It could have gone another way

After watching Jerome Powell stack it last Wednesday, it could have gone equally bad for us here in Australia.

But, not so.

Yesterday, and to RBA Governor Lowe’s credit, he stated the RBA will not be hiking interest rates just yet, but in a solid move he did signal a stop to quantitative easing (QE) – and it’s about time.

While he is staying out of the interest rate lagoon at present, it won’t stop Australian banks hiking lending rates to improve their net interest margins (i.e., ~30% of funding still comes from offshore/U.S. where borrowing costs will start to increase) but it also won’t be a stake in the heart for Australian equities.

And in contrast to Peter Costello’s comments yesterday that the move has damaged the RBA’s credibility – there are some positive implications that our ex-treasurer is not talking about. That is, the current setup is good news for:

• debt intensive projects that will either mine resources or value-add them, or develop projects that will deliver them into the global electrification and decarbonisation thematic, in addition to supplying inputs for global infrastructure projects.

• companies seeking to raise equity in a supportive environment.

• USD denominated exporters given the AUD is now likely to weaken further against the USD.

Perhaps he’s regretting trimming 1.1% in his Future Fund’s equity portfolio too soon? A missed memo?

Who would know……

Inflation, the Australian variant

Although the RBA board did not use the word, we can fairly assume it still sees inflation as ‘transitory’; predicting a peak in underlying inflation of 3.25% in coming quarters before declining to around 2.75% over 2023 as supply side problems are resolved and consumption patterns normalise.

Petrol and building materials (i.e., price of new homes) were the only factors he called out.

Guidance yesterday reiterated that the cash rate will not be increased until actual inflation is sustainably within the 2% to 3%  range. Lowe does not see that as yet.

While it might take a little longer, ‘transitory’ is most likely correct and were it not for the Democrats being in power in the U.S., it’s likely Jerome Powell would also still be using what’s apparently become a dirty word.

Thankfully, the RBA did signal an end to bond buying after the final purchase is made on February 10.

In my book, it gets high marks for that (better late than never).

However, it won’t consider the issue of the reinvestment of proceeds from future bond maturities (i.e., whether it shrinks the balance sheet or maintains it by reinvesting) until its next meeting in May. So, the jury’s still out.

Jerome Powell said last week that the Fed’s decision to reduce (shrink) the Fed’s balance sheet would be guided by maximum employment and price stability goals and would be data driven.

He also said during question time with the Press that the first interest rate hike would be decided, and probably occur at the March 15-16 meeting. And there would need to be a couple of meetings after that before putting a balance sheet plan into effect.

That would mean a U.S. plan might not materialise until FOMC’s June meeting at the earliest and that in turn would mean that Governor Lowe and the RBA board will probably need to consider what they do with the RBA’s balance sheet before there is a plan to normalise the world’s reserve currency balance sheet.

So, it’s probably unlikely we will know anything until mid-year (a little later than Lowe is indicating) unless wage growth numbers over the next few months paint a vey clear picture.

If persistent wage inflation becomes entrenched, that would suggest an increase in the pace of interest rate normalisation.

But if not, low rates for a very long time, and potentially more monetary stimulus at least in the U.S., Europe, Japan and China, as has been the experience for many years.

What now?

Yesterday, all Australian treasury yields were down in the immediate aftermath of the statement, other than for 7 and 10 year yields which were flat. The dollar weakened before partially recovering and equities were up moderately.

All in all, not a bad scorecard and a pretty good ‘transitional’ decision in contrast to Powell’s recent fender bender.

It’s also likely that Governor Lowe is watching the increasingly dovish behaviour in China closely.

As I wrote recently, China is adding more accommodation due to declining growth, not withdrawing it. It can dismantle Evergrande and deal with other companies that need to ‘pay the Party’ through other means - which it is doing, so further accommodation can be pointed to areas where it is needed (and withdrawn from others)

Given the make up of the RBA board, Governor Lowe would also be well acquainted with what a moderating China looks like for some of Australia’s most important exporters. Not so good.

He would also have factored in the part that China’s COVID-zero policy is playing to extend the supply chain carnage and therefore expecting supply chain blockages to persist longer than expected.

And after some years of very slack prudential lending standards (until recently) he will no doubt be wanting to keep domestic rates low until well after Omicron has passed, and support a slightly lower AUD.

By design or not, yesterday’s policy move was supportive in dealing with the above factors.

In contrast, hiking rates now in the face of all of the above, particularly when inflation is so far supply-side in nature would have likely set up a COVID recovery train wreck for Australians.

So, good call on the nature of inflation, interest rates and RBA cash rate guidance.

And as for signalling an end to QE - he gets a 7 out of 10. I’ll reserve the final 3 marks until we see a plan that can credibly dredge the $640 billion swamp of over-liquidity, back to where it should be.

Bravo Governor Lowe.

The final part of this three part series will follow shortly.

Mike