The inflation data were hot last week, but that’s not exactly the point.

So inflation has caused a bit of panic in markets and the media.

This is your quarterly reminder from Uncle Jon to chill the hell down everybody.

Yes, the inflation data came in much hotter than expected.

It was up 2.1% in the quarter, smashing expectations for a 1.7% rise. That gave us a headline annual inflation figure of 5.1%, well ahead of expectations for a 4.6%.

At 5.1%, this is the highest rate of inflation since 2000, but that 2000 number was driven by the introduction of the GST, so this is one for the history books.

So look, no denying that the inflation data is hot.

But that’s also not surprising. At 5.1%, that still puts us a fair way behind the US, the UK and even New Zealand. So we were always heading this way. We just got there a few months quicker than expected.

And when you break it down, the drivers of inflation aren’t a surprise. Transport is the big one, with that component running at a massive 13% year on year. The other big one is housing costs, running at 6.7%.

Now this is the central point. Both of these two measures are really stories about supply shocks.

Transport is driven by the spike in fuel prices, which is all thanks to the war in Ukraine.

Housing costs are driven by a material shortage that’s hammering the building industry right now.

So these things are all about supply shocks.

Why does that matter?

Well there’s a big difference between inflation that comes out of supply shocks compared with inflation that comes out of demand shocks.

Supply shocks tend to be more temporary (or ‘transitory’ in the language of central bankers), while demand shocks are more likely to be permanent.

And why does that matter?

Well, if it’s temporary, then there isn’t all that much point rolling out the rate hike guns to fight it. If the RBA lifts rates that will have precisely zero impact on global oil prices anyway.

Indeed, oil prices have already turned deflationary. Remember for inflation to keep rising, prices need to keep going up. If they go up and then stop, then inflation drops to zero.

So oil prices have already come a long way off their recent highs, and are therefore going to start putting downward pressure on the inflation rate.  

Similar story with building costs. Material prices have become expensive, but are they going to keep on getting more expensive?

And this is what the RBA will be mulling up. If inflation is all about transitory supply shocks, then there’s not all that much need to jack up interest rates.

So personally, I expect they’ll hold fire today, although I’m not high conviction on that.

And while I’m certain we’ll get a rate hike in June either way, I still don’t see the case for an aggressive rate hike cycle.

I know markets are pricing it in, especially after last week’s inflation numbers, but I still don’t see the argument.

Rates will ‘normalise’ from their history lows, but I don’t expect them to go all that much higher from there.

JG.

Markets are off the planet right now.

Markets are tripping right now. I can’t even fathom what they’re thinking.

Based on the cost of money across different time horizons, right now, markets are pricing in nearly eleven straight rate hikes by July 2023.

Eleven!

Even if we assuming the tightening cycle starts in June – which I personally struggle to see happening – but assuming things kick off in June, that’ll mean the RBA will hike by 25bps every meeting for 13 months straight!

Never mind that this has literally never happened before.

And never mind that that would give us the highest interest rates in the developed world, which would put a rocket under the Aussie dollar.

There’s something weird going on here. This is just not going to happen.

And while the market is pricing in eleven rate hikes (man, I can’t even say that with a straight face), I’m not sure we’ll even get one.

I’ve written about this before, but there’s a few reasons why I reckon the RBA will be very reluctant to hike.

First, the wages data just doesn’t support the case. The RBA has said they will wait til they see strong wage data in print, but it hasn’t happened yet, and it’s not clear it will happen with the next wages print either.

Second, mortgage rates have already started drifting higher, and thanks to the huge number of borrowers who went to fixed rates in 2020, there’s something like $500bn worth of fixed-rate mortgages resetting to higher rates over the next year or so. So that gives the RBA a free hike for nothing.

Third, I’m still not seeing permanent supply-side bottlenecks. Yes, there’s been a lot of disruption (including a war!) but it’s not clear to me that it’s baked in as permanent yet, and I reckon the RBA will want to wait and see as well.

Fourth, China is still going full-tilt at resaphing its property sector. This will deflate commodity and energy demand at best, and crash the global economy at worst. The international situation contains massive downside risks, and the RBA will be well aware of them.

When central banks hike rates, usually something breaks.

We live in highly finacialised and leveraged economies. These economies get used to low rates.

When rates rise, that puts stress across the system. You never know where it’s going to show up – US sub-prime mortgage derivative, emerging market bonds, crypto? It could be anywhere.

But as this chart from TS Lombard shows, whenever the US Fed hikes, something breaks.

Today’s central banks are well aware of this tendency, so they’re got take a very cautious approach.

That is, they’re not going to rush in all guns blazing with 11 rate hikes in a row.

