Beijing eases pressure

China’s PBOC eased up on its crackdown on wealth management products (WMPs) and related bank lending. The resulting fall-off in new credit and a spike in interbank lending rates threatened to precipitate a sharp contraction.

Copper rallied off long-term support at 5400. The reaction is secondary and breach of 5400 remains likely, signaling a primary down-trend.

Copper A Grade

Iron ore is consolidating in a narrow bearish pattern above support at 60. Breach seems likely and would signal another decline, with a target of 50*.

Iron Ore

* Target: 60 – ( 70 – 60 ) = 50

Shanghai’s Composite Index rallied to test its new resistance level at 3100, after breach signaled a primary down-trend. Respect would confirm the decline, with a medium-term target of 2800*, but government intervention may bolster support. Recovery above 3100 would mean all bets are off for the present.

Shanghai Composite Index

* Target medium-term: May 2016 low of 2800

ASX banks break support

The big banks fell sharply on the week’s turmoil, with the ASX 300 Banks Index breaking support at 8500. Breach signals a primary trend reversal, offering a medium-term target of 8000*.

ASX 300 Banks

* Target: 8500 – ( 9000 – 8500 ) = 8000

Resources stocks rallied over the week. Expect strong resistance on the ASX 300 Metals & Mining index at 3000.

ASX 300 Metals & Mining

Iron ore continues in a bearish narrow consolidation above support at $60. Breach would offer a short-term target of $50*.

Iron ore

* Target: 60 – ( 70 – 60 ) = 50

These are ominous signs for the ASX 200 which is testing medium-term support at 5700. A sharp fall on Twiggs Money Flow flags strong selling pressure. Breach of primary support at 5600* would signal a reversal, offering a target of 5200*.

ASX 200

* Target medium-term: 5600 – ( 6000 – 5600 ) = 5200

Sell in May and run away?

Markets fell sharply today. But before we look at the charts, let’s examine three fundamental measures of market stress.

A yield differential near zero indicates bank margins are being squeezed. Lending normally slows, leading to a recession. But the current yield differential of 1.45%, calculated by subtracting the yield on 3-month T-bills from the yield on 10-year Treasuries, is reasonably healthy.

Yield Differential

The yield spread between the lowest investment grade corporate bonds (Baa) and 10-year Treasuries is a useful measure of market risk. The risk premium widens in times of uncertainty. Since 2016 the Baa spread has fallen by more than one percent, to 2.25%, indicating low market risk.

10-Year Corporate Bond Spreads

The above indications are supported by the St Louis Fed Financial Stress Index which is at a record low of -1.451 since its commencement in 1994.

St Louis Fed Financial Stress Index

The St Louis Fed Financial Stress Index measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.

The average value of the index, which begins in late 1993, is designed to be zero. Thus, zero is viewed as representing normal financial market conditions. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress.

Real GDP growth dipped to 1.9% for the first quarter 2017, compared to 2.0% for Q4 2016. While growth is modest, hours worked by nonfarm employees improved to 1.55% in April 2017 from a low of 1.03% in February, suggesting that growth is likely to continue.

Real GDP & Hours Worked

There is little sign of stress in financial markets other than the latest Trump turmoil.

RBA stuck

Great slide from the NAB budget presentation:

RBA Interest Rates in a Cleft Stick

The RBA is in a cleft stick:

  • Raising interest rates would increase mortgage stress and threaten stability of the banking system.
  • Lowering interest rates would aggravate the housing bubble, creating a bigger threat in years to come.

The underlying problem is record high household debt to income levels. Housing affordability is merely a symptom.

There are only two possible solutions:

  1. Raise incomes; or
  2. Reduce debt levels.

Both have negative consequences.

Raising incomes would primarily take place through higher inflation. This would generate more demand for debt to buy inflation-hedge assets, so would have to be linked to strong macroprudential (e.g. lower maximum LVRs for housing) to prevent this. A positive offshoot would be a weaker Dollar, strengthening local industry. The big negative would be the restrictive monetary policy needed to slow inflation when the job is done, with a likely recession.

Shrinking debt levels without raising interest rates is difficult but macroprudential policies would help. Also policies that penalize banks for offshore borrowings. The big negative would be falling housing prices as investors try to liquidate some of their investments and the consequent threat to banking stability. The slow-down in new construction would also threaten an economy-wide down-turn.

