Economic Update – Summer 2021
Globally, central banks have been moving towards tighter monetary policy over the last few months. Central banks in Norway, New Zealand and South Korea have raised interest rates, the Bank of Canada has ended quantitative easing and brought forward its expected first rate hike, the Bank of England looks likely to start raising interest rates soon, and several emerging market central banks have raised rates.
And in Australia, the RBA has now ended its 0.1% yield target for the April 2024 bond (which had helped keep 2 and 3-year fixed mortgage rates around 2%) and implicitly brought forward its guidance on the first rate hike to late 2023 (previously this was not expected to be “before 2024”).
Missing in this are the Bank of Japan and European Central Bank that both show little sign of moving towards monetary tightening reflecting their history of lower inflation rates.
What’s driving central banks to more hawkishness?
The move to the exits from easy money reflects three key developments:
- First inflation has risen sharply in numerous countries.
- Second, economies have been recovering with coronavirus outbreaks having smaller impacts on economic activity. And in Australia recovery now looks to be back on track after the recent east coast lockdowns.
- Thirdly, there is increasing confidence that coronavirus is (gradually) coming under control
So, in short, the need for emergency ultra-easy monetary conditions is receding.
The removal of monetary stimulus is a sign of recovery
- Central banks are reflecting the reality of economic recovery, so, it’s really a vote of confidence in recovery. And the reduction in monetary stimulus is being offset for share markets by stronger profits. This can be seen in the current US profit reporting season which has seen 82% of companies beat expectations by an average of around 10%.
- Monetary policy remains ultra-easy and is a long way from being tight.
- Even if the first rate hikes from the Fed and RBA are sooner than we anticipate, the experience of the last 30 years suggests an initial dip in shares around the first rate hike but then the bull market resumes – and continues until rates become onerously tight which weighs on economic activity and profits.
The main risk is supply constraints
Of course, the main risk is that this time is different due to supply constraints resulting in much higher for longer inflation necessitating aggressive monetary policy tightening over the next six to 12 months. The most likely scenario is that, as workers return to work with reopening (and backpackers and immigrants return to Australia) and consumer demand swings from goods back to services with reopening, goods supply bottlenecks will start to recede allowing the spike in inflation to recede later next year. Of course, this could take 6 to 12 months to work itself through, but it should ultimately delay the need for an aggressive tightening in monetary policy.
The key implications for major asset classes are as follows:
- For fixed income, monetary tightening initially means higher bond yields and so is negative for this asset class. Only when monetary policy becomes tight, seriously threatening economic growth, will long term bonds decline significantly.
- For shares monetary tightening usually means slower more volatile returns but (absent external shocks) new bear markets usually only commence when monetary policies become tight and we are a long way from that.
- Interest rates are shifting from a tailwind to a headwind for Australian housing demand. Property demand tends to be more geared than demand for shares leaving the property market sensitive to interest rate moves. And fixed rates have played a bigger role lately, so rising fixed rates combined with higher serviceability buffers are likely to slow price gains further into next year ahead of likely price falls in 2023 as the RBA starts hiking.