Downshift Down Under
April 25, 2008
By Joachim Fels | London, Gerard Minack | Australia & Manoj Pradhan | London
A Tale of Two Countries
Australia’s and New Zealand’s economies have much in common. Both have benefited from a buoyant housing market, strong growth in Asia and the related boom in hard and soft commodities. Inflation has shot above the central banks’ target zones. Official interest rates, at 7.25% in Australia and 8.25% in New Zealand, are the highest in the advanced economies (leaving Iceland aside). However, housing markets have turned and the recent plunge in confidence indicators suggests that domestic demand is about to slow sharply. While sticky inflation is likely to keep both central banks on hold for now, we think that monetary policy will eventually be eased significantly over the next 18 months, by more than markets are currently pricing in. We look for the RBNZ to go first, probably as early as September, followed by the RBA in 2009. In both cases, we see rates falling by about 200bp in 2008/09. Australia: Big RBA Rate Cuts Coming (in 2009) Gerard Minack There are growing signs that the Australian domestic demand cycle has peaked. If they are confirmed – as I expect – then the RBA may have to sharply ease monetary policy over the next 18 months. The recent rate increases – the RBA has tightened policy four times since last August – seem to be biting. There has been a very sharp fall in consumer confidence, to the lowest levels seen since the last recession. Consumer confidence is not a perfect leading indicator, but falls of this size have typically been followed by materially weaker consumer spending. Although not as severe, business confidence has also been dented. Domestic corporate sentiment may also have been affected by cost increases and tighter credit conditions, as well as reflecting early signs of weaker domestic demand. The consensus view is that domestic demand will slow, but that it will be a gentle soft landing. Short-rate futures are pricing in a moderate degree of easing. My view is that the slowdown in domestic demand could be sharper than expected by the consensus, forcing the RBA to ease rates by more than expected in 2009. As I see it, three factors have worked against monetary policy over the past 3-4 years. Two of those policy-neutralising factors may be about to reverse, suddenly increasing the potency of policy – effectively producing financial conditions that are inappropriately tight. Three factors have worked against the monetary policy tightening implemented by the RBA. The first is the commodity boom, which has lifted Australia’s terms of trade (the ratio of export prices to import prices) to its highest level since the early 1950s. This effect has meant that Australia’s real national income has risen significantly faster than real GDP over the past four years. The boost will continue this year: higher prices for bulk commodities (iron ore and coal) will probably lift the terms of trade by another 10% this year, in my view. The second factor is the boom in house prices and the follow-on impact on household wealth. As in the US, the rise in house prices has been associated with mortgage equity withdrawal. The new news, however, is that there are early signs that the housing market is rolling over: homes for sale have increased, while clearance rates are falling. Prices are falling in some areas. The third (and arguably most important) factor blunting tighter policy has been the unusually slow pass-through of higher rates. Despite higher cash rates, the average actual interest rate paid on the stock of household debt has increased by less than 0.5% from early 2004 to late 2007. Several factors have contributed to this, but the most important appears to be the greater use of fixed-rate mortgages (historically the vast majority of mortgages have been floating-rate). However, as mortgages move off their fixed terms (typically 3-5 years), many borrowers will face a significant jump in debt-service costs. Although the mining sector is likely to remain strong, it’s important to realise its relatively small size: it accounts for around 5% of GDP and directly employs 1.5% of the workforce. If consumer demand slows, then the labour market is likely to soften and domestic demand should weaken sharply. All this is against a backdrop where many measures of household finances – such as debt-service burden and leverage – are more stretched than in the US. My view is that the RBA will start easing policy late this year or early next year. This is broadly what is priced into the market. Where I disagree with the market is over the extent of the easing: given the financial risks in the household sector, I expect that the RBA will have to ease