Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Wednesday, 28 January 2015

Huge day for interest rate news !

Soft inflation data expected

A massive day for interest rate twitchers today with the release later this morning of the inflation data for the December 2014 quarter.

There has been a theory in Australia which goes something like this:

-China slows down and the iron ore price crashes

-Australian property falls sharply in price

-Australian banks become insolvent as mortgages go bad

Or variations upon that theme.

1 - Commodities

The first part was more or less a given, with Australia's terms of trade now coming back down to earth from incredibly high levels. 

This morning the iron ore price of $US62.80/t takes the spot price back all the way back down to about where it was in May 2009,

This has clear implications for national income.

While the larger miners (BHP, RIO) have cash costs much lower than this level, there are a range of smaller producers higher up the cost curve that will be struggling to turn a profit unless the Australian dollar falls much further from its current level.

Meanwhile the larger producers continue to pump the market with supply, which must inevitably result in a shake-out of some of the smaller producers - meaning mine closures and jobs losses.

This is by no means only an iron ore story. 

Indeed Australia's coal production is in more precarious position, with many of our coal mining companies sitting higher up the cost curve.

Meanwhile, copper was off again by more than 3 percent overnight sitting at just US$2.46/lb.

In short it's a mixed story - Australia is shipping commodity volumes that we could only have dreamed about a decade ago, but we are doing so at prices which have been sliding by the month.

Such is the nature of commodity cycles. Resources companies produce commodities and therefore are unable to differentiate on their product, and instead they compete on price.

It's dog eat dog and the larger companies with the economies of scale and lowest cash costs will be the winners.

Bulk Commodity Exports graph

With mining construction also now falling into a sharp decline, it would seem that the dollar must fall further and the notion that interest rates will not fall further appears remote to me, though obviously I could be wrong. 

2- Housing

While commodity prices are indeed, falling, the house price part of the equation has certainly not happened.

In fact, as one might well have expected, as interest rates fall, house prices have been rising in most cities. 

Housing Prices graph

And so too are housing loan approvals to record highs, mainly driven by investors, which is part of a structural or generational shift towards a new way of living in Australia.

I analysed the latest round of housing finance data in much more detail here.

Housing Loan Approvals graph

3 - Banks

The other aspect of low interest rates is that life has become comparatively easier for existing homeowners.

Fitch's Dinkum Index shows mortgage arrears at a 7 year low.

"The latest "Fitch Ratings Dinkum Index", which records 30 and 90 day mortgage arrears, showed that arrears have declined to 7 year lows (30 Day) and 5 year lows (90 Day) respectively."

I also analysed the Genworth (GMA) Q3 results here, which showed that mortgage delinquencies have been cascading significantly lower by book year since 2009.

"In South Australia and in regional Queensland in particular, where a weak economy and a troubled coal sector are biting respectively, we do see some risks of elevated delinquency rates.

Indeed rates of delinquency have already run notably higher in Queensland (0.49%) and South Australia (+0.43%) than elsewhere in Australia, but thanks to exceptionally low delinquency rates in New South Wales (0.30%) and Victoria (0.32%), the portfolio records a very low rate of Australian delinquencies in aggregate at just 0.36%.

We expect that the unwinding of the mining construction boom will have some effect too, although this may be cushioned to some extent by the lucrative remuneration packages that many employees and contractors have enjoyed through the construction phase of the boom.

GMA's delinquency rate of 0.36% is skewed higher by the troublesome 2008 book year.

However, since that time, mirroring the findings of Reserve Bank research (which revealed that the average mortgage holder is some 24 months ahead on mortgage repayments thanks to Australia's unique loan product structuring), delinquency rates have fallen consistently over the following 5 book years.

Low interest rates and low interest repayments are clearly helping homeowners, and mortgage stress is relatively speaking low at the present time."

Aussie banks have not therefore become insolvent. 

In fact they are being valued at or close to their highest ever prices.

Commonwealth Bank (CBA) shares yesterday reached their highest ever valuation closing at $87.63 (as recently 2011 the valuation was well below $50).

Granted share markets do no always price companies rationally, but this does not look like the share price of a bank which is in trouble or about to grapple with insolvency issues (and few companies can be more analysed in Australia than CBA, so this represents a reasonable market consensus).

Inflation to decide rate cuts

Aussie homeowners are naturally enough hoping for further interest rate cuts in the first half of 2015 and today's inflation data will play a key role in deciding whether we get a cut in February or March.

I looked at the Q3 2014 inflation figures here which showed that weakning inflation has potentially left the door open for further cuts.

The market is expecting a soft reading of just 0.3 percent, which as per my tweet below which would take "headline" inflation below the 2 to 3 percent target band at just 1.8 percent.

Falling oil prices have likely played a key role here, however, and the key figures to watch will actually be the core readings which strip out the effect of outliers - the trimmed mean and weighted median.

The market expects to see an average of around 0.5 percent for the December quarter on the core readings.

If that happens then core inflation will be sliding towards the lower end of the 2-3 percent target range at just 2.2 percent and the clamour for interest rate cuts will likely become a cacophony.

In summary then, if core inflation prints at 0.5 percent or lower, then interest rate cuts become more probable.

More later...