Of the two, I would favor the former option as having less risk. But there is a third option: wait in the hope that something will turn up. That is the line of least resistance and therefore the most likely course government will take.

China’s Great Cleansing Has Begun | Basis Point

From David Chin at Basis Point:

….China’s commodity futures markets are the ‘canary in the coalmine’ for hints that the markets may be in for an even wilder ride.

Most WMPs [wealth management products] have a maturity between 1-4 months and managers of these WMPs need their Chinese retail investors to roll over by buying new WMPs. If this stops or slows, (which is happening now – see Bloomberg) it will result in assets being force-sold by fund managers to pay back expiring WMPs. The liquid assets that have boomed in recent months such as iron ore futures, will be, and have been, the first to be sold. Next to be sold will be shares, international assets and local property and local corporate bonds if there is still a functioning market for them.

Source: China’s Great Cleansing Has Begun – Basis Point

Oil price fall is caused by tighter monetary conditions | Lars Christensen

Lars Christensen is one of the founding members of the Market Monetarism school of economic thought, having coined the term himself. Market Monetarists advocate that central banks target nominal GDP, instead of inflation, in order to achieve more responsive monetary policy and more stable economic growth.

Is the great China crash upon us? | Macrobusiness

By
Reproduced with kind permission from Macrobusiness.

From Axiom Capital:

While we, as well as the few bearish peers we have, have warned of a pending “credit event” in China for some time now – admittedly incorrectly (China has proved much more resilient than expected) – the more recent red flags are among the most profound we’ve seen in years – in short, we agree with fresh observations made by some of the world’s most famous iron ore bears. Thus, while it is nearly impossible to pinpoint exactly when the credit bubble will definitively pop in China, a number of recent events, in our view, suggest the threat level is currently at red/severe.

WHERE IS CHINA AT TODAY VS. WHERE THE US WAS AT AHEAD OF THE SUBPRIME CRISIS? At the peak of the US subprime bubble (before the failure of Bear Stearns in Mar. ‘08, and subsequently Lehman Brothers in Sep. ’08, troubles in the US credit system emerged as early as Feb. ’07), the asset/liability mismatch was 2% when compared to the total banking system. However, in China, currently, there is a massive duration mismatch in wealth management products (“WMPs”). And, at $4tn in total WMPs outstanding, the asset/liability mismatch in China is now above 10% – China’s entire banking system is ~$34tn, which is a scary scenario. In our view, this is a very important dynamic to track given it foretells where a country is at in the credit cycle.

WHAT ARE THE SIGNS WE ARE SEEING? In short, we see a number of signs that point to what could be the beginning of the “popping” of the credit bubble in China. More specifically: (1) interbank rates in China are spiking, meaning banks, increasingly, don’t trust each other – this is how any banking crisis begins (Exhibit 1), (2) China’s Minsheng Bank recently issued a ghost/fraudulent WMP (they raised $436mn in funds for a CDO-like asset that had no assets backing it [yes, you heard that right] – link), (2) Anbang, the Chinese conglomerate who has used WMP issuance as a means to buy a number of assets globally (including the Waldorf Astoria here in the US),  is now having issues gaining approval for incremental asset purchases (link), suggesting global investors may be getting weary of the way in which Anbang has “beefed up” its balance sheet, (3) China’s top insurance regulator, Xiang Junbo, chairman of the China Insurance Regulatory Commission, is currently under investigation for “severe” disciplinary violations (link), implying some/many of the “shadow” forms of transacting in China could become a bit harder to maneuver (which would manifest itself in higher rates, which his exactly what we are seeing today), and (4) as would be expected from all of this, as was revealed overnight in China, bank WMP issuance crashed 15% m/m in April to 10,038 from 11,823 in March, a strong indicator that faith in these products is indeed waning.

Exhibit 1: Interbank Rates in China

Source: Bloomberg.