rates by up to 200bp through 2009. New Zealand: Growth Slowing, RBNZ Easing to Start in September Joachim Fels & Manoj Pradhan The cycle has peaked. New Zealand has enjoyed almost a decade of solid economic growth, averaging close to 3.5% since the end of the 1998 recession. The key drivers for buoyant domestic demand were large-scale immigration, a related house price and residential construction boom, a decline in unemployment to a multi-decade low of 3.4% last year, and a major boost to New Zealand’s terms of trade due to the sharp rise in soft commodity prices (dairy products alone account for close to 25% of New Zealand’s exports by value). However, there are accumulating signs that the cycle has peaked and that economic growth will slow sharply this year and next, for three reasons: • First, overall monetary conditions have tightened considerably. With the official cash rate (OCR) standing at 8.25% and inflation running at 3.4%, real short rates are at around 5% and thus clearly in restrictive territory. The real policy rate significantly exceeds our simple measure of the neutral, or natural, rate. In addition, the global credit crisis has pushed interbank rates higher, which in turn has contributed to a rise in both fixed and floating mortgage rates. The RBNZ estimates that almost 30% of the existing mortgage debt on fixed rates will re-price by 70-150bp over the next year from an average rate of just above 8%. Thus, the effective mortgage rate is likely to continue to rise over the next 12-18 months. Moreover, the past strength of the NZD is still feeding through to exports. • House prices falling. Second, reflecting rising interest rates and slower net immigration, housing activity has slowed dramatically and house prices are now falling. Despite a still strong labour market and a further increase in the terms of trade, this is likely to slow consumer spending. • Third, export growth looks set to slow this year. Gerard Minack expects domestic demand growth in Australia, New Zealand’s main trading partner, to slow sharply (see above). Also, the past NZD appreciation should dent manufacturing exports and tourism receipts. Last but not least, agricultural production has faced a severe supply shock from extreme weather gyrations, which hampers the outlook for primary exports. Plummeting confidence. In line with this assessment, recent sentiment indicators have indeed fallen sharply, signaling slower growth ahead. Consumer confidence plummeted to the lowest level in a decade in the March quarter, suggesting a significant slowing in consumer spending. Also, the Quarterly Survey of Business Opinions (QSBO) showed a sharp fall in general business confidence in the March quarter to a low not even seen in the late 1990s recession. Below 2% GDP growth. Against this backdrop, we expect annual GDP growth to decelerate sharply over the course of this year to below 1% by 4Q, from the 3.7% in the year to 4Q07. We see annual growth averaging 1.6% this year and 1.7% next year, only half the growth rate recorded in 2007. Thus, we are more pessimistic than the RBNZ, which expected growth to slow to around 2% over the next couple of years in its March Monetary Policy Statement (MPS). In the next policy statement, due on June 5, the bank is likely to acknowledge a weaker growth outlook. Slower growth and above-target inflation pose a policy dilemma for the central bank. Overall CPI inflation rose to 3.4% in the year to March from 3.2% in December, and thus further above the 1-3% target range. We expect inflation to peak at 3.7% in the September quarter (NZ CPI data are only available on a quarterly basis) and to ease back into the target range in 1H09. This is roughly in line with the RBNZ’s own projections. However, in the March Policy Statement, the RBNZ emphasised the upside risks to its inflation projections. Given the sharp weakening of economic activity, the bank may indicate in June that the risks have become somewhat more symmetric, and may also revise down its central inflation forecast slightly. First cut in September, 225bp in total. Once there is more evidence that growth has slowed during 1Q08, we expect the RBNZ to take back some of the rate hikes of 2007 in 2H. This could happen as early as September, when the RBNZ will release another MPS. Our central scenario is for three cuts of 25bp each at the September, October and December meetings, followed by another 100bp of easing during 2009. While this looks aggressive relative to the RBNZ’s own interest rate forecast and market expectations, these cuts would still only take the OCR down to 6% or, based on our CPI forecast for late 2009, around 3.5% in real terms; this would still be above what we would consider to be a neutral level.
