RBA slashes interest rates – the lucky country is getting nailed

Today the Reserve Bank of Australia (RBA) surprised markets by cutting official interest rates by 0.5% to 3.75%. Weaker inflation data out last week and a deluge of soft economic data has got the RBA rattled. We’ve discussed bubbles down under on this blog before and think that a combination of a falling terms of trade, a current account deficit, a deleveraging consumer, below target inflation, a softer labour market and a housing bubble will see the RBA retain a bias to cut interest rates further.

Dylan Grice from Societe Generale recently wrote a piece that rather nicely added to the debate:

“Australia has five of the world’s 15 most expensive cities (on a median price to median income ratio), has seen household debt levels explode in recent decades, and even has a current account deficit despite the windfall terms of trade improvement caused by the commodity bull market. This is not a robust base from which to weather a Chinese hard landing, if and when it comes”…”When you scratch the surface of the Australian ‘miracle’ you don’t just find an unmiraculous commodity super-cycle: you also find an equally unmiraculous credit super-cycle as well. A credit bubble built on a commodity market built on an even bigger Chinese credit bubble, Australia looks like leveraged leverage, a CDO squared.”

The RBA is hoping that interest rate cuts will boost the flagging economy. We are not so sure. The Australian economy has already received two interest rate cuts in November and December last year. The impact of these cuts on the real economy has been muted to say the least when we look at key consumer indicators like retail trade and consumer confidence.  The problem is the major banks have not passed on the interest rate cuts to the heavily indebted consumer. A standard variable loan in November 2011 was 7.80%. Today, the same loan will cost 7.55%. And it doesn’t look likely the banks will pass on today’s cut either (at least not all of it), as they are likely to continue to point to higher funding costs as a reason to retain higher interest rates and hence protect profits.

So what is happening down under? Here are a few key data points that have raised our eyebrows:

• One in seven Australian taxpayers own an investment property.
• Australian housing credit is at its weakest level in 35 years.
• New home sales are an at 18 year low.
• House prices are down 10% in real terms from the June 2010 peak and nominal prices have been falling for 15 months, which is the longest downturn in a decade.
• 63% of property investors reported a taxable loss in 2009-10 according to the Australian tax office.
• 74% of those making a loss on their investment property earned less than $80k AUD per year (the average full-time adult earns around $70k AUD per year).

The housing bubble shouldn’t be the only thing keeping the RBA up at night. At least until very recently, the Australian Dollar has held up surprisingly well in the face of falling bond yields, most likely thanks to the world’s infatuation with Australia’s debt. This doesn’t look sustainable.  Most recently, we talked about the worrying and dramatic rise in foreign ownership of the Aussie government bond market and figures recently released show that foreigners bought another A$16bn of Australian government bonds, the second biggest amount ever, eclipsed only by the previous quarter’s $20.8bn surge. Foreign ownership increased from 80.4% at the end of Q3 to a record 84% at the end of Q4 (see attached graph).

But as we argued in January, if China wobbles or the Australian housing market starts to correct then the RBA will be forced to cut rates which will reduce the Australian Dollar’s appeal.  A recent Bloomberg article gives a great insight into what’s driving the flows – foreigners are piling into Australian government bonds as a carry trade and as a means to gain exposure to the currency.  If the yield pick up diminishes and/or the currency falls, then the huge number of foreign investors will start to leave, which will put further downward pressure on the currency.  Australia isn’t as bad as Ireland – the government won’t go bust as it can print its own currency, but the banking sector is obviously vulnerable.  It’s easy to see how a nasty downward spiral can quickly develop.