DOES CHINESE PRESIDENT XI JINPING HAVE ALL OF THIS UNDER CONTROL? In a word, increasingly, it seems the answer is no. What’s the evidence? Well, in March, interbank rates spiked WAY past the upper corridor of 3.45% to ~11% (Exhibit 2), a strong indicator that the PBoC is losing its ability to “maintain order”. And, admittedly, while there are levers the PBoC can pull, FX reserves are at scary low levels (discussed below), suggesting the PBoC is quickly running out of bullets. Furthermore, corporate bond issuance in China was negative in C1Q, which means M2 is going to be VERY hard to grow (when MO is negative); at risk of stating the obvious, without M2 growth in China, economic growth (i.e., GDP) will undoubtedly slow – this is not the current Consensus among market prognosticators who think things are quite rosy right now in China; yet, while global stock markets are soaring, the ChiNext Composite index is down -7.5% YTD vs. the Nasdaq Composite Index being up +12.8% YTD. In our view, given China’s importance to the global commodity backdrop, we see this as a key leading indicator (the folks on the ground in China are betting with their wallets, while global investors continue to place their hopes on: [a.] a reflationary tailwind that we do not believe is ever coming [China is now destocking], and [b.] hope that President Trump will deliver everything he’s promised [which, in this political environment, we see is virtually impossible]).

Exhibit 2: Overnight Reverse Repo Rate

Source: Bloomberg.

CHINA’S FOREIGN EXCHANGE (“FX”) RESERVES ARE DANGEROUSLY CLOSE TO LOW LEVELS THAT WILL LIKELY CAUSE AN INFLECTION LOWER IN THE CURRENCY. Based on a fine-tuning of its formula to calculate “reserve-adequacy” over the years, the International Monetary Funds’ (“IMF”) approach can be best summed up as follows: Minimum FX Reserves = 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities. Thus, for China, the equation is as follows: 10% * $2.2tn + 30% * $680bn + 10% * (RMB 139.3tn ÷ 6.6) + 15% * $1.0tn = $2.7tn of required minimum reserves. Furthermore, when considering China’s FX reserve balance was roughly $4tn just 2 years ago, we find it concerning that experts now peg China’s unofficial FX reserve balance somewhere in the $1.6-$1.7tn range. Why does this differ from China’s $3.0tn in reported FX reserves as of Feb. 2017? Well, according to our contacts, when adjusting for China’s investment in its own sovereign wealth fund (i.e., the CIC) of roughly $600bn, as well as bank injections from: (a) China Development Bank (“CDB”) of roughly $975bn, (b) The Export-Import Bank of China (“EXIM”) of roughly $30bn, (c) the Agricultural Development Bank of China (“ADBC”) of roughly $10bn, as well as capital commitments from, (d) the BRICs Bank of roughly $50bn, (e) the Asian Infrastructure Investment Bank (“AIIB”) of $50bn, (f) open short RMB forwards by agent banks of $300bn, (g) the China Africa Fund of roughly $50bn, and (h) Oil-Currency Swaps with Russia of roughly $50bn, the actual FX reserve balance in China is closer to $1.69tn (Exhibit 3).

Stated differently, based on the IMFs formula, sharply contrasting the Consensus view that China has years of reserves to burn through, China is already below the critical level of minimum reserve adequacy. However, using expert estimates that $1.0tn-$1.5tn in reserves is the “critical level”, and also considering that China is burning $25bn-$75bn in reserves each month, the point at which the country will no longer be able to support the renminbi via FX reserves appears to be a 2017 event. At that point, there would be considerable devaluation in China’s currency, sending a deflationary shock through the world’s commodity markets; in short, we feel this would be bad for the steel/iron ore stocks we cover, yet is being completely un-discounted in stocks today (no one ever expects this event to occur).

The early 2007 analogy is a good one. This is coming at some point in the next few years. I remain on guard but skeptical at this point given China does have other levers it can pull to keep the credit running and is indeed pulling them in fiscal policy. As well, the problem can always be made worse before it’s made better. Authorities are, after all, bringing this on.

It’s a fascinating question. Could China endure a “sudden stop” in credit if counter-party risk exploded, much like happened to Wall St in 2008? The usual analysis reckons that China’s publicly owned banks can always be ordered to lend more but what if they lose faith in each other? It’s probably true that Chinese authorities could still force feed credit into the economy but, equally, it’s difficult to see how an interbank crash in confidence would not slow the injection, at minimum via choked off-balance sheet vehicles like WMPs.

There is no doubt, at least, about what happens when it does arrive:

  • the final washout of commodity prices;
  • Australian house price crash;
  • multiple sovereign downgrades, and
  • an Aussie dollar at 40 cents or below.

It’s the great reset event for Australia’s bloated living standards. That is why we say to you get your money offshore today. We can help you do that when the MB Fund launches in the next month with 70% international allocation.