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Foreign Official Reserves Could Reach US$8 Trillion by Year-End
April 25, 2008
By Charles St-Arnaud | London
Summary and Conclusions The world’s official reserves have now reached a level of US$6.6 trillion, and have grown by about 25% over the last year. At this rate, they could easily breach the US$8 trillion mark before the end of 2008. Japan has breached the US$1 trillion level in reserves and Russia could follow in about two years. Asian countries and oil exporters continue to be the main accumulators of reserves. Interventions continue to be the main source of reserve accumulation, especially in oil-exporting countries. With the current high oil prices leading to big C/A surpluses in oil-exporting countries, we estimate that official reserves of the GCC countries could increase by between 3 and 7-fold between now and 2015, depending on the scenario. This would make the GCC countries the fourth-biggest holder of official reserves. Key Features of the World’s Official Reserve Growth We make the following observations: • Observation 1. Total reserves are now US$6.6 trillion. The world’s official reserves have continued to grow at a rapid pace, reaching US$6.6 trillion in early 2008, from US$5.2 trillion only a year ago. The average pace of the world’s reserves continues to be over US$110 billion a month. Over the past 12 months, total official reserves have increased by US$1,355 billion or roughly over 25% per year. This is a sharp acceleration: the average pace of the world’s foreign reserve growth was only about US$30 billion a month or US$360 billion per year in 2005. At this rate, total official reserves could breach the US$8 trillion level by the end of this year. • Observation 2. Asian exporters and oil exporters remain the key reserve accumulators. Of the total stock of reserves, Asia and oil-exporting countries account for US$4.1 trillion and US$1.1 trillion, respectively. In terms of monthly growth, they account for US$73 billion and US$57 billion, respectively. (Much of the oil exporters’ balance of payments surpluses have ended up in their SWFs rather than official foreign reserves.) With US$1.57 trillion, China is the largest reserve holder in the world, followed by Japan (US$1.0 trillion) and Russia (US$507 billion). • Observation 3. Japan joins the trillion dollar club. China is no longer the only country with more than US$1 trillion in official reserves. As of March 2008, Japan’s reserves just breached the US$1 trillion mark. The next country to potentially hit this mark would be Russia. At its current pace of reserve accumulation of roughly US$18.5 billon, coming from the strong inflows from oil and gas exports, Russia could join the club in about two years. • Observation 4. Interventions continue to be the main source of reserve accumulation. Of the US$100 billion in monthly reserve growth, making some assumptions, roughly 53% of the total could have come from outright interventions, with possibly only 14% from interest earnings on the underlying assets and 34% from valuation changes (i.e., EUR appreciation). Over the last 12 months, the proportion of growth coming from interventions has been almost 70%. It seems that the pace of interventions has slowed somewhat recently. Most of the deceleration comes from AXJ countries, as intervention accounts for only about 40% of the change in reserves. The reserves data for the AXJ countries is mainly for January and coincides with a period of a sharp decline in risk appetite around the world, which has led to a decline in global equity markets (US and AXJ were particularly affected). This has likely reduced the amount of inflows going into the region. This, in turn, has reduced the necessity for these countries to intervene in the FX market to slow the appreciation of their currencies. • Observation 5. GCC countries are defending their pegs. The aggregate official reserves for the GCC countries are US$151 billion, roughly the size of Hong Kong’s reserves, but about double the UK’s reserves. Of the US$27 billion increase in the reserves of the GCC countries in the latest month, more than 96% can be attributed to interventions. This proportion was 88% on average over the past 12 months. The massive inflows associated with high oil prices are putting a lot of pressure on the GCC countries. The only country which has not seen a very high level of intervention is Kuwait, but it is also the only GCC country with a currency that is not pegged to the USD. The Kuwaiti dinar is actually pegged to a basket, in which the weight on the US dollar is very high. As a consequence, the Kuwaiti authorities have not had to intervene as much as other GCC authorities and have let the dinar appreciate by about 8% over the past 12 months. How Large Could GCC Reserves Grow? For the GCC as a whole, official reserves surged sharply in 2007, reflecting not only high oil prices, but also a bigger proportion of the C/A surplus (most of which is coming from