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Downside surprise to dispel insouciance while encouraging another rate cut

by Dr. Stephen Nash | May 01, 2013


Asset allocation should be designed to provide stable investment returns and not be moved around all the time. However, sometimes the market tells you, as the song goes, “the times, they are a changing”, and adjustments to asset allocations appear well founded at certain points in time.

We are currently at such a point in time.

Recent economic data from Europe (which included low inflation figures) fell short of market expectations and it appears growth estimates will be cut dramatically, which that will drive out a insouciance about what is now a very, challenging time ahead for Europe. Meanwhile, in the US, a similar series of weaker than expected data releases (though not yet as severely negative as Europe) has already been observed. We anticipate that what has occurred in Europe is soon to occur in the US, so that a correction to the recent optimistic view of markets is upon us. Indeed, we argue that the bond market has already begun to build these expectations in; the fall in government bond yields has already begun. Applying these insights to domestic monetary policy, we argue that emergent concerns of the RBA, regarding the housing market, should soon be swept aside in the context of lower government spending via a tight Federal Budget.

In this article we explain these arguments in the following three parts:

  1. European data releases are reviewed, in terms of how they have met expectations, or how they have “surprised” the market.
  2. Historic movements in equities and bonds in three prior situations are surveyed, where the interaction between the economic surprise indices and asset prices are considered.
  3. Parts 1 and 2 paint a picture that frames current discussion of domestic monetary policy.

1. Economic surprise

While economists would have you believe that the “fundamental” data is of most importance, expectations of that data are, in reality, the most important indicator for investors. Importantly, the Citigroup Economic Surprise Index measures the difference between actual data releases and the Bloomberg survey median expectation. Above zero indicates that actual data is beating consensus expectations, and below zero indicates that actual data is falling short of consensus expectations.

Markets become overly pessimistic on economic data and that brings down expectations, as we saw in June of 2012, in Figure 1 below. Then the data did not fulfil those overly pessimistic expectations and expectations then improved, as they did from June 2012 to early 2013 in Europe, and late 2012 in the US. While concerns about the fiscal cliff curtailed US expectations earlier than European expectations, the stage now appears to be set for US economic data to further disappoint, as it has already started to do. All this should transpire in a week where the ECB will probably cut rates, and in a week that has a key economic release in the US; non-farm payrolls.

2. Asset class performance and economic surprise

If the US Economic Surprise Index should follow the European Index, then the US Surprise Index is also headed significantly lower. Recent data on the economy has been weaker than expected, including a series of Federal Reserve surveys, as well the recent GDP and employment data. Importantly, the US following Europe is not purely coincidental, as it is driven by the sequester spending cuts in the US, which William Dudley estimated to cause a 1.75% “drag” on economic growth in the US over 2013.

The U.S. fiscal policy program, for example, does not appear well-calibrated to the current set of economic circumstances. We have too much fiscal restraint in the short term, and too little consolidation in the long term. The degree of fiscal restraint this year (about 1¾ percent of gross domestic product [GDP] in 2013) is quite large relative to the forward momentum of the economy. Thus, we have a tug-of-war between the improving economy and the current large negative fiscal impulse. How this tug-of-war gets resolved—which force dominates—won’t be known for some time. In other words, the level of uncertainty about the near-term outlook in the United States remains quite high [emphasis added] (Opening Remarks for the Transatlantic Economic Interdependence and Policy Challenges Conference, April 22, 2013, William C. Dudley, President and Chief Executive Officer, Remarks at the Transatlantic Economic Interdependence and Policy Challenges Conference, Federal Reserve Bank of New York, New York City).

Such an estimate is much larger than private sector forecasters had been thinking, and it suggests that current fiscal spending cuts will have an expanded, and significant, impact on the US economy; not that growth will completely stop, but that it should slow substantially. As Figure 2 shows, when the data starts to disappoint, as indicated by the light blue line, the equity market responds, although a time lag exists. Also, the data is highly auto-correlated, meaning that worse than expected data tends to either fall short of, or exceed, expectations for extended periods. Hence, disappointing data tends to follow disappointing data, and encouraging data tends to follow encouraging data.

Several recent examples can be illustrated, as follows:

  • In March 2011, economic data began to disappoint, as signalled by a decline in the Economic Surprise Index (the light blue line in the Figure 2). Then, the equity market momentum stopped for about three months, before falling away in July of 2011, as shown in the circled area in Figure 2.
  • In February 2012 the economic data began to disappoint, as signalled by a decline in the Economic Surprise Index (the light blue line in Figure 2). Then, the equity market continued to rally, before declining in May of that year.
  • In December 2012 and March 2013, economic data began to disappoint, as signalled by a decline in the Economic Surprise Index, (the light blue line Figure 2). While the market is currently dismissing this decline, we expect that equity markets will begin to factor in weaker data and do what they did in the last two occasions; substantially correct in price.

