We're all residents of Extremistan now...
WILL THE MARKETS – both housing and equity – continue to be responsive to changes in the cash rate made by the Reserve Bank of Australia? asks Dan Denning in his Daily Reckoning Australia.
Or will Aussie mortgage rates decouple from the cash rate as the global cost of capital goes up? Those were just two of the many interesting questions that came out of last night's debate with Rory Robertson from Macquarie Bank.
If you're a pugilist or a fan of broken noses, you will be disappointed to learn the evening did not come to blows. It was spirited though. And by the end of the night, it was clear what the differences are in the positions: one camp believes things are pretty much okay here and house prices are supported by population growth and low interest rates. The other is a bunch of wacko residents of Extremistan with odd theories about what money is.
More on that shortly! A hint – we are all residents of Extremistan now, thanks to 30 years of cheap money fuelled global growth. The great contraction is upon us.
But the RBA was really the big newsmaker in Sydney yesterday and was not at all worried about Extremistan. The men who set the price of money in Australia decided it was neither too hot nor too cold yesterday. It's just right...for now.
If it's really true that a small group of men and women can know what the price of money should be at any given moment, then we're going to write Pope Benedict and ask that he canonize Glenn Stevens. Each interest rate decision is a kind of transubstantiation...a miracle whereby the tens of millions of private calculations in the real economy are simultaneously subsumed in the brain of the central banker...and turned into a price.
Monetary miracles aside, the markets seemed to like the RBA's statement. US stocks were up and the Aussie Dollar rallied. Newswires referred to the RBA's vaguely bullish comments about Asian growth. Everyone is still hoping China can do whatever it's still doing for Australia, in whatever way it's still doing it.
What is it doing, anyway? It occurred to us that the correlation between low levels of Australian unemployment (around 5.6%) and Chinese resource demand is something more alleged than proven. There may actually be some proof that Chinese resource demand supports a large part of the Aussie job market. But we haven't seen it yet. If you have some, let us know.
Meanwhile, the Wall Street Journal's Matt Phillips reports that the RBA's statement might not be as bullish as risk traders and yield hunters have been led to believe. He quotes this line from yesterday's announcement:
"The expansion remains uneven, with the major advanced countries recording only modest growth overall, but growth in Asia and Latin America, to date, very strong. There are indications that growth in China is now starting to moderate to a more sustainable rate."
"Starting to moderate"...? Hmm. The issue of China's relative strength has indirect bearing on the housing argument. The bulls argue that a strong economy with low unemployment means no mortgage stress for cashed-up and fully employed homeowners.
Only a rise in unemployment to US-like levels (officially 9.7% but likely at least twice that) would kick the legs out from under all those new first home buyers the government invited into the market.
But as long as it's all good in China...she'll be right.
And in what looks at least to be unambiguously good news, Australia ran a $1.65 billion trade surplus in May, according to figures released yesterday from the Australian Bureau of Statistics. Thank you coal, you black beauty you. And thank you iron ore you reddish orange beauty, you.
That kind of national income may, now that we think about it, support employment indirectly. The money comes in. It has to go somewhere. Will it go to foreign shareholders? The government (taxes)? Or will it go forth into the economy and multiply?
John Peters, a senior analyst at Commonwealth Bank, says the figures may force the RBA to put up rates even higher later this year. "Trade will clearly be one of the key factors to drive economic growth back to a higher level, along with dwelling investment and business investment. This type of growth in export income is a fairly significant stimulus."
If he's right, then the obverse must be true too, right? That is, if booming coal and iron ore exports support the economy in strange, mysterious, and potentially stimulating ways, then crashing coal and iron ore prices undermine Australia's economy in potentially recessionary ways, do they not? Well of course they do. It's not that much of a mystery.
Still, we'll leave it others to decide who won last night's debate. To be fair to Rory, most of the time, anyone making the orthodox, steady-as-she-goes, keep doing what you're doing argument is right. Most of the time, the extremist economists are wrong. But not all the time. And when they are right, the magnitude of their rightness is breath taking.