oil) going into official reserves, rather than into SWFs or private flows. Over the last 12 months, the GCC countries’ reserves have almost doubled, increasing by US$72 billion. The annual C/A surplus of the region was in the US$200-250 billion range in the last two years, and could rise towards US$250 billion this year. We estimate that about 30% of the current account surplus of the region is funneled to official reserves, while the rest goes to SWFs and private entities. The proportion of the current account surplus going to official reserves has increased dramatically over recent years, as it was around 5% earlier in the decade. In A Petrodollar Tsunami Warning, February 21, 2008, we estimated that, with oil at US$100 a barrel, annual inflows related to oil exports in the GCC countries are about US$700 million per year; if oil reached US$120, the annual inflow would be about US$800 billion. With these kinds of numbers, it is easy to estimate that, as long oil prices remains high, the current account for the GCC countries will remain high. We have built three scenarios for the official reserves, assuming that there will be a 30:70 split between money going to the official reserves and to SWFs and private entities. If we assume a perpetual, stable C/A balance, which would be coherent with continued elevated oil prices, official reserves could rise at the rate indicated, approaching US$800 billion by 2015. If we suppose that the C/A balance of the region continues to grow by 10% every year, as oil prices continues to move higher, official reserves would reach US1.1 trillion in 2015. If we assume that the C/A balance decreases by 10% every year, as GCC countries adopt a more flexible exchange rate policy, the official reserves position of the GCC countries would be US$560 billion in 2015. Whatever the scenario, the GCC countries’ official reserves will continue to grow sharply over the next few years, especially if they maintain their current exchange rate regimes. Collectively, they are very likely to become the fourth-biggest holders of official reserves after China, Japan and Russia in 2-3 years.
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AUD: Liquidity, Coal and Carry: Is Parity within Reach?
April 25, 2008
By Luca Bindelli | London
Summary and Conclusions Despite the recent volatility increase, the AUD outperformed. The interest rate advantage hardly explains the recent AUD strength, as we will see. Despite this loss of support coming from carry trade-related activities, we believe that the ample global liquidity and fundamentals will support a commodity-led support for the AUD. Moreover, we suggest that the (Chinese-led) demand for coal will be a major plus for the AUD. Carry and Global Volatility As one of the highest-yielding currencies, and favored by a low-volatility environment, the AUD has benefited from strong support over the past few years. A recent BIS paper estimated that for each point rise in the VIX, the AUD lost 0.14% against the USD (see J. Cairns, C. Ho, & R. Mc Cauley, 2007, “Exchange rates and global volatility: implications for Asia-Pacific currencies”, BIS Quarterly Review, March. The estimation period covers 2000-06.). This result is generally taken as quite intuitive: as AUD is a ‘high-beta’ currency, one would expect the AUD to underperform in periods of higher risk aversion and volatility. However, despite the rising volatility floor in VIX since early 2007 (VIX rose from 10 to roughly 20), AUD/USD gained 18%. Interestingly, AUD/JPY moved 3% higher over the same period (while AUD/CHF moved only 3% down). This causal evidence does not support the view that the AUD should underperform in periods of uncertainty. (Admittedly, the AUD sold off during spikes of risk aversion. Our focus in this piece is more on the volatility trend.) In this piece, we report evidence on carry trade as a driver of IMM speculative positions in AUD. To proxy the degree of attractiveness of carry trade strategies, we use a measure introduced in our past writing: the carry to risk ratio (3M Libor spread over 3M AUD/USD implied volatility). The 1-year correlation between IMM speculative positions and carry to risk ratio is significantly positive throughout the period. (This is consistent with the BIS findings, as our measure also varies due to changes in volatility.) This suggests that carry trade build-up and unwind can largely help to explain moves in the speculative AUD positions. Two exceptions to this pattern are notable: • First, back in late 2004, despite carry to risk remaining flat until mid-2005, AUD/USD fell. At that time, commodity prices started to plateau, and even fell, suggesting that the price action in AUD was led by commodity prices (Australia’s growth also fell significantly in late 2004). • Second, the period beginning late 2007 until now: The Fed cut aggressively since last September, pushing the carry to risk higher (despite the rise in volatility). Again, the first alternative explanation that comes to