Figure 2

What is bad for equities is usually good for bonds, as Figure 3 shows below, so that the corrections in equity prices forced yields lower in the two examples mentioned above, and the fall in yields has just begun for the third wave. Using the same points in time as above:

  • In March 2011, the Economic Surprise Index, or the light blue line in Figure 3 fell sharply. Then the bond market momentum stopped in terms of yields rising, before yields fell dramatically in July 2011, as shown in the area circled in Figure 3 below
  • In February 2012, the Economic Surprise Index, or the light blue line in Figure 3 fell again. Then bond yields stopped rising before yields fell in May 2012.
  • Currently, the Economic Surprise Index is falling again. However, the bond market is not dismissing this disappointing data, as the rally in yields is already underway. We expect that bond yields will continue to fall, as markets begin to factor in even weaker data and do what they did on the last two occasions; substantially rise in price and fall in yield.

Figure 3

3. RBA now cleared for easing

Bearing in mind that the momentum in global economic releases is for weaker than expected results, we can consider the implications for domestic monetary policy. Accordingly, we provide a list of factors supporting an interest rate cut by the RBA and those that are against:

Positives for a rate cut

  • Unemployment, now trending upwards
  • Global growth stalling as indicated in the economic surprise indices
  • Commodity prices improved recently, yet trend lower
  • Federal government revenues are declining and placing the budget in a tighter position
  • Private sector credit not lifting enough
  • NAB business survey, business expectations remain pessimistic.

Negatives for a rate cut

  • Housing finance shows some positive momentum for established housing from investors
  • Retail sales showing some signs of growth and supported by improved sentiment
  • Consumer sentiment lifted by recent rises in equity prices
  • Auction clearance rates are very high, suggesting momentum in house prices is up

The recent experience in New Zealand, with very firm housing prices emerging in response to low interest rates, may now be of some concern to the RBA. Here, a recent speech by Luci Ellis, Head of Financial Stability Department at the RBA, gave some guidance on the RBA position with regard to house price growth, in the following series of quotes:

  1. ... Trend housing price growth will be slower in future than in the previous 30 years ...
  2. A second implication is that, if housing price growth is now cycling around a lower average, there will be more periods when prices are falling (a little) in absolute terms ...
  3. If trend growth in housing prices will be slower in the future than in the past, trend housing credit growth will necessarily be slower too. [emphasis added] (Housing and Mortgage Markets: The Long Run, the Short Run and the Uncertainty in Between, Luci Ellis, Head of Financial Stability Department, Address to the Citibank Property Conference, Sydney - 23 April 2013).

Lower inflation, leads to lower price growth, after the adjustment to lower rates has proceeded. That adjustment has already ended, according to the RBA.

It takes time before the people who borrowed before inflation declined have paid off their loan and dropped out of the calculation. It also takes time for this additional borrowing capacity to bid up housing prices. But the transition does end after a while, and it is our assessment that it has now ended [emphasis added] (Housing and Mortgage Markets: The Long Run, the Short Run and the Uncertainty in Between, Luci Ellis, Head of Financial Stability Department, Address to the Citibank Property Conference, Sydney - 23 April 2013).

So, lower inflation means lower price growth and this means lower credit growth to housing and in turn that probably means that the normal transmission, from monetary policy to construction growth, will still occur, yet at a slower pace. In other words, with the CPI now under control, the RBA seems to be saying that they do not expect a rapid rise in house prices, which tends to suggests, all else being equal, that monetary policy is set to be made a little more accommodative, so as to raise the momentum of growth in the non-mining economy.

Yes, we have some growth in the domestic economy, yet it is just not enough to offset the declines in the mining sector and with the lags in policy, the time will soon come for the RBA to ease again, within the context of struggling developed world economic growth.


Europe remains a concern to financial market pricing, and the recent run of data has been a “shocker”, to use a colloquial expression; something that contrasts to the prevailing insouciance about the future of Europe that currently exists within financial markets. Expectations have risen above what the reality of the economy can now justify, and one can only expect the ECB to, among other things, try and allay fears by easing monetary policy this week. Austerity is treating the problem of the past, debt, without addressing the problem of the future; economic growth. Europe can, and will, find a solution to this difficult problem, yet it needs to shake away feelings of complacency, before a solution is to be found.

Complacency is still apparent in global equity markets, because equity markets are driven by mass sentiment and “retail” client trading; sentiment that takes time to adjust to changes in economic trends. In contrast, bond markets are dominated by institutions, who react more quickly to changes in economic data; being largely unburdened by “retail” client trading and sentiment.

Yet, equity market sentiment should change soon.

US Treasury, and Australian Commonwealth, ten year bond yields have already reacted, by beginning to fall in yield. We expect there is more is to come and the equity market will correct as it begins to price more moderate growth. Such a backdrop suggests the emergent concerns of the RBA, concerning housing prices will soon dissipate as the RBA seeks to boost the momentum of the non-mining sector in the context of a tight budget. Additional easing of monetary policy is not only logical, it will seem very much consistent with the ongoing slow growth in global developed economies, as we head towards the conclusion of the 2013 calendar year. All this suggests that asset allocation needs to ensure that investors have enough interest rate risk, so as to offset oncoming equity market volatility, and the QTC 2033, in the high 4% range, offers an excellent opportunity to gain such interest rate exposure.