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Friday, November 14, 2008

"With real interest rates falling to zero - let's party"

So says Adam Carr at ICAP Securities -

"Key points:

. Australia typically has not had a recession unless we’ve had to deal with a housing inventory overhang (such as in the US currently) or a business investment glut. We’ve had neither.

. There is a structural housing underbuild and most business investment is geared toward mining. Resource sector gearing is low.

. In past recessions, policy ineptitude played a large part in driving the economy into recession. This time round both monetary and fiscal policy have worked hard and fast to forestall the worst.

. Importantly the real cash rate is currently close to zero. It has rarely been lower.

. Yes home lending has been weak and house prices have fallen, but that’s in response to the discount variable mortgage rate piping 9% and a real mortgage rate of over 5%.

. The credit crisis has blunted the usual transmission mechanism and credit has tightened. That said, it hasn’t frozen up - business credit growth is still robust overall. Further, compared to the cost of funding, mortgage rates remain high and so should continue to fall. Already the discount variable rate is 7% and 3yr fixed rates are about 6.9% (both lowest since mid-2006). The real mortgage rate is about 2% - home lending is set to accelerate.

. As spreads normalise we should see the variable mortgage rate approach 5.25% (lowest since 1965) if the cash rate hits 3.5% or 6.25% (lowest since 2002) if cash only hits 4.5%. Either way a great environment to gear-up.

. House prices tend to respond to free money by rising – so do stocks. This should stimulate housing construction activity and buttress household wealth. Both of which also argue against a recession.

. A modestly rising unemployment rate should prove no obstacle – in 2003 when house prices peaked, the unemployment rate averaged 6.2%.
So I reckon Q308 to Q109 will be a period of ongoing consolidation and household balance sheet repair. House prices will probably continue to fall in Q3 and Q4 and then pick-up in Q109.

. Global growth is still a big swing factor – if it completely capitulates then clearly the above analysis changes – the unemployment rate will surge. Ain’t no-one going to borrow if we’re headed for a depression. So this is what we have to track to see whether I’m on the right path – but barring Armageddon, I reckon things don’t look disastrous for Australia.

. The point is a zero real cash rate is a rare event – it should stimulate domestic demand sufficiently so that we avoid recession – the 90-94% of those still in jobs will probably never have it so good again...


It’s a brave call not to be pessimistic in this environment – analysts appear to be falling over themselves in the bearish stakes and while the news flow is undoubtedly bad, I think looking into next year there are some good reasons to be feeling comparatively optimistic about things.

Recent data and market pricing suggest that another aggressive easing is in store in December and for a betting man that’s the way to go. I reckon we’ll get at least 50bp given the fall in business confidence. But let’s face it, literally anything could happen and I don’t think it pays to get to into an in-depth about 50 or 75 or whatever – the RBA likes surprises. Point is, rates are coming down and looking beyond the next meeting IB futures are pricing in a 3.5% cash rate by February and 3% by June.

As much as I want to see rates go down to 3.0% - I don’t think they will and I certainly don’t think they should. I do think they’ll get to 4.5% though as there is no way the RBA will risk tarnishing is reputation by allowing the economy to fall into recession. Either way – my pick is the RBA will be hiking well before the 2009 year is out, maybe even as early as Q3. Don’t roll your eyes – hear me out, I know uncertainty is high but there are some very good reasons to believe next year will be party time – for those with jobs.

First things first. It’s not impossible but I don’t think it’s probable that the Australian economy is headed for recession – the key will be the next two quarters (Q4 and Q1) – but if we don’t go into to recession then - I reckon we can rest easy.

For a start, history has shown that you don’t get a recession in Australia unless we have one of either a housing inventory overhang or a business investment glut. We’ve had neither. There is no doubting that both of these sectors are set to post sluggish growth in the near-term– yet I don’t think the stars are aligned for a complete collapse in activity sufficient to throw the economy into recession.

At the very least and as Ken Henry pointed out - the behaviour of policy has been markedly different this time around. Monetary policy or general macro policy ineptitude/incompetence has played a big part in past recessionary processes - the difference this time being that the RBA recognised its earlier mistake and reversed course.

That done, take the business investment backdrop. Most of it over the last 3 years was geared toward the mining sector – all of it according to some statistics. No doubt some plans will be shelved, but if all the clap-trap about capacity constraints etc was even remotely true you have to assume resource firms would be planning for the inevitable upturn and won’t pull back too much – the BRICs still need to develop etc at some stage right? In any case, investment is unlikely to fall to the extent that that we’ve seen in past recessionary periods anyway. This is especially so because corporate balance sheets are reasonably healthy and particularly in the resource sector.

