Contrasting economic trends in Australia and the US

Principal Economist's View

 

This month has seen the Australian cash rate and the Australian 10-year bond yield fall below their US counterpart for the first time since 2000. In a large part, this is reflective of the relatively weaker cyclical performance of the Australian economy vis-à-vis the US and expectations that this trend will persist.

Let’s review the current state of both economies. The US economy has been recovering strongly, registering above-trend growth and pushing the unemployment rate below estimates of full employment. President Trump’s large tax cuts passed in late 2017 will also boost growth by around 30-40bps over 2018 and 2019, providing even more stimulus to the US economy.

With excess capacity in the US economy eliminated and the US government injecting further stimulus, the Federal Reserve will be forced to continue to tighten monetary policy over the coming few years to keep inflation close to target. We expect another two hikes by the US Federal Reserve over the remainder of 2018 and a further two hikes in 2019. The risks are the Fed may need to raise rates even quicker, with the median FOMC projection factoring in three hikes in 2019.

In contrast, the Australian economy is recovering more slowly than the US, with below-trend growth registered in 2017. Our expectations are for growth to improve to an around-trend pace of 2¾ per cent in 2018 and 2019. However, the Australian economy continues to face excess capacity, with our unemployment rate above estimates of full employment. Fiscal policy is also slowly being tightened in Australia, underpinned by the Government’s commitment to return to a balanced budget by 2020/21, in stark contrast to the situation in the US.

Australia’s slower cyclical recovery vis-à-vis the US, our current excess capacity (compared to excess demand) and fiscal tightening (vs fiscal easing), means that any monetary policy tightening by the RBA will be more gradual than the Fed. At this stage, we expect the RBA to raise rates once in the second half of 2018 and a further two hikes in 2019, although the risks are that the RBA may be tempted to wait even longer before starting to lift rates. Given this, our current forecasts are for Australian cash rates to remain below that of the US until late 2020.

However, we would not expect Australian 10-year government bond yields to remain below the US for anywhere near that long. The key reason is that Australia’s long-term growth trajectory is much more favourable than the US, reflecting our relatively stronger population growth outlook. As interest rates are very closely linked to economic growth, Australian cash rates will tend to eclipse their US counterpart in the long-run. 10-year government bond yields, which factor in likely cash rate outlooks 10 years into the future, will therefore also be higher in Australia than the US in the long-run.

One of the mechanisms that tends to keep Australian interest rates above the US is the Australian dollar (AUD). During periods of cyclical weakness, the freely-floating AUD will tend to depreciate sharply, supporting our growth and inflation outlook. This then limits the extent of monetary policy easing required by the RBA, with the currency delivering much of the needed stimulus to the economy. 

However, for the past two years, the AUD has been trading in a relatively narrow band. If anything, the AUD has trended slightly higher against the US dollar despite Australia’s relatively weaker economic position. In our view, this trend will not persist and the AUD should fall over the coming year, reflecting the deteriorating interest rate differentials and a modest pull-back in commodity prices. This fall in the AUD will help push the economic cycle in Australia and the US into closer alignment.

Once it becomes increasingly apparent that the recovery in the Australian economy is gaining traction and core inflation is back in the RBA’s target range, we would expect Australian bond yields to once again rise above those in the US. However, this is most likely still 6-12 months away, or possibly more should the AUD continue to remain surprisingly resilient.

Table 1: Financial market movements, 22 – 28 March 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,605.0

-1.5%

US

2.78%

-4.4 bps

US Dollar Index (DXY)

90.06

0.2%

Nikkei 225

21,031.3

-2.6%

Japan

0.04%

0.1 bps

USD-JPY

106.85

1.5%

FTSE 100

7,044.7

1.3%

UK

1.37%

-7.4 bps

GBP-USD

1.408

-0.1%

DAX

11,940.7

-1.3%

Germany

0.50%

-2.6 bps

EUR-USD

1.231

0.0%

S&P/ASX 200

5,789.5

-2.5%

Australia

2.59%

-11.1 bps

AUD-USD

0.766

-0.4%

Source: Bloomberg

 

To read the full report, including the Economic update by region, click here.

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