mind is the recent commodity price surge. Indeed, we find that the 1-year correlation between AUD/USD and the net long positions in the Goldman Sachs Commodity Index contract (IMM) is currently as high as 0.80. These comments suggest that risk aversion and volatility are only a part of the story, and that the commodities’ path will become more critical for the AUD, as carry trade strategies seem to have been put to rest recently. Having said this, we expect the RBA to remain on hold at 7.25% throughout 2008 (due to Australia’s economic resilience and inflationary pressure build-up), thereby maintaining a yield advantage against most (easing) economies. Liquidity Condition Should Support Commodities Capital inflows in the presence of fixed exchange rates lead to FX reserves accumulation. Further, if these are not entirely sterilized, we should observe easier domestic monetary conditions. This in turn can feed into higher asset prices. The same holds true for the investment of reserves itself. We looked at excessive liquidity conditions, as measured by the world FX reserves, and commodity prices. Our study shows how correlated the two series are (0.60 over the last 25 years). (We use the Reserve Bank of Australia commodity price index (which is heavily weighted to materials exported to China – mainly energy and base metals).) According to our calculations, the causality running from FX reserves to commodities prices is confirmed and strongly significant (we use a Granger causality test). This supports the thesis that FX reserve accumulation can lead to asset price increases (commodities in this case). As of January, FX reserves were growing at close to 30%. This growth in liquidity was mainly driven by China’s reserves (accounting for 26% of world reserves). To us, this evidence suggests that liquidity has been a driver of the current commodity boom, and it may continue to remain so in the near future. Looking at the investment rationale, not only has the search for yield been one of the main drivers of this boom in commodities, but it appears likely that commodity investment as a hedge against rising inflation risks may also explain a large part of the recent prolonged AUD support (NZD and CAD as well). In other words, the commodity currencies act as an indirect hedge against commodity-led inflation risks. China’s Demand for Coal: Australia’s Gold Mine As well as the liquidity-driven process, traditional supply and demand factors will help to support the AUD, we think. Infrastructural demand, increasing urbanization and demographic issues all suggest that China will need to expand its demand for commodities in the near future. Due to its commodity export pattern (energy, base metals and bulks), Australia is particularly well exposed to this need. Moreover, the reliance of China on coal as a source of energy is notable. In 2006, according to the BP statistical review, China accounted for 39% of the world coal consumption (roughly equal to its production share). Moreover, coal accounts for 70% of Chinese energy consumption (oil is 20%). With only 13% of proven world reserves in coal, China is set to become a big importer. (At 48, reserve to production ratio is still quite high for China, but is tiny compared to Australia’s 210 ratio.) Our energy analysts note that only five years ago China was the biggest thermal coal exporter, but it is now becoming a net importer (see Global Coal Update: 2008 Contract Prices – Simply Extraordinary! April 9, 2008). Their new forecasts suggest an increase of 200% in coking coal (used mainly for steel production), and a 125% increase in thermal coal in 2008. The rise in coal prices has been steep over the recent period. To sum up, Australia, being the biggest world exporter of coal (with nearly 30% of world exports), is set to benefit extensively from this situation in the near future. (As of 2007, the export share of coal in Australia’s trade was 13%. At the same time, China accounted for 14% of total exports (up from 5% in 2000). ) With global liquidity conditions and fundamentals remaining supportive of commodities, we would favor AUD longs in 2008. In particular, we think that coal will have important positive consequences for the terms of trade, and consequently AUD. Gerard Minack, our Australian economist, expects the terms of trade to rise by 10% over the coming year. This improvement should mainly happen on the back of the expected coal price surge (and iron ore). Given where AUD/USD currently stands, a breach of parity does not seem impossible this year. Moreover, recent evidence shows that the commodity boom goes hand in hand with a dollar decline. A clear risk to this scenario is that global growth should ultimately impact the demand for commodities and drive prices down. With the US being ‘first in, first out’ in this global growth adjustment, we think that AUD/USD would be at risk. Having said this, we see this as more of a (early) 2009 story.
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