As for the housing sector. Well, as we all know, there is a structural underbuild in Australian housing. While not likely to rebound in the near-term the pre-conditions are building for a rebound in 2009.

Credit turmoil aside, the pivot point is/was the outlook for house prices. This is because falling house prices aren’t exactly conducive to borrowing or building – not to mention the wealth impact on households. So like most people I had to change my pants when I saw that 1.8% fall in house prices for the June quarter and I started thinking that a recession wasn’t that ridiculous.

Yet, there is every reason to be optimistic that we’ll see a trough in prices soon, perhaps in Q3 or Q4 which should put a floor under the housing market.

I mean we have to face facts. There is an enormous amount of policy stimulus already… and with more to come? Most importantly - the real domestic cash rate is and will probably remain close to zero well into next year (according to the curve and official inflation forecasts).

Think about that for a minute – money will be practically free. It is negative in the world’s major economies and the world is flushed with cash. Low real cash rates do amazing things for house prices as the below chart shows (note that the house price scale is inverted).

Now I’m not talking in the immediate future given credit conditions, but certainly for next year things have got to be looking better. Just sit back and think about it for a minute. Who among you isn’t salivating at the prospect of another 100bp to 200bp or even 75bp coming off their mortgage rate. I go to BBQ’s and everyone is talking about either taking out a margin loan or looking to buy property next year – just waiting biding their time.

Yes home lending has been weak and house prices have fallen, but that’s in response to the discount variable mortgage rate piping 9% and a real mortgage rate of over 5%.

Already though, the discounted variable rate is around 7% (lowest since July 2006 and 3yr fixed rates are under that again at 6.9% (lowest since April 2006) when the cash rate was 5.75%. Let’s take the market at face value. At 3.5% and at current spreads we’d get a discount variable mortgage rate of 5.25%. Even at a cash rate of 4.5% you’d get a 6.25% rate. If that hasn’t got you quivering with excitement nothing will. Yes the standard variable mortgage rate is still high at 8.36% about the same as it was in Dec 2007. Yet using the standard discount rate of around 7% gives a real mortgage rate of about 2% - below what it was in 2006.

In any case, over the next few months mortgage rates should fall further regardless of what the RBA does. Sure spreads remain high and I’m not suggesting that they’ll come down tomorrow or next week. They’re trending down though – and the absolute cost of funding has dropped sharply – 3m BBSW is at 4.75% - you’ve got to go back to 2003 to see a rate like that.

So the std variable mortgage rate should fall sharply and soon – the 3yr fixed rate already has my friends. There may be some short-term commercial reasons for the std variable spread to bbsw being so wide - but its looking a bit over the top and you’d have to think it will come in soon.

A sceptic might say that the unemployment rate is set to rise. Sure this could prove to be a dampening factor and in our industry it maybe a little too close to home. I don’t reckon it’ll prove too much of one. Remember what happened after the brief slowdown we had in 2000/01. The RBA cut rates by 200bp in that year, God bless them, setting the stage for what was to become a massive house price bubble. House prices peaked in 2003 and that was with an unemployment rate averaging just under 6%! In fact, between June 2002 and June 2003 when the unemployment rate averaged 6.2%, house prices rose on average by 4.5% per quarter. Some stats for the background – the standard variable mortgage rate was 6.55%, the real cash rate averaged 1.7% and the 3yr fixed rate averaged 6.3%.

So I reckon the next few quarters (Q308 to Q109) will be a period of consolidation and household balance sheet repair. As rates continue to come down it’s game on and it will probably present the best opportunity to gear up in some time. The downside is that the RBA will probably be hiking rates in 2009 – perhaps as early as Q309.

Global growth is still a big swing factor – if it completely capitulates then clearly the above analysis changes – the unemployment rate will surge. Ain’t no-one going to borrow if we’re headed for a depression. So this is what we have to track to see whether I’m on the right path – but barring Armageddon I reckon things don’t look disastrous for Australia though growth will slow sharply to 1.6% or 2% or whatever. The point is a zero real cash rate is a rare event – it should stimulate domestic demand sufficiently so that we avoid recession – the 90-94% of those still in jobs will probably never have it so good again."