The hikes are coming, but not quite there yet: HSBC
GUEST OBSERVER
At last, the official labour force survey is starting to line up with other labour market measures, such as job advertisements and business surveys.
For quite some time we have argued that the divergence had largely reflected measurement issues in the official survey.
Stronger official prints in recent months means that the indicators are now all showing a tightening labour market.
The positive momentum is also consistent with the view emanating from the business surveys.
The NAB survey showed business conditions and capacity utilisation around decade highs in May.
This is happening despite weak real GDP numbers for 1Q.
The GDP print, which was published in early June, showed growth of 0.3% q-o-q and 1.7% y-o-y.
However, as we noted last month, we think most of the weakness reflects the impact of Cyclone Debbie and unusually wet weather on the east Coast.
Despite weak real GDP, nominal GDP rose by a strong 7.7% y-o-y, which is its fastest rate in over five years.
Nominal growth has been boosted by the rise in commodity prices, although there are also some signs that the nominal lift has moved beyond just a mining story.
Corporate profits have also picked up in a broad range of non-mining sectors.
However, as yet, we have not seen a pick-up in wages growth.
Although there are signs that wages growth has stabilised, it is still running at multi-decade lows.
Nonetheless, we expect wages growth to pick-up in 2H17 supported by a number of factors.
First, corporate profits growth is strong and historically this leads to a rise in wages growth.
Second, the labour market is tightening, and even though the link between wages and jobs market conditions may be weaker than in the past we still expect some traction.
Third, the minimum wage was lifted by more this year than last year, which we expect could add 0.2-0.3ppts to wages growth.
The lift in wages growth should support a gradual rise in underlying inflation.
Once the RBA sees clear evidence of a lift in wages growth, we expect that a hike will not be too far away.
On fixed income strategy, expect front-end risk premium to rise as the RBA would like to remove accommodative policy if/when the data allows, similar to other central banks.
As we pointed out last month, ahead of the 1Q national accounts, Cyclone Debbie and wet weather on the east Coast were expected to hold back first quarter GDP growth and indeed they did (Chart 1).
Exports fell, partly due to a fall in coal exports out of Queensland, retail sales were held back and housing construction also declined in the first quarter.
Much of this disruption is likely to be temporary.
Coal exports and retail sales have already bounced back and there is still a considerable pipeline of work yet to be done on apartments in major cities.
We expect modest growth in 2Q, as the cyclone effect continued into April, and then a strong bounce back in 2H.
Although real GDP was weak in the first quarter, nominal GDP rose at its fastest pace in over five years, particularly supported by higher commodity prices (Chart 2).
Measures that are better at abstracting from the impact of weather, such as business surveys and the labour market numbers, are also showing that underlying economic conditions are improving, rather than deteriorating.
Indeed, the NAB survey shows that business conditions and capacity utilisation are around decade-highs (Chart 3 and 4).
The improvement in surveyed business conditions is consistent with a strong recent lift in profits.
Although part of this reflects the effect of higher commodity prices on the mining industry, with mining profits up 113% y-o-y, non-mining profits have also lifted by a strong 17% y-o-y.
The jobs numbers suggest the labour market is tightening rather than loosening.
Given measurement issues in the official survey we have, for some time, been putting more emphasis on other measures of the labour market, such as the job advertisements and business surveys.
To keep track, we constructed a labour market index, which has shown a trend improvement in the jobs market, unlike the official survey (Chart 5).
However, the official numbers are now starting to come back into line.
A strong lift in the official jobs growth numbers in the past three months drove the unemployment rate down to 5.5% in May, which is its lowest level since 2013 (Chart 6).
The official numbers also showed a sharp jump in hours worked in May, which has brought the trend growth in hours worked back into line with the employment numbers (Chart 7).
A key question for the RBA is: when will the tightening in the labour market start to translate into a pick-up in wages growth?
The main indicators are showing signs that wage growth has stabilised, but there are few signs of a pick-up at this stage.
Many other countries are also grappling with the fact that labour markets have tightened, but wages growth has not yet lifted.
Our central case is that local wages growth will gradually pick-up in the second half of 2017.
Our view has largely been formed around the idea that there is a strong historical positive correlation between the terms of trade (mostly driven by commodity prices) and unit labour costs in Australia.
Typically, when commodity prices rise and support a pick-up in nominal GDP, some part of this boost to incomes ends up in wages growth.
Although it could be argued that the lift in commodity prices will have less effect this time around, as there is unlikely to be another mining investment boom, it is also worth keeping in mind that profits are also rising in the non-mining industries (Chart 8).
As the chart shows, there is also a strong positive correlation between non-mining profits and wages growth.
The recent lift in the minimum wage also supports our view.
The Fair Work Commission announced a 3.3% rise in the minimum wage from 1 July 2017, which is larger than the 2.4% rise announced last year.
This decision directly affects around one-quarter of all workers and can also form the benchmark for other enterprise bargaining agreements.
We expect the decision to lift wages growth by 0.2-0.3ppts.
The improvement in the local labour market and business conditions as well as improving global economic conditions and a recent shift in rhetoric at other central banks will all act to re-affirm the RBA’s view that it will not need to cut the cash rate further.
Although the RBA’s commentary has suggested that the leverage-fuelled housing market boom had been the key reason that it is not considering further cuts, improvements in the local and global macro-economy over recent months would further bolster the central bank’s resolve.
The RBA will also be keenly aware that central banks have gradually been turning more hawkish in recent weeks.
The Federal Reserve has clearly suggested that it will begin to reduce its balance sheet soon and that it intends to continue to lift its policy rate.
The ECB has given stronger hints that it may reduce its quantitative easing program soon.
There is debate at the Bank of England, amongst the MPC members, about the possibility of a rate hike.
Officials from the Bank of Canada and Norges Bank have turned more hawkish in recent weeks.
We do not expect the RBA to introduce any explicit forward-guidance in its policy statement, although the tone of the commentary may very well be a little more upbeat than previously, particularly on the local labour market.
We expect the RBA to point to forthcoming CPI numbers as the next key release to watch.
In our view, once the RBA has clear signs that wages growth is past its trough it will not be long before it will seek to move towards a more normal cash rate setting.
Our central case is for a hike in 1Q18 (not quite yet, but sooner than the market is currently pricing).
A growing theme in developed market central bank communication has been a boldness in signalling the removal of accommodative monetary policy, with softening headline inflation and weak wage growth downplayed.
The Bank of Canada’s recent communication shift was particularly interesting given that Canada shares many similar macro attributes with Australia, meaning they tend to be cyclically synchronised.
That front-end pricing has moved to opposite extremes presents an attractive cross-market opportunity, in our view.
Even if the RBA is not the “next cab off the rank”, we believe the risk-reward favours positioning for higher AUD front-end risk premium.
Current OIS implies a broadly flat path for the cash rate over the next 12 months, while only Japan and Switzerland have a lower spread between 2Y IRS and the 3m fixing among the G10 countries.
Yet, the RBA has set a very high bar for cuts and we suspect the central bank has a strong desire to remove its accommodative policy if/when the data allows.
Recent tightening of the labour market (the unemployment rate fell to 5.5% in May – the lowest since 2013) should embolden the hawks.
Paul Bloxham is the Chief Economist for HSBC and Daniel Smith is the Economist for HSBC. They can be contacted here.
