We Wouldn’t Want to be Glenn Stevens Right About Now

Conclusion: RBA Governor Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months, but given recent economic data it seems more likely that the tightening cycle has peaked in Australia.


Position: Short the Aussie dollar (FXA).


Reserve Bank of Australia governor Glenn Stevens has his work cut out for him. On one hand, he’s got to deal with a confluence of inflationary pressure at multi-year highs. On the other hand, broad-based slowing of Aussie economic data has become hard to ignore. Recessionary? Perhaps not, but we certainly would not rule that out at this juncture. Needless to say, we expect next Monday’s RBA monetary policy announcement and the accompanying commentary to be market-moving, given the increasingly divergent nature of Australia’s economic fundamentals.


We are short Australia’s currency as of this afternoon and think Stevens would be borderline crazy to hike rates at any point over the intermediate term. As we outlined in April, the bias of risks to Australia’s developed-world-beating benchmark interest rate of 4.75% is heavily skewed to the downside in our opinion.  Our view is divergent from the global FX market, which is is clearly pricing in additional RBA rate hike(s) on the heels of this week’s acceleration in CPI and PPI – both to 10-quarter highs.  Given the rapid appreciation of the Aussie dollar over the last twleve months (+23.3%), much of this is likely priced in to the currency, which makes the risk/reward compelling on the short side.


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Interestingly, both the interest rate futures market and interest rate swaps market are pricing in RBA hawkishness (on the margin) on the heels of today’s CPI report. Rate futures suggest a 28% chance of an RBA rate cut by December, down from 100% just two days ago. In the same time period, swaps market expectations for RBA rate cuts over the NTM nearly halved, falling from -42bps to -23bps, and those same expectations went from signaling an 8% probability of a rate cut to a 2% probably of a rate hike next Monday.


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Interestingly, Australia’s one-year inflation swap rates hardly budged. The securities, which exchange fixed payments for returns equivalent to Australia’s CPI over the specified duration, have been in free-fall since mid-to-late April (right around the time we introduced our Deflating the Inflation thesis). The short-to-intermediate-term slope of this market is in unison with our call that the intermediate-term peak of commodity prices is in the rear-view mirror, which should help converge Australia’s headline CPI towards its core CPI rate at -90bps below.


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Perhaps the most important driving force behind the muted reaction in Australia’s inflation swaps market is a glaring lack of consumer demand, which may force Aussie retailers and service providers to discount aggressively in order to sell-through product.


Anecdotally, Australia’s second-largest department store chain, David Jones Ltd., cut 2H earnings guidance to -12% from +5% just two months ago. Our daily grind through Australia’s economic data suggests this micro-level activity is both pervasive and supported by the top-down trend we’re seeing across the Australian corporate sector. A recent quarterly Deloitte survey of 100 CEOs of large, listed enterprises found that only 23% of respondents were positive about the financial outlook for their company – the lowest level since the survey began in 2009 and a near -50% decline from 1Q11. Moreover, Australian deposit-to-loan ratios (a gauge of corporate willingness to invest) at 1.25x are at the highest levels since the thralls of the financial crisis, according to a recent East & Partners study.


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The widespread bearish sentiment in the Australian corporate sector is largely driven by a weak Australian consumer. Since mid-to-late 2009, Australian consumer confidence and retail sales have made a series of lower-highs and we see further downside over the long-term TAIL. This is driven by a weakness in Australia’s residential real estate market, which, in turn, drives Australia’s household savings rate to new highs (the current 11.5% reading is just -10bps below a 25-year peak). We would expect to see this trend continue over the long-term TAIL absent any material easing in monetary policy. We are not alone in this regard; a recent National Australian Bank residential property price index designed to predict home value values on a one-year forward basis showed a -1.4% decline in the 12 months from 2Q11 (vs. +0.6% in the 12 months from 1Q11).


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Some key metrics to consider regarding Australia’s property market: 

  • Nearly 2/3rds of Australian citizens own homes (population = 22.5 million);
  • Roughly 90% of encumbered households have variable-rate mortgages (rate hikes are incredibly painful);
  • At 155% of disposable incomes, Australian households are more +16.5% more levered than U.S. households were just prior to the financial crisis (133%);
  • Australia has the most unaffordable housing in the English speaking world, according to a January Demographia survey (6.1x gross annual household income vs. 3x in the U.S.); and
  • A recent Zillow.com survey confirms the Demographia survey results: the median house price in Australia ($503k in May) is nearly 3x that of the U.S. ($184k in June). 

Judging by this data snapshot, which shows an over-levered consumer facing exorbitant housing prices, it should come as no surprise to see that demand for mortgages in Australia has plummeted to the lowest levels ever in May (+6.2% YoY). Ever, as they say, is a long-time. Moreover, a pickup in mortgage delinquency rates, which hit a record high of 1.79% in 1Q11 according to Fitch Ratings, should put incremental pressure on Australia’s banking system at large and may slow credit growth to other parts of the economy in the event of a systemic buildup in reserves. It’s worth noting that mortgage debt represents 59% of total Aussie bank credit.


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Oddly enough, Australia’s unemployment rate has trended down on both an intermediate-term and long-term perspective and remains just +10bps above its post-crisis low. Additionally, a long-term investment boom driven by the mining industry should continue to exert downward pressure on Australia’s unemployment rate. On the flip side, robust RBA expectations for the long-term TAIL of Australia’s labor market need to be tempered, as we strongly believe Prime Minister Julia Gillard’s carbon tax legislation will slow the rate of investment in this sector – widely noted to be the only beacon of light in Australia’s labor market. The other three main labor market sectors (manufacturing, services, and construction) continue to show material signs of weakness.


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Should Australia’s labor market weaken incrementally, we feel Australian economic growth could be at an even greater risk.  As well, we think that Glenn Stevens could shock the Australian economy into a pronounced economic downturn by looking through the current slowdown and hiking rates within the next few months. He could also choose to ease consumer fears regarding additional tightening and provide much-welcome support to Australia’s ailing retail sector and housing market by cutting rates. Either way, we are comfortable shorting the Aussie dollar at this price.


Darius Dale


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