Comment from Colin:

I share Macrobusiness’ skepticism over the timing of a possible Chinese crash, especially because they have in the past shown a preparedness to kick the can down the road rather than address thorny issues – making their problems worse in the long run. But I do see China’s stability as a long-term threat to the global financial system which could precipitate a major down-turn on global stock markets.

ASX 200 advance slows as iron ore falls

Iron ore found support at $60.

Iron ore

The ASX 300 Metals & Mining Index has taken some encouragement from the rally, with support at 2850. But bear rallies are normally short in duration and reverse sharply.

ASX 300 Metals & Mining

The ASX 200 advance has slowed after the recent sell-off in the resources sector. But rising Twiggs Money Flow still signals buying pressure and another attempt at 6000 seems likely.

ASX 200

* Target medium-term: 5800 + ( 5800 – 5600 ) = 6000

ASX 300 Banks, the largest sector in the broad index, is consolidating above its new support level at 9000. Declining Twiggs Money Flow warns of medium-term selling pressure. Reversal below 8900 is unlikely but would warn of a correction.

ASX 300 Banks

Bank exposure to residential mortgages is the Achilles heel of the Australian economy and APRA is likely to keep the pressure on banks to raise lending standards and increase capital reserves, which would lower return on equity.

Australia: Financial Stability | RBA

Extract from the latest Financial Stability Review by the RBA:

….In Australia, vulnerabilities related to household debt and the housing market more generally have increased, though the nature of the risks differs across the country. Household indebtedness has continued to rise and some riskier types of borrowing, such as interest-only lending, remain prevalent. Investor activity and housing price growth have picked up strongly in Sydney and Melbourne. A large pipeline of new supply is weighing on apartment prices and rents in Brisbane, while housing market conditions remain weak in Perth. Nonetheless, indicators of household financial stress currently remain contained and low interest rates are supporting households’ ability to service their debt and build repayment buffers.

The Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets, focusing in particular on interest-only and high loan-to-valuation lending, investor credit growth and lending standards. In an environment of heightened risks, the Australian Prudential Regulation Authority (APRA) has recently taken additional supervisory measures to reinforce sound residential mortgage lending practices. The Australian Securities and Investments Commission has also announced further steps to ensure that interest-only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of past poor lending practices. The CFR will continue to monitor developments carefully and consider further measures if necessary.

Conditions in non-residential commercial property markets have continued to strengthen in Melbourne and Sydney, while in Brisbane and Perth high vacancy rates and declining rents remain a challenge. Vulnerabilities in other non-financial businesses generally appear low. Listed corporations’ profits are in line with their average of recent years and indicators of stress among businesses are well contained, with the exception of regions with large exposures to the mining sector. For many mining businesses conditions have improved as higher commodity prices have contributed to increased earnings, though the outlook for commodity prices remains uncertain.

Australian banks remain well placed to manage these various challenges. Profitability has moderated in recent years but remains high by international standards and asset performance is strong. Australian banks have continued to reduce exposures to low-return assets and are building more resilient liquidity structures, partly in response to regulatory requirements. Capital
ratios have risen substantially in recent years and are expected to increase further once APRA finalises its framework to ensure that banks are ‘unquestionably strong.’

Risks within the non-bank financial sector are manageable. At this stage, the shadow banking sector poses only limited risk to financial stability due to its small share of the financial system and minimal linkages with the regulated sector, though the regulators are monitoring this sector carefully. Similarly, financial stability risks stemming from the superannuation sector remain low.

While the insurance sector continues to face a range of challenges, profitability has increased of late and the sector remains well capitalised.

International regulatory efforts have continued to focus on core post-crisis reforms, such as addressing ‘too big to fail’, as well as new areas, such as the asset management industry and financial technology. While the goal of completing the Basel III reforms by end 2016 was not met, discussions are ongoing to try to finalise an agreement soon. Domestically, APRA is continuing its focus on the risk culture in prudentially regulated institutions and will review compensation policies and practices to ensure these are prudent.

Reading between the lines:

  • household debt is too high
  • apartments are in over-supply and prices are falling
  • we have to maintain record-low interest rates to support the housing bubble
  • APRA is “taking steps” to slow debt growth but also has to be careful not to upset the housing bubble
  • the Basel committee has been dragging its feet on new regulatory guidelines and we cannot afford to wait any longer

Source: RBA Financial Stability Review PDF (2.4Mb)

Inflation surges

Inflation is rising, with CPI climbing steeply above the Fed’s 2% target. But core CPI excluding energy and food remains stable.