ROTFL.

JG.

I’m expecting a property-friendly budget today.

The budget is shaping up to be a pretty property friendly.

On the whole, the budget is going to maintain a stimulus footing. There’s more money going into the economy through spending than there is coming out through taxes.

And it will be true that the budget bottom line that we used to care about so much is improving. The economy is going great guns, and a commodity boom is funnelling huge amounts of cash into government coffers.

But despite the projected improvement, the federal budge will remain well and truly in the red going forward.

And that’s cool. I’m ok with that.

The experience in India shows us that the global pandemic is still with us. And it’s like a fire. You can put it out in one corner of globe, but until its extinguished everywhere, you’re always at risk.

So let’s not get complacent just yet.

So we can expect the money to keep flowing, with a particular focus on infrastructure.

And we know from the information leaked already that there’s going to be a few sweeteners for the housing market.

The list, according to the AFR, looks like this:

• An extra 10,000 places will be made available under the New Home Guarantee, allowing first home buyers to buy a place with as little as a 5 per cent deposit, while the amount of money that can be released from their superannuation will be lifted to $50,000.

• More than 10,000 single parents will be allowed to buy a home with a 2 per cent deposit under a separate government-guaranteed home loan scheme targeting women.

• The government will allow the superannuation guarantee to increase to 12 per cent after flirting with stopping it.
• The maximum amount of voluntary super contributions that can be used to purchase a first home will be increased to $50,000 from $30,000.

Classic. Who doesn’t love this.

Everyone wins. For some people, it’s going to become easier to get a house. That 2% deposit thing is a real game-changer, and I think it’s a great idea to support single women on that mission.

Landing secure housing for you and your kid is a huge step towards creating better life outcomes for everybody.

And at 2%, it really makes that deposit hurdle a lot lower for a lot of people. For a property worth $700K, we’re talking about a deposit of just $14,000, rather than something like $140,000 for most people.

So that’s huge.

It does mean the tax-payers are taking on the risk of default and so on, but I’m ok with that too.

The family home always comes first, and if someone is defaulting on a mortgage you know its because things have seriously gone pear-shaped. Default is not a decision taken lightly.

And in a world where we’ve got cash for everyone, why not given single mothers a leg up too?

The thing we have to watch here is what impact this has on the entry-level of the segment.

Since these are all demand-side measures, pushing up demand can also push up prices.

And on the whole, all of these measures, on top of the huge cash-splash on infrastructure, will give property prices a lift.

It’s a very price-positive budget. I think we can say that much.

JG

The RBA doesn’t want you to be rich. They need you to be rich.

I don’t know if you’ve picked up on it, but there’s a drive to make you richer.

Are you feeling it?

Gina Reinhart is. All the rich-listers are. Their wealth has jumped a staggering 24% in the past twelve months. Gina’s has double. Doubled! According to the AFR:

Despite a global pandemic dominating global economies the top 200 richest Australians increased their collective wealth by 24 per cent in 2020 to $424 billion.

Australia now has a record 104 billionaires, including seven people in the elite “ten-digit club” with a wealth exceeding $10 billion.

Mining magnate Gina Rinehart is once again Australia's richest person, having increased her wealth two-fold in just 12 months.

Ms Rinehart topped the Australian Financial Review Rich List for 2020 with a personal wealth of $28.89 billion, a figure up 109 per cent on last year.

Partly that’s a mining story and it’s related to the mining boom. But most rich-listers aren’t from the resources sector, and their wealth is booming too.

No, it’s a cheap money story.

Money is so cheap (I say cheap. It’s practically free!) But it’s so cheap these days that those with deep pockets are making a motza.

And while the 1% always make out like bandits in a crisis, there’s a push to make ordinary Australians wealthier too.

And it’s working.

In fact, household wealth hit fresh record highs at the end of 2021, and the quarterly increase in wealth was the biggest in 11 years!

Household wealth is now up a pumping 7 percent on a year ago – despite the worst recession in decades.

That’s not bad.

Even the young’uns are feeling wealthier. At least one study of Gen Z and Millennials found that four in five are wealthier now than they were pre-Covid:

Gen Z-focused money education platform Flux surveyed 807 of its followers on social media site Instagram in February, finding the crisis has had a positive effect on the personal finances of many young Australians, notwithstanding the broader economic downturn.

The vast majority of respondents (82 per cent) to the poll indicated that they were in a better financial position now than before the pandemic hit early last year.

Government stimulus, financial returns from investment markets and an ability to save income amid the state-imposed lockdowns were among the key reasons identified.

Ahh. Investing Gainz. I know that one.

