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The short answer is that the Reserve Bank of Australia (RBA) will have to wait for a very long time to get a glimpse of the true state of inflation data, and hence will have to remain patient. This weaker than expected CPI could also mean the RBA extends its stimulus. For investors this means the low interest rate environment will remain.
During the pandemic, headline inflation printed a very low -1.9% quarter on quarter in June 2020 and a very high 1.6% quarter on quarter in September 2020. These two numbers will have to drop off first for the distortion to go away. This then takes us to the fourth quarter of 2021, with the RBA forecasting inflation to fall back to only 1.5% year on year.
Sure, inflation is backward-looking data, however, it’s in the RBA’s mandate to be within its 2 to 3% target. The RBA has been missing its inflation target for six years now, with the expectation that it will not be met until 2024, according to its own forecast. Here lies the danger! Inflation expectations are setting in, which makes it even harder for wage growth to rise above 2%, even at full employment.
JCB’s view is that the RBA is likely to stay dovish in 2021 until it can gain clarity on inflation data and this will likely occur next year. The RBA will likely move its Yield Curve Control (another way of interest-rate setting that involves buying government-backed debt to keep yields below a certain level) from April 2024 to November 2024.
The reason is simple. The bond market operates on signals. The only subtle change in the RBA’s signal so far this year is that its commitment to keeping interest rates unchanged until 2024 is not a pledge; it is only a forecast. That was enough to send Australian bond yields higher than the US Treasury and Canadian bond yields, despite the Bank of Canada’s tapering announcement. If the RBA’s preference is to have lower Australian bond yields than the other major markets, then it can’t point to the exit sign for monetary policy just yet.
Many bond investors have been puzzled by interest rates selling off on the reflation trade combined with a very high growth forecast this year. Many central bankers have been communicating that the high inflation prints are from base effect. We recently published a white paper titled ‘Over the Inflation Hill’, in which we concur with the base effect (the base effect is the distortionary impact on a monthly inflation figure that results from unusually high or low levels of inflation in the year ago month). As a result, a base effect can be a muddy assessment of inflation levels over time and we estimate returns from bond yields reaching their peak yields in this economic cycle at different points in time. And we believe it is not as bad as many may fear.
Due to this base effect of inflation (data rotation), we are all going ‘over the inflation hill’ and that journey is sure to provide plenty of volatility, lower expected returns from some assets and many powerful arguments amongst asset allocators.