Index which gives a pulse of current activity was 3.0%, around its long term trend of 3.1%."

JP Morgan: February rate cut will be "close call"

2012-01-25T13:26:00.001+11:00

A good summary from JP Morgan:

The Q4 CPI data essentially delivered a 1-1 draw and, therefore, is inconclusive for next month’s RBA decision. The headline result printed softer than expected at flat (consensus 0.2%q/q, J.P.Morgan 0.4%q/q), but the all-important trimmed mean core measure was a little higher at 0.6%q/q (consensus 0.5%, JPM 0.7%). There was a small upward revision to the prior quarter’s core print to 0.4%q/q from 0.3%. This all leaves core inflation tracking at an average of 2.5%oya over the second half of last year, bang in line with the mid-point of the RBA’s target zone. Annual headline inflation remains above target at 3.1%oya, but it is trending down.

For the RBA, then, today’s data gives us little to work with – it doesn’t grease the wheels for the February rate cut that is 65% priced in financial markets (and all-but unanimously forecast by market economists – before the data), but nor does it shut the door. With the RBA’s Board meeting still two weeks away, we are sticking with our call for a 25bp cut in February, but without much conviction. Indeed, the decision will be a very close call, as recent minutes indicate was the case with each of the two rate cuts the RBA delivered late last year.

Core inflation surprises market on high side, forcing jump in AUD and big sell-off in bonds

2012-01-25T12:16:00.004+11:00

The single best indication of the correct reaction to today's inflation data was in the financial market's response. In short, there was big disappointment--the market was, as I had correctly predicted, positioning for a very low number, and proved way wrong. Those economists forecasting super-low core inflation prints of around 0.2% or 0.3%--one was even angling for a negative number!--were frankly blown out of the water with the RBA's two core measures averaging 0.6% (to one decimal place).

The Aussie dollar jumped from US1.047 before the print to US1.052 after. More tellingly was the reaction of Australian government bond futures. The benchmark 3 year government bond contract immediately plummeted 10 points from 96.74 to 96.64 as traders priced in higher long-term interest rates. The 30 day interbank futures contract also substantially reduced the probability of a rate cut in February, although it is still pricing-in a better-than-evens chance.

There is little doubt that today's inflation data creates more complications for the RBA.The average of the RBA's two main core measures--the trimmed mean and the weighted median--was 0.6%. The Bloomberg consensus was 0.5%, but all economists expected the risks to be skewed to the downside. (Remember also this is an inflation estimate produced using the ABS's much-improved expenditure class and seasonal-adjustment methodologies. So there are no excuses for the numbers.)

As I had canvassed here in previous columns, more issues arose as a result of upward revisions to past data. In particular, both measures of third quarter core inflation revised up from 0.3% to 0.4%. Crucially, this leaves Australia's 2011 calender year core inflation rate sitting at, officially, 2.6%, which is slightly above the mid-point of the RBA's 2-3% target band. The risk is that the fourth quarter also gets revised up, and the numbers start looking a little ugly for Australia's central bank.

With interest rates now substantially below where they were in 2011, and the benefits of the remarkable Aussie dollar appreciation mostly behind us, it is hard to see how the RBA is going to be confidently forecasting the much lower inflation outcomes over the next two years it requires to justify more stimulatory policy than the one it already has in operation right now (with two pre-emptive rate cuts in November and December). Sure, if the economy starts growing clearly sub-trend, it could make the case. But today it is far more difficult, unless of course this RBA finds it easier to cut rather than raise rates.

There is, to be sure, much water to still flow under this bridge before the RBA meets again in February. But only a fool would refute the notion that a rate cut in February has become another line-ball--or in UBS's words-"close" call.

Market positioning for very low core inflation result...

2012-01-25T10:41:00.000+11:00

At this stage, I think a "surprise" will be anything equal to or less than 0.2% (ie, more than one standard deviation away from the consensus view of 0.5%). Even then, the market is really positioning for a low number, so it might not move huge. The upside is more complex. A "surprise" would certainly be 0.7% or higher, because nobody is expecting it. However, the price action will be in the interbank futures and OIS contracts, and less so in the 3 year government bonds given the structural demand for those contracts, as witnessed during 2011. That is, even with a high number I don't think many will have the balls to short Aussie bonds this far out from an RBA meeting. Having said that, the global theme is risk-on.

Are Aussie house prices on the rise again?

2012-01-25T09:18:00.000+11:00

For most of this year Australians have had to read asinine media articles reporting purported experts predicting catastrophically-large 20%, 40% and, last week, 60% falls in domestic house prices.

The fact that these individuals have no experience successfully forecasting housing market conditions seems to be utterly inconsequential to the journalists desperately seeking to peddle doom-and-gloom.

The best information we have today suggests that Aussie house prices will have tapered by around 3.5% over the course of 2011. That’s right: less than one-tenth the decline sensationally predicted by the closely-covered doomsayers (no prizes for guessing who I am referring to here).

Wiser readers will realise that this is history repeating itself: the same individuals expressed the same opinions during the global financial crisis only to see Aussie house prices surge over 2009 and 2010.

And now we have mounting evidence that the housing market is staging a slow recovery, as I’ve projected in these pages for some time. The key catalyst appears to have been the RBA’s decision to swing 180 degrees from expecting to hike interest rates to cutting them in November and again in December. A low core inflation result from the ABS today would significantly increase the prospect of a third delicious rate cut for home owners at the RBA’s February board meeting.