So Australians, despite the Covid recession, are feeling a lot wealthier.

But none of this is an accident.

This is exactly what the RBA wants to happen.

It’s something called ‘The Wealth Effect’.

When Aussies feel wealthier, they go out and spend more, and that’s good for the economy.

It’s a virtuous circle. The wealthier we are, the more we spend and consume, and the wealthier we all become. That’s the wealth effect.

And the easiest way to help Aussies feel wealthier is for house prices to go up.

(Over half the gain in wealth in the last quarter of last year was due to rising house prices.)

So the RBA is very happy to see house prices rise. A couple of years ago, the RBA published research that found that a 1 per cent increase in the value of housing wealth will lead to a 0.16 per cent increase in the long-run level of consumption.

So that’s a pretty decent bang for your buck.

And this is also why house prices and share prices tend to move together.

When house prices rise, they spend more, which boosts revenue and profits, which in turn boosts share prices.

This is the wealth effect in action.

And so this is why the RBA is more than happy to run the economy very hot over the next few years.

And they’re happy to see house prices soar too, because they know a lot of that is going to feed back into the economy and boost growth.

The wealth effect is in full effect.

So I wouldn’t be on the other side of this bet – of this push to make Aussies richer. There’s a saying in America: “Don’t fight the Fed.”

My advice?

Don’t rumble with the RBA.

JG

Bonds and stocks don’t dance together anymore. It’s a strange new economy.

So I think I’m looking pretty good right now.

Last week, on Wednesday, I said that the US equity market was looking a little bubbly.

By the end of the week, markets had heard the message, and the US market was hammered. Tech stocks were hit hard. Australia followed dutifully behind.

I’m so clever.

But it’s easy to say in hindsight.

And the truth is that markets can look ‘bubbly’ or at least stretched, for ages before something comes along and gives them a nudge.

But last week, something did come along and give markets a nudge.

And that thing was rising bond yields.

Now someone asked me why rising bond yields would cause stock prices to fall.

That’s a very, very good question.

In fact, that’s a question everyone wants to know right now:

But this is the thing. I don’t think anyone really knows the answer.

In the old days, back when I started investing, my mentor would get out of his horse and buggy and say, stocks and bonds always go in opposite directions.

When stocks go up, bonds go down. When stocks go down, bonds go up.

And it was such a reliable thing that people developed portfolio allocations based on it. Beginning investors were advised to follow Rick Ferri’s Two-Fund portfolio mix: 60% stocks, 40% bonds.

The idea is that bonds would help protect your portfolio in a stock market rout.

Bonds gave you protection.

And they did. It was true for generations. Stocks and bonds would move in opposite directions.

Remember, equities carry risk. Bonds, since they’re backed by the government, carry almost no risk.

And the idea was that in a risk-on environment, people would sell bonds and buy stocks. And in a risk-off environment, they’d sell stocks and buy bonds.

That transfer of demand would cause prices to move in opposite directions.

And that’s what seemed to happen.

Until the QE era kicked in.

After that, there seems to be almost no correlation at all. If anything, stocks and bond prices tend to move together.

(Oh, I’m talking about prices there. In the news you’re hearing everyone talk about ‘rising bond yields’. As a property investor I’m sure you know that if a price falls, and the return remains the same, the yield goes up. So when you hear “rising bond yields” you know we’re also talking about falling bond prices.)

So yeah, last week we saw falling bond prices (and rising yields) AND falling stock prices.

So much for the 60:40 mix.

(You were 100% down on Friday.)

Anyway, back to the puzzle at hand. Bond yields went up, and shares were sold off.

There’s two parts there. What happened to bond yields? And then what happened to shares?

So first, let’s look at why bond yields went up?

The key factor seems to be rising expectations of inflation.

As I’ve noted before, sentiment around the US economy and the Australian economy is pretty bullish right now. That’s on the back of super-cheap interest rates and massive fiscal spending.

I mean, check out the chart on the US money supply. Totally nuts:

But now, there’s so much money gushing into the system, that people are starting to worry about inflation.

The rate of return on bonds – the yield – has inflation cooked into it. So when inflation, or inflation expectations rise, yields go up.

And so the increase in yields reflects a growing belief that our economies are starting to run a little too hot.

They’re a little too awesome.

Now, that sounds like a good thing for stocks right?

Companies love a hot economy. That’s good for sales right?

But no, stocks got sold off.

And why was that?

Well, to understand that, we have to get to the mystery at the heart of the modern economy. We have to get to the thing that everything hinges on right now.

More on that tomorrow.