More importantly, our central point last night was that central-bank manipulation of the cost of capital is what creates bubbles...giant oceans of misallocated capital based on bogus price signals that encourage consumption and production out of whack with underlying demand (not supported by cheap money).
Further, there is ample evidence in the last ten years that globalization accelerates instability. Cross-border capital flows are great for investors, to be sure. But the more complicated any system gets, the more unstable it gets too. And in the chase to instantly price in and understand thousands of events each day, investors rely on models to find out where the best place to park their capital.
But these models – from Long Term Capital Management's to Bear Stearns and Lehman and AIG – rarely model the extreme event (a credit depression). Statistically, their models tell them the probability is so low it is not worth preparing for.
We've seen how that worked out, haven't we? And if the number of extreme financial events seems to occurring with more frequency than models would suggest, an inquiring mind would want to know why, wouldn't it?
The answer, we think, is obvious. Cheap money creates credit bubbles and misallocated capital. Asset prices driven up by borrowed money eventually revert back to a mean when the money dries up. Our central argument is that Australian house prices are the last in a long line of leveraged asset booms, all of which, save Australia's housing market, have blown up.
Real estate, though, unless it's a world-class cluster-storm like the US subprime crisis, rarely blows up. It unwinds over many years. Buyers are generally not forced to sell and the market can remain illiquid for many years until a market clearing price emerges. In real terms, house prices stagnate.
That is one possibility here in Australia. Another is that we are indeed flat-out crazy and fail to understand the basic structural forces that support house prices in Australia – immigration, restricted supply, low rates, and a pre-disposition to homeownership.
For various reasons we won't go here, we think all of those arguments are tenuous, or at least variable (immigration rates can change...demand for accommodation does not automatically correlate to mortgage finance demand...interest rates are at historic lows and probably headed up).
But by the end of the night, we think the debate had produced a clear difference of honest opinion. Rory, if we understand him correctly, believes the ultimate job of the central bank is to support asset prices by lowering the cash rate in times of crisis. We believe the central bank creates the crisis with an artificial cost of money that inevitably is kept low to promote growth (and keep the property spruikers happy).
It ought to be the central banks role to promote and guard sound and honest money, not support asset prices. But then, we don't believe there ought to be a central bank at all. And in any event, the coming months will tell us who really determines the price of money in Australia – the RBA or the global bond market.
Already Australian banks borrowing money over-seas – and Aussie banks finance at least a quarter of their domestic lending from foreign borrowing – are having to pay more than the cash rate. Funding costs are up. Rory conceded that in a genuine credit crisis, Australian banks would be hard done by.
The question is whether there will be a crisis that pushes up funding costs so high Aussie banks must put up mortgage rates too. It may not have to be some crisis event, though. As we've reported in the past, public and private sector borrowing – some new short-term borrowing and some rolled over from lower rates – is set to hit nearly $5 trillion in the next 24 months.
Australian banks have to compete for that capital with other global borrowers. The big saving grace now is that the difference in yields between Australian and American debt makes some Australian debt attractive on a yield basis to foreign investors.
Imagine that! Investors hunting for yield through securitised residential mortgages, because they can't get a decent yield on lower-risk government or corporate bonds. Now, where did we find that happening before...?
You could even argue, though Rory didn't, that fixed income Australian securities would be the toast of the globe if the Fed chooses to keep rates low. But our argument would be that in a second phase of the credit depression, Australian assets will be treated like the plague (as is the case with most risk plays...and Australia is considered a risk play). Without the funding, what then for house prices?
What we both agree on is that no one knows what will happen. Here at The Daily Reckoning Australia, we believes that the Austrian theory of the business cycle has both explanatory and predictive power when it comes to figuring out what has to happen at the end of a leveraged asset boom. But it is true – from meat pies to the platypus (both reptile AND mammal!) and in many other ways – that Australia is exceptional.
Maybe the housing market here will be the only exception to the rule...
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