Delta variant to bring out the doves?

As the economy continued to track a “better than forecast trajectory we previously set out our view that the RBA would not be rolling over the YCC target to the Nov 2024 bond, but would be undertaking a 3^rd round of bond buying, reviewing the QE programme to opt for a more flexible open-ended approach. Maintaining the current pace of buying A$5bn/week at this stage but reviewing the programme on a quarterly basis in light of economic outcomes.

In light of the recent virus outbreak and subsequent tightening of restrictions we do not see any changes to the above. Though current circumstances are likely to see the RBA leaning more dovish with respect to accompanying commentary and Lowe’s speech, pushing back on market pricing with respect to pre-2024 rate hikes.

Prior to the latest lockdowns, the economy had continued to track a far better trajectory than forecast. In the labour market momentum has strengthened and both business and consumer confidence are buoyant. Showcasing the Australian recovery and supporting the outlook for near term growth, providing vaccine penetration is increased and a path to normalisation is laid. The botched vaccine rollout clearly remains a risk factor here. 

As we have outlined prior, Positive trends have emerged, underemployment is at the lowest level in 7 years and limited migration is promoting skills shortages giving rise to a tighter labour market and the potential for wages growth. With a continued decline in underemployment (measure of labour market slack that typically accounts for most of the weakness in wage growth, rather than unemployment itself) and emergent skills shortages with closed international borders cutting off migrant workers, there is evidence that wages are turning a corner and could soon accelerate. In addition, job ads continue to point to ongoing strengthening momentum within the labour market, promoting continued upside relative to forecast trajectories, with unemployment likely continuing to decline in the coming months, increasing the probability sooner than expected rate hikes.

Despite these positive trends emerging, the decline in labour market slack required to promote sustained wages growth in the order of 3% (a level Lowe touts at which inflation may sustained within target) remains an unknown. Don’t forget to see wages growth around 3-3.5%, the RBA has forecast that unemployment should be tracking toward 4% (but this could be lower) – the last time unemployment was around these levels was 2008.

I.e., A 4.5% headline unemployment rate may be within reach, but will it be enough to engender sustained wages growth in the order of 3%. While the economy continues to track a stronger economic trajectory than forecast the reality is the inflation environment in Australia is weak, the RBA is no longer pre-emptive, and the market may well have gotten ahead of itself in pricing tightening. Once international borders reopen, the resumption of migrant flows will promote renewed downward pressure on wages, remaining a risk factor to current dynamics and sustained wages growth. And Governor Lowe has stressed the RBA’s more reactive policy stance/inflation-targeting regime now requires actual, not forecast, inflation to be within the 2-3% target band before raising rates.

This means the RBA’s targets are still a long way off and many uncertainties remain, which in current circumstances should see Lowe leaning dovish and pushing back on market pricing, whilst simultaneously allowing for some flexibility by not rolling the 3-year target.

At present, the economy is far from full employment or full capacity, significant labour market slack remains, promoting weakness in wages and limiting upside inflationary pressures. In light of this focus remains on the RBA’s ongoing challenge to meet mandated price targets, achieving their goal of a tighter labour market, wages growth and hence inflation - alongside this their ability to wind back accommodative policy settings.

Recent events in Australia have offered a stark reminder that the health crisis is not over, vaccine penetration is low, and winter is around the corner as the nation struggles to contain a spread of the Delta coronavirus variant, which is likely to reduce the emphasis on allowing for upside outcomes – albeit still within the context of the next round of QE being open ended and not rolling the 3-year target. Although the recovery seen to date in both the labour market and the economy has been full steam ahead and debatably world leading, there is still a lot of noise and the trajectory will not be linear.

In real terms this will likely bear out as the RBA not opting to roll the YCC to Nov 24 bond, while extending QE as a flexible and open-ended bond purchase programme, for now maintaining the current pace of A$5bn per week. Avoiding unwanted upward pressure on the exchange rate, and stunting policy transmission via the exchange rate channel will also be top of mind. Expect Lowe to lean dovish to take any hawkish interpretations out of the move.

Were the RBA to roll the YCC reference tenor to the November 2024 bond, this would signal that the bank does not expect inflation to be sustainably back between their 2-3% target until late 2024, and correspondingly lift rates until late 2024/2025. Thus, losing the flexibility of any upside tail risks if the economy were to continue tracking a more favourable recovery trajectory. Even in light of current events, this would seem amiss. Though clearly the risk headed into the meeting with economists and strategists almost unanimous on this front is that the Delta variant brings out the doves, and the RBA opt to roll to the November 2024 bond (low likelihood). To date the economy has suffered less than feared and recovered better than expected – it seems prudent to at least allow for upside, whilst simultaneously keeping their foot on the gas.