The first tangible signs of the recovery derived from RP Data-Rismark’s November house price index release, which reported a marginal 0.1% increase in seasonally-adjusted dwelling prices. This was the first rise in capital city home values since December 2010. Importantly, even stronger capital growth was found across Australia’s ‘regional’ (ie, non-capital city) markets.

A key question that will be resolved next week is whether this November data was a once-off or indicative of a more sustainable theme. More specifically, will the preliminary November month result revise up or down, and what will the index tell us about the highly seasonal month of December?

Today a second leading house price index provider, Australian Property Monitors (APM), has echoed these findings, reporting that nationwide house prices actually ground-out a tiny gain over the December quarter (ie, the three months inclusive of October, November and December).

The main take-away here is not that home values are inflating again: it is, on the contrary, that they are not falling, or falling at an accelerating rate, as Steve Keen has predicted.

In today's release, APM comments, “Median house prices have risen nationally for the first time since September 2010, indicating early tentative signs of recovery in the housing market…The rise in the national median house prices reflects activity in the Sydney and Melbourne housing markets over the December quarter.”

APM’s chief economist, Dr Andrew Wilson, adds, “This result is significant as it shows an end to a recent trend of falling prices over the past year, with the realistic potential for a sustained turn-around in some markets.”

The coincidence between the APM and RP Data-Rismark house price index paths is especially encouraging because they use markedly different methodologies. APM’s index is based on a ‘stratified median’ technique pioneered by Dr Anthony Richards (and colleagues) at the RBA. RP Data-Rismark uses a more sophisticated hedonic regression approach. Over the long-term, the two indices tend to move very closely together.

The recovery in housing activity, which seems to be occurring more rapidly than perhaps even I forecast, is entirely understandable.

Australians have benefited from a tremendous improvement in housing affordability. Capital city house prices have not increased since May 2010. In fact, they have tapered by a cumulative 4.5% (one bad day for the sharemarket!). At the same time, disposable incomes per household have risen by around 14%. On a longer-term basis, Rismark’s analysis suggests that disposable incomes per household have outpaced capital city dwelling prices by more than 15% since the end of 2003.

The final nail in the affordability argument is, of course, mortgage rates. The RBA’s munificence has bequeathed borrowers with home loan rates that are now well-below their 15 averages. Ubank is offering variable rates of 6.14% and fixed rates of just 5.93%.

If the RBA cuts again in February, and further thereafter, as some analysts believe they will, expect to see the return of rapid house price appreciation. As I've said before, housing (and bank-intermediated credit growth) will be the chief beneficiary of any interest rate relief.

Better than expected Euro data overnight (again)

2012-01-25T08:02:00.000+11:00

From UBS:

OVERNIGHT DATA - Better than expected Euro zone PMIs

* EU: Euro zone manufacturing PMI (Jan) was better than expected at 48.7
(mkt: 47.3) from 46.9, and services PMI rose to 50.5 (mkt: 49.0), from
48.8. The composite PMI rose to 50.4 from 48.3, highest since August,
pointing to further stabilisation.

* EU: Manufacturing PMI rose in Germany to 50.9 (mkt 49, prev 48.4), but
France edged down to 48.5 (mkt: 49.0) from 48.9.

Terry McCrann back in business...

2012-01-25T07:53:00.000+11:00

One of the wise old men of Australian journalism starts his RBA coverage again today, and teaches us at least three things that were not widely appreciated. I am assuming Tez has the benefit of discussing these matters directly with the RBA, unlike you and me (unless you're an overseas hedge fund, which are regularly granted private audiences with the central bank). And he has creatively come-up with yet another label for me! His insights include:

1/ "The RBA's decision to cut in December was a very, very, finely balanced thing. It really could have gone either way." I myself argued this, but some thought it was a slam-dunk.

2/ "What helped tip the balance was a belief that the RBA could effectively have a half cut. That's to say, the RBA fully expected the banks to only deliver cuts of 15 points. That must now play into the coming decision, but it plays into the decision very messily." In short, the RBA was apparently only punting on half a cut being passed through and, yet again, got the banks' reaction functions wrong (the 'again' bit refers to November last year).

3/ "It's also incidentally going to be a messy year for inflation with the arrival of the carbon tax on July 1. Messy, for everything and everybody." This is an important point that I had sort-of under-weighted. The RBA will be worried about the carbon tax's impact on inflation expectations, especially in an environment where house prices are rising again, and likely to rise faster and further after more rate cuts.

If economists' forecasts are right (chart), we likely get a rate cut in February

2012-01-24T21:13:00.000+11:00

Enclosed below is Bloomberg's survey of Australian economists for core inflation tomorrow. The average and median are both 0.5%, which is probably low enough to give the RBA room to cut rates in February subject to revisions to past data and other global economic information. This is also consistent with current financial market pricing. What is interesting about this survey is that there are quite a number of very low estimates: two guys are predicting 0.2%; three are hoping for 0.3%; and one is punting on 0.4%. This is not so odd in pure distributional terms, but these numbers are way below the recent core inflation average of around 0.8%. Looked at a little differently, there is nobody predicting 0.8% or higher. So it seems the smart money is going to be looking for a benign inflation result tomorrow, and, if we can bank that, a good chance of a rate cut in February. I am not sure how folks will react if core inflation somehow prints high.

Dad and son somewhere in Lord of the Rings land...

2012-01-24T15:32:00.001+11:00

- Posted using a mobile device

Business Spectator column on bank funding costs

2012-01-24T13:52:00.001+11:00

Read it here.