“The earlier part of the move was driven by rising inflation expectations because one of the components for bond yields is compensation for inflation,” he said. “More recently, the increase in bond yields has continued and it has come about by an increase in real yields.”

Real yields are the component of the bond yield that is left after investors receive compensation for inflation, and are a good proxy for underlying economic growth expectations.

“If people think that economic growth is going to improve, then real returns – economic growth after inflation – are likely to improve across the entire economy because it’s easier to generate positive returns when the global economy is growing,” Mr Hamlyn said.

Relative yields. – 1.55 T vs 1.51 in equities. Higher yield with zero risk.

Corporate interest burden increases

Discounting

Higher bond yields a negative for gold, since gold doesn’t generate yields.

Discounting

Bond yields, in a way, represent the opportunity cost of investing in equities. For example, if the 10-year bond is yielding 7% per annum then the equity markets will be attractive only if it can earn well above 7%. As bond yields go up the opportunity cost of investing in equities goes up and therefore equities become less attractive.

The yield on bonds is normally used as the risk-free rate when calculating cost of capital. When bond yields go up then the cost of capital goes up. That means that future cash flows get discounted at a higher rate. This compresses the valuations of these stocks.

On the forward rates front, the fed funds futures market is now pricing in more or less a full hike in 2022 as well as two in 2023, and we think the 2022 expectation will be viewed by the Fed as excessive and potentially starting to become problematic.”

Treasury drawdown = liquidity coming

US Broad money up $3tn y/y

JG

Mortgage holidays are hiding a lot of pain. But if that pain makes it way on to the banks’ books, they’re in real trouble.

In less than 100 days, the Australian economy will topple over a cliff.

Australia is doing better than most nations right now (tell that to the one in five workers who lost work!), but the mountain of stimulus and support we’ve put in place is all due to end in September.

We’re talking about JobKeeper and the JobSeeker supplement, but we’re also talking about mortgage deferrals.

Remember that banks have been offering borrowers a ‘holiday’ from their repayments.

According to the Australian Banking Association, 772,600 loans have been deferred across Australia, including 480,700 mortgages.

That’s one in 14 mortgage holders – about 7% of the market. Substantial.

And while mortgages account for a bit more than half of the number of loans, they account for about three quarters of the value of loans deferred. $234.1 billion total loans have been deferred, of which $173.5 billion are mortgages:

So… so far, so good. A substantial number of loans have been deferred, but we’re not talking about the collapse of the mortgage market.

But the key thing here is how this shows up on the banks’ books.

Remember that when the deferrals were announced, some people wondered why the banks weren’t going further.

Because the loans aren’t simply being paused. Anything you miss has to be made up, in the time that remains. That pushes your minimum monthly repayments up somewhat.

And when they were asked why they were deferring rather than pausing the loans, the banks said that if they ‘paused’ the loans, they would be technically “impaired”.

An impaired loan is a loan that has gone bad, with a higher risk that it will not be repaid.

That has serious implications for the banks. APRA – the banking regulator – has rules about how much capital you hold against your loan book, and it depends on loan quality.

So, to make some numbers up, if you have $100 of high-quality loans, you might have to hold $10 in cash.

But if you have $100 of impaired loans, you might need to hold $20 or $30 in cash.

That is, if the banks pause the loans, the loans get treated as ‘impaired’ and that means the banks have got to come up with extra money to hold against those loans. 

How much of a problem is that?

Well, economics grey-beard Alan Kohler does some back of the envelope calculations.

If the deferred loans were treated as impaired this year rather than deferred, and the big four’s share of them was the same as their 80 per cent share of total loans and advances – probably a safe assumption – impaired loan expense would be 16.6 per cent of their loans and advances and would more or less wipe out their capital…

After six months, the support program runs out in September, at which point, it is assumed, $224 billion in loans, plus whatever is deferred between now and then, would instantly become 90 to 180 days in arrears…

September is rushing towards the banks. How many of the 744,904 people and businesses, and counting, will be able to resume repayments? How long can loan deferrals go for? What proportion of the loans must be classified as impaired at September 30? What provisions must be struck for future impairments? How much capital would need to be raised to cover these sums? If it’s a 12-figure amount (that is, more than $100 billion), who will supply it?…

But if the government’s various income support packages end in September and October, as planned, the bank support will have to begin, or else the pandemic crisis will turn into a financial crisis like no other.

Yup. If October comes, JobKeeper ends and all these loans move from deferred to impaired (not even assuming more people end up in default), the banks get “wiped out”.

And it seems to leave the government with the choice of either nationalising the job market, or nationalising the banking sector.

Both options are ugly.

This is going to take some fancy footwork to get out of this one.

… and we’ve got 100 days and counting.

JG.