The Australian economy in 2017: the great unknown

We head into Tuesday’s Reserve Bank of Australia (RBA) meeting knowing that it is a near certainty that we will not see a rate cut, with the general tone of recent commentary from central bankers reasonably upbeat.

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Source: Bloomberg

For the first time since November 2014 interest rate expectations are perfectly neutral.

The market is craving a catalyst, but that won’t emerge overnight and for the RBA to even think about further easing or even tighter policy further down the line, a trend needs to develop that forces their hand.

There are a number of key themes the RBA are focused on and for traders, investors and economists, the monetary policy statement will give us further insight on exactly how they see the world. Any view on the future direction of commodities, especially bulks is important, given the correlation between iron ore and AUD/USD. If the current level of iron ore, steel and coking coal can be maintained, then this should be reflected in a boost to the national accounts in 2017 and will remain a tailwind for the economy. However, while higher terms of trade will boost revenue, we can’t get too excited about investment just yet. We recently heard from RBA Assistant Christopher Kent about his concerns about the mining downturn and the impact that is having on parts of the Western Australia and Queensland economy.

All eyes on the housing market in 2017

Housing will be a huge factor in the fate of the Australian economy through 2017. Recent data detailed a 3.1% QoQ decline in residential construction, which is hardly inspiring, although house prices are strong and auction clearance rates (in apartment and houses) are upbeat. The recent RBA November minutes surmised these dynamics well, detailing that “assessing conditions in the housing market had become more complicated”. We have also recently seen a number of domestic banks lift their fixed-rate mortgages in line with the increase (or sell-off) in longer-dated Australian bond yields. There seems little doubt that, if inflation expectations continue to rise in most developed markets (including Australia), then domestic banks will have to increase rates further, or face huge headwinds to net interest margins.

Wages are also a key concern for the RBA, especially if inflation does push back into the RBA’s 2-3% target band and house prices head lower. If not accompanied by wage growth, an increase in mortgage repayments would represent a tightening of financial conditions at a household level and that would be a toxic mix for the RBA that a further cut in interest rates would not solve. We recently saw wage inflation at a record low of 1.9% and the RBA have flagged this as a concern on a number of occasions.

So for short-term traders, now is really not the time to be thinking about changes in monetary policy (from the RBA), but that question should become more pertinent in 2017. The debate in 2016 has really been around how low interest rates can go, but I think this debate will shift, with economists divided on whether rates go down from here or whether the pick-up in global inflationary forces actually spills over into Australia and we start talking about hikes in late 2017, early 2018. It seems logical that the clarity to help answer that debate lies in employment trends, commodity prices, house prices and construction, and ultimately where developed market bond yields are headed. A rise in bond yields, if not accompanied by wage increases, could be a strong negative for the Australian economy.

Watch Q3 GDP print

This Wednesday we get the Q3 GDP print, with the consensus estimate of 0.4% growth QoQ (2.7% annualised). With weakness seen in the Q3 business investment report, there could be downside risks to this print, but we still get inventories, company operating profits and net exports as a percentage of GDP in the lead up to the GDP data. Keep in mind in the range in estimates varies from -0.3% to +0.7% so economists have a wide range of views. Morgan Stanley is calling for the Australian GDP to decline 0.3%. If this comes to fruition, it would be the fourth decline in the last 100 quarters. One for the radar.

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