Consumer Price Index

Job gains were the lowest since May 2016.

Job Gains

But the unemployment rate fell to a low 4.5%.

Unemployment

Hourly wage rate growth has eased below 2.5%, suggesting that underlying inflationary pressures are contained.

Average Hourly Earnings Growth

The Fed is unlikely to accelerate its normalization of interest rates unless we see a surge in core inflation and/or hourly earnings growth.

ASX 200 faces bank headwinds

The ASX 300 Banks Index continues to test support at 9000. Declining Twiggs Money Flow warns of selling pressure and reversal below 8900 would warn of a correction.

ASX 300 Banks

The ASX 200 continues its advance towards 6000, with rising Twiggs Money Flow signaling buying pressure. But it is vulnerable to a correction in the Banks Index, the largest sector in the broad index.

ASX 200

* Target medium-term: 5800 + ( 5800 – 5600 ) = 6000

The economy is still exposed to a property bubble and APRA is likely to keep the pressure on banks to increase their capital reserves, which would lower their return on equity.

APRA: Wayne Byres warns banks need more capital

From APRA chairman Wayne Byres’ keynote address to the AFR Banking & Wealth Summit 2017, Sydney:

Haven’t we done enough already?

The third question is: haven’t we done enough already?

The banking system certainly has higher capital adequacy ratios than it used to. But overall leverage has not materially declined. The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6½ per cent at the end of 2016.

Bank Leverage

The difference between improved risk-based measures of capital adequacy, and the more limited improvement in non-risk based measures of leverage (Chart 6), is driven to a significant degree by changes in asset composition. In particular, it reflects the increasing concentration of the banking system in mortgage lending (which benefits from lower risk weights – Chart 7).

Bank Risk Weighting

It implies the system has de-risked more than deleveraged. But that assessment is itself premised on a critical assumption: that a high and increasing concentration in mortgages is generating a lower risk banking system. In the current environment, it is certainly an assumption that deserves a bit more scrutiny. While it might be a reasonable proposition most of the time, we need to be wary of the fallacy of composition when concentrations grow.

….The case for the Australian banking system to be seen as unquestionably strong remains as valid today as it did when the FSI recommended it in 2014. And, as much as we would like international policy deliberations to be complete, we do not think it right to defer a decision on this issue any longer…..

Bank leverage has barely improved despite substantial increases in capital ratios as banks have increasingly concentrated their exposure in residential mortgages which have lower risk-weighting. Chart 7 above shows how the average risk-weighting of bank assets has declined over the last decade.

Neel Kashkari, president of the Minneapolis Fed, believes that banks need to hold far higher capital in order to avoid future bailouts. His proposal:

….force banks to finance themselves with capital totaling 23.5% of their risk-weighted assets, or 15% of their balance-sheets without adjusting for risk (the “leverage ratio”). This, says Mr Kashkari, would be enough to guard the financial system against a shock striking many reasonably-sized banks at once. Any bank deemed too big to fail would need a still bigger buffer, eventually reaching an eye-watering 38% of risk-weighted assets….

It’s widely accepted that Australia’s big four banks are too-big-to-fail. If that is the case, applying Kashkari’s measure would require them to increase bank capital by 200%.

Even without the too-big-to fail buffer, the major banks would require a 100% increase in bank capital to meet the 23.5% capital requirement for risk-weighted assets. And a 150% increase to match the 15% minimum without risk weighting.

The question needs to be asked: is APRA doing enough to protect Australians from a financial crisis? To me the answer is a clear NO.

Source: Pages – Fortis Fortuna Adiuvat: Fortune Favours The Strong

Hat tip to Macrobusiness.

Sorry folks, this ain’t no property bubble

I have been predicting the collapse of the Australian property bubble, so feel obliged to also present the opposite view. Nothing like confirmation bias to screw up a good investment strategy.

Here Jessica Irvine argues that the property bubble will not burst:

Believe me, no one is keener than me to see a property bubble burst.

But sadly – for would-be buyers, at least – I just don’t see it happening.

Sure, there are risks.

If it turns out that banks have been lending to people who really can’t afford it, then we have a problem when interest rates start to rise.

Experts have been calling the end of the property market for years. But banks insist they stress test customers for a 2-percentage-point rise in interest rates and require “interest-only” borrowers to prove they could afford to repay principal too, if required.

