Cliff Notes: US and European banking sector uncertainty to limit central bank actions
Key insights from the week that was.
The US banking system was in the spotlight this week, with fragility emerging amongst the regional banks, shocking global interest rate expectations. Domestically, data received was broadly in line with our views on the economy.
Beginning in Australia, the Westpac-MI Consumer Sentiment survey delivered yet another dismal update on confidence. That the headline index remained at 78.5 for a second consecutive month indicates sentiment is firmly entrenched in deeply pessimistic territory, a situation only comparable to the major economic dislocations observed during the 1980s-90s. With inflation and interest rates remaining the dominant concern for households, the survey reported a further weakening in expectations for family finances, intentions to purchase a major household item, and the medium-term economic outlook.
Most notable, however, was the sharp deterioration in homebuyer sentiment. The ‘time to buy a dwelling’ sub-index fell 11.1% in February to 65.7, the weakest reading since 1989 – an era where standard variable mortgage rates were in excess of 15%. Exacerbated by a curious lift in house price expectations (+8.6%), it seems price-led improvements in affordability are no longer providing a buffer to the severe impact of rising interest rates on housing market confidence. Despite recent softening, household’s views around the labour market remain broadly supportive, with expectations for unemployment still below the long-run average.
On employment, the February labour force survey reported an expected bounce-back in jobs as a larger-than-usual number of people who were waiting to start a new job – identified in the January survey – returned to work. The gains were evident across most areas of the survey: the 64.6k lift in employment growth more than reversing the 27.5k decline reported in the prior two months; the unemployment rate falling from 3.7% to 3.5% as a surge in full-time work saw the underemployment rate fall 0.4ppts to 5.8%; and accordingly, seasonally adjusted hours worked lifting by a substantial 3.9%. Taken together, it suggests that the labour market has begun the year on a firm footing; however, the outlook remains challenging, with slack to emerge in the labour market into the second half of 2023.
Into the longer-term, the recovery in immigration flows should provide some underlying support to the problem of labour unavailability. Indeed, according to official population data, the estimate for net overseas migration in Q3 2022 printed a record +106.2k for the quarter. This, in addition to the upward revisions for Q1 and Q2, aligns with our view that net overseas migration is set to print at a historic high in 2022. Looking at 2023, Australia’s overseas arrivals and departures data also continues to reflect substantial progress, with strong net inflows of temporary workers and a sizeable lift in international student arrivals, up +120k in February. From the removal of COVID-zero restrictions, the nascent strength in inflows from China is also becoming increasingly apparent, indicating that immigration will remain highly supportive of labour supply over the next few years.
Given the sustained pressures around business conditions, the fragility of business confidence re-emerged as a key issue in the latest NAB business survey. Indeed, the survey reports that high inflation and rising interest rates remain a clear drag on the strength of demand, as evinced by the continued cooling in forward orders growth and the downtrend in general business conditions. As a consequence of these mounting headwinds, the business confidence index declined by 10pts, and is once again reflective of a pessimistic business mood. With the domestic outlook gloomy, business confidence will struggle to earn significant reprieve over the period ahead.
Taking into consideration the sum of domestic conditions and the global uncertainties discussed below, we have changed our RBA view. As discussed by Chief Economist Bill Evans, we now expect a pause in April to be followed by a 25bp hike at the May meeting to 3.85% which we now expect will be the peak rate for this cycle. We continue to believe an extended pause will prove necessary into 2024 given inflation’s persistence after which 150bps of easing is expected, 25bps a quarter from Q1 2024 to 2.35% in Q2 2025.
Moving offshore, the closure of Silicon Valley Bank (SVB) last Friday shocked global financial markets given its significance to both the tech sector and the national economy. Signature Bank in New York was also closed within days, and a cascading crisis of confidence ensued. Mid-week, the threat of rapid outflows and a dramatic decline in its share price saw another regional bank, First Republic, downgraded to junk by both S&P and Fitch despite there being no known similarities with SVB or Signature, nor obvious concern regarding its business practices. This also occurred despite authorities’ swift action to guarantee the deposits of both SVB and Signature after they re-opened under the control of the FDIC. Overnight then, a combined effort by US banks and regulators was needed to sure up confidence in First Republic and the sector more broadly, banks across the country depositing a cumulative $30bn of deposits to show trust and provide liquidity.
Along with the measures already in place, this action should go a long way to restoring trust in the regional banks amongst households and businesses. However, the hit to broader confidence is likely to have a lasting impact on economic activity and employment, particularly given the economy has been growing below trend for a year and there are downside risks for the period ahead.
Inflation also remains a risk though. While core CPI inflation (ex food and energy) surprised to the upside in February at 0.5%, this was a result of shelter which contributed close to 0.3ppts by itself. For the policy outlook, this is not a concern as all leading indicators of rents point to an abrupt deceleration ahead. The remaining detail was also constructive for the medium-term. Goods inflation was negligible overall, and key sub-categories such as food witnessed to easing commodity and wage pressures – note, the latter was also evinced last Friday by the February nonfarm payrolls report where both hourly and weekly earnings decelerated, keeping real wage growth negative. Albeit volatile and still high versus history, on a multi-month basis, growth in the price of airfares is also in a downtrend. New car prices meanwhile were little changed and used car prices continue to fall. Incorporating this information into our forecasts, we continue to expect a return to near-target inflation in the second half of 2023.
So for the FOMC, while there is still cause to raise by 25bps next week, this is likely to be the last hike for the cycle, with the uncertainty around the banking sector to also tighten financial conditions. A lengthy pause is still expected into early-2024 however, as it will take time for inflation risks to fully subside. Over 2024 and 2025, we then expect the fed funds rate to be brought back near neutral, allowing growth to slowly accelerate back towards trend.
While the market currently has considerable doubts over the outlook for the FOMC given the uncertainties around US banks, the ECB’s decision to still raise by 50bps at their March meeting despite Credit Suisse’s woes and fears over the implications for the European financial system highlights that central banks have confidence and also like to keep their monetary and financial stability decision making separate. In the press conference that followed the Council’s decision, ECB President Lagarde made clear that the ECB and regulators stood ready to do what is necessary to avert any risk of crisis or disfunction in the banking system; but she also highlighted the need to make sure that risks to the welfare of the economy from inflation are dealt with. Without incorporating the effects of current developments, inflation was forecast by the ECB to come back to target in late-2025 even with growth above trend in both 2024 and 2025 (1.6%). As for the US, recent instability is likely to soften growth and dampen inflation, reducing the need for further policy action from the Governing Council. We now also only see one more hike of 25bps by the ECB at their next meeting, with policy to then remain on hold to 2024 before a progressive return to a neutral level by mid-2025.
Data from China this week was thankfully very constructive. Following the end of COVID-zero and despite the usual disruptions of lunar new year, fixed asset investment surprised to the upside, growing 5.5% year-to-date at February. This included a significant positive surprise for residential construction, fuelled by a return to growth for property sales, 3.5% year-to-date, and with confidence also aided by house price gains. The consumer was also shown to be in robust shape and willing to spend at February, retail sales gaining 3.5%. Together with the burgeoning trade opportunities apparent across Asia, these nascent domestic demand trends point to strong growth in 2023 and an ability to sustain growth near authorities’ 2023 target for a number of years to come.
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