Weekend Economist: A telling tale

Over the last six months, the difference between Australia’s long and short-term interest rates has narrowed. That would typically be attributed to a tightening monetary policy stance -- but here it's a little different.

Last year we launched a redesigned version of the Westpac-MI Leading Index that was first calculated back in the late '60s. 

The new version incorporates a range of variables that are designed to capture the following forces in the economy: housing (dwelling approvals); the consumer (Westpac-MI Index of consumer sentiment, expectations component, and the Westpac-MI Index of Employment Expectations); the labour market (aggregate hours worked); global conditions (US industrial production); and financial markets (S&P/ASX 200; Reserve Bank commodity prices in AUD; yield spread).  

Compared to the previous index the redesigned Leading Index has considerable appeal because the components are all monthly series that are hardly ever revised. Readings are also timelier -- published a month earlier than the old measure -- with analysis showing the revised Index is also a little quicker to detect turning  points in the business cycle.

Note that there are still limitations. The Index is designed to provide an indication of the likely pace of economic growth over the next three to nine months. In effect the 'model' is fitted to overall GDP growth. Inevitably this means that it, like any model, will have difficulties when there is a major change in the way GDP growth operates.

The mining investment cycle we are seeing in Australia is arguably an example of that sort of change. Although the Leading Index components still capture some of the drivers (commodity prices) and effects of this cycle it will likely struggle to predict the magnitude and timing of associated growth variations due to the long lags on mining investment projects and the 'lumpiness' of investment in the sector (due to both the 'bunching'  of projects and their very large size).

Having said that our experience with the new Leading Index over the last year or so is revealing some interesting insights into the growth outlook. Consider the movement in July. The benchmark measure -- the six-month annualised deviation from trend growth rate -- increased to -- 0.65 per cent in July from -0.73 per cent in June. Although it improved a  little, this is the sixth straight month that it has been below trend,  indicating that growth in the Australian economy is likely to stay  sub-trend over the second half of 2014 and into 2015. That is consistent with the RBA's revised forecasts in its August Statement on Monetary Policy.

Our analysis indicates that these  imply a forecast annualised growth pace of around 2 per cent for the  second half of 2014, lifting to a 3 per cent pace in the first half of 2015 (better but still below trend). Westpac is more optimistic around the growth outlook than the Reserve Bank but our near term view is also broadly consistent with the signal from the Leading Index. We expect below trend growth in the second half of 2014 but at a 2.75 per cent annualised pace rather than the 2 per cent implied by the Reserve Bank.

In particular, we  are expecting the pace of consumer spending in the second half  to lift from 2 per cent (annualised) in the first half of 2014 to 3 per cent in the  second half. That more positive consumer outlook is expected to strengthen further in the first half of 2015, helping to lift growth momentum in the broader economy to a 3.5 per cent annualised pace (a more upbeat view than that implied by the Leading Index).

The Leading Index components provide some further insights.  While the Index growth rate has been consistently below trend over  the last six months, there have been some notable shifts in the  components driving that below-trend pace. When the Index growth rate first dropped below trend in February (–0.09 per cent), the key drivers were: the Westpac -MI Consumer Sentiment Expectations index (–0.35ppts) and the Westpac MI Unemployment Expectations index (–0.24ppts).

Offsetting those negatives were dwelling approvals ( 0.30ppts); US industrial production ( 0.21ppts) and the yield spread (0.12ppts).  Commodity prices, the S&P/ASX200, and hours worked had a negligible impact.  In July the growth rate in the Index has fallen further below trend to –0.65 per cent. However, the major contributors now are: commodity prices (–0.69ppts); the yield spread (–0.32ppts); and aggregate hours worked (–0.17ppts). Offsetting those drags are US industrial production ( 0.36ppts) and the S&P/ASX200 (0.18ppts).

Overall though, the main drag on momentum has shifted from the consumer to commodity prices and the yield spread.  As discussed above and elsewhere, our view on the consumer is more positive although sentiment will remain vulnerable near term given the heightened sensitivity to political developments.  Similarly, we expect commodity prices to broadly stabilise by the end of the year, although there will be some more weakness near term (prices in AUD terms will likely be down again for the month of August).

The changed contribution from the yield spread is a particularly interesting sub-plot. The yield spread is probably the most esoteric of the Index components. Although it’s commonly used as a lead indicator, particularly in the US but also in Australia, the yield spread or yield gap is a metric that's likely to be unfamiliar to many. It is the difference between long and short term interest rates -- in this case the 10-year government bond yield minus the 90 day bank bill rate. It can be thought of as the 'slope' of the interest rate curve where a positive is upward-sloping (long rates higher than short rates) and vice versa.  

While there are many forces affecting both long and short rates, the slope of the curve typically corresponds to the expected impact of monetary conditions on the economy, i.e. the stance of policy. A positive spread implies positive expectations for the economy (both growth but also higher inflation) and expansionary policy settings.  A 'negative' spread can be thought of as expectations for slowing growth and contractionary monetary conditions. Shifts along this continuum imply shifts between tighter and easier monetary conditions.

Over the last six months, the yield spread has narrowed from 139bps to 87bps has seen, a 52 bps narrowing (although notably the spread remains positive, i.e. stimulatory). That move has come from declining long term rates and stable short term rates. Over the last six months the Australian 10-year government bond rate has fallen 49 bps from 4.00 per cent to 3.51 per cent, while the 90 day bank bill rate has been virtually unchanged.  

Typically this would be interpreted as a tightening in the stance of monetary policy. However, the yield curve story in Australia reflects both domestic and international developments -- long rates in particular tend to be more influenced by developments abroad.  We can determine how much of the move is from offshore by benchmarking to the US. Over the same period US 10-year government bond rate has declined 9 bps. That means 40 bps of 49 bps fall Australian government bond yields is due to a narrowing in the spread between Australian and US bonds.  So the majority of the move is specific to Australia. Hence it does seem to reflect a shift in the domestic growth outlook and the implied stance of monetary policy.

One way to view this is that the long end of the curve has moved to reflect a weaker outlook but the short end has not. That may be due to the high 'hurdle' the RBA is putting on further rate cuts.  Consider this exchange from the RBA Governor's appearance  before the House of Representatives Standing Committee on  Economics this week: in response to a question about whether  the bank had a 'Plan B' if the hoped-for pick up in non-mining  investment were not to come through:  "... you cannot make people be confident; I certainly cannot make  them. It is not that I am unwilling to consider lower rates, even than these, if that really would be helpful. That is the question we would have to ask: how much help would it give versus what risks it would bring? And that is the question we would ask each month. So it is not an unwillingness there, but it is just a sense that, you know, I do not really think interest rates are the answer, really, just at the moment. That could change if something else happens. But I do not think, to the extent that the economy has some ailments, that it is because interest rates are punishingly high. I think we need this environment where there is more confidence to move ahead. I cannot make that happen. I have allowed the horse to come to the water of cheap funding. I cannot make it drink."

 We do not expect to see the Reserve Bank changing rates anytime soon. That is because we recognise the bank's high hurdle to cutting rates in the near term. Further out we expect that the growth profile for Australia will gather considerably more pace than is expected by the RBA and, arguably, the yield curve.  Accordingly we continue to expect the next move in rates will be a tightening but not until the second half of 2015, with August currently pencilled in for the date of the first move. 

Bill Evans is Westpac Banking Corporation's chief economist. 

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