Saturday, September 1

More gloom - but it looks cyclical not structural

What an interesting week. Many Australians woke up this week to the realisation that the mining boom just might have bust. In Canberra, it looks like we are facing new rounds of austerity and downsizing. But not to worry, this spring house prices are set to spring back.

And on my gloom indicator (using data from RBA table F2), we reached a new post-GFC peak with Friday's data. But there is a little silver lining to these storm clouds. We will come to that in a moment.

Not so long ago, I said I would worry about this when it reached 20 points. Well it is at 20 points and I am not fully worried. I would say that I am alert but not (yet) alarmed.

In the last week, there has been an interesting debate in the blogosphere about Australia's economic outlook. The central question in this debate is whether the current downturn in China is cyclical or structural. The macro-bears tick the box marked structural. They think we are going to hell in a hand basket. The China boom is over. Go straight to jail. Do not pass go. Do not collect $200.

The bulls think the worst we are in for is a tight time. China will slow a little and rebalance, but inevitably its demand for iron ore and coal will pick up, perhaps before Christmas.They argue that China is only one-quarter the way through its development trajectory and there is a long development path ahead necessitating years of Australian exports.

So where do I sit. If inversion in the bond market reflects the wisdom of crowds, its nervousness is at the cyclical end of the spectrum. The inverted rates only go out as far as three years, but not five years. In the worst of the GFC build-up, yields were inverted out to ten years. At worst, the bond market sees a short to medium run problem, a couple of years max, not a long run problem.

Let's look at the graphs. In each of these graphs I take the yield rate for one period and subtract the yield rate for the next period. All other things being equal, long-term bonds carry more risk than short-term bonds from the same agent. As a consequence, investors typically expect a greater yield on long-term bonds than short-term bonds. In these charts, that results in the blue line being below the origin. When the blue line is above the origin, it means that investors see less risk in buying longer term bonds compared with shorter term bonds.

But like everything economic, there are competing analyses.

On the one hand, the inversion in the 3-2 graph above may simply reflect European storms. Other nations are using the Australian government as a safe haven in their time of trouble. The demand for three year bonds may be saying more about foreign affairs than the Australian economy. Indeed, without this external demand there may not be much inversion at all.

The story from the other hand would note the degree of inversion in the short run (on the 3-2 graph above) is currently higher than it was with the run into the GFC. The bears would say that even if I am right about only needing to fear a short downturn, it's going to be deep and feel like I have been whacked in the head with a frying pan.

Usual caveat: I am not a financial advisor and this is not financial advice.

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