More worrying is the mortgage broking channel, where a recent ASIC investigation found most of the high loan-to-value loans are written. If there is a weakness in the housing market, it’ll be in this area of lending standards and so called “macroprudential” policies when interest rates start to rise. The recent clamping down on investor loans is welcome.

But ultimately, the defining thing about bubbles is that they inevitably must pop.

But where is the trigger for a widespread home price collapse?

In a world of low inflation and growth, the Reserve Bank is likely to raise interest rates very gently, cushioning households.

Widespread job losses would be a trigger, but there is no talk of that. With record low wages growth, labour is hardly expensive at the moment.

Bubble proponents point to very high household debt levels relative to incomes. But the structural lowering of interest rates in the late 1990s and again after the global financial crisis has increased the amount of debt households can afford to service from a given income.

Lower rates have also helped many households build significant “buffers” against future rate increases, in offset accounts and other forms of saving.

Bubbles form when asset prices disconnect completely with market fundamentals.

But there are very good reasons to expect housing to be so expensive.

Forget the Cayman Islands, housing – owner occupied and investment housing – offers the best tax shelter around, from negative gearing and the capital gains tax discount on investment housing to the complete exemption of the family home from capital gains tax AND from the pension asset test.

Meanwhile, rapid population growth has been met by sluggish increases in housing supply. Incompetent state governments have created a premium for inner-city housing, where buyers can avoid paying the indirect costs of long commutes.

In the aftermath of World War II, home ownership rates skyrocketed as governments focused on supply.

But since then, governments have instead implemented policies that boost only the demand side of the equation, with tax concessions and cash bonuses for buyers that only increase prices.

Absent any trigger for widespread forced property sales, home owners will always respond to sluggish market conditions by sitting on their properties for longer. Lower volumes provide a cushion against falling prices.

In such a market, the best a first-time buyer can hope for is that future price gains might come back into line with income growth.

Indeed, that’s exactly what happened after the early 2000s property boom when Sydney prices stagnated for almost a decade.

It’s less exciting, but more likely.

Jessica makes a good point about offset accounts which may cause real household debt to be overstated. This warrants further investigation.

But she seems too complacent about market fundamentals:

  • an oversupply of apartments;
  • negative gearing and capital gains tax advantages that could be removed by the stroke of a pen (or a tick on a ballot paper); and
  • prospective sharp cuts to immigration (again dictated by the ballot box)

Interest rate rises seem unlikely in the near future as inflationary pressures are fading. But I doubt that new homebuyers could afford a 2 percent rise in interest rates, that would amount to an almost 40% increase in monthly repayments for some. Even if they survive, repayments will take a big bite taken out of other household consumption and hurt the entire economy.

Also, the RBA may plan to increase rates gradually, to cushion the effect on homeowners, but Mr Market could have other ideas. And if you think central banks act autonomously from markets, think again.

Source: Sorry folks, this ain’t no property bubble

3 Headwinds facing the ASX 200

The ASX 200 broke through stubborn resistance at 5800 but is struggling to reach 6000.

ASX 200

There are three headwinds that make me believe that the index will struggle to break 6000:

Shuttering of the motor industry

The last vehicles will roll off production lines in October this year. A 2016 study by Valadkhani & Smyth estimates the number of direct and indirect job losses at more than 20,000.

Full time job losses from collapse of motor vehicle industry in Australia

But this does not take into account the vacuum left by the loss of scientific, technology and engineering skills and the impact this will have on other industries.

…R&D-intensive manufacturing industries, such as the motor vehicle industry, play an important role in the process of technology diffusion. These findings are consistent with the argument in the Bracks report that R&D is a linchpin of the Australian automotive sector and that there are important knowledge spillovers to other industries.

Collapse of the housing bubble

An oversupply of apartments will lead to falling prices, with heavy discounting already evident in Melbourne as developers attempt to clear units. Bank lending will slow as prices fall and spillover into the broader housing market seems inevitable. Especially when:

  • Current prices are supported by strong immigration flows which are bound to lead to a political backlash if not curtailed;
  • The RBA is low on ammunition; and
  • Australian households are leveraged to the eyeballs — the highest level of Debt to Disposable Income of any OECD nation.

Debt to Disposable Income

Falling demand for iron ore & coal

China is headed for a contraction, with a sharp down-turn in growth of M1 money supply warning of tighter liquidity. Falling housing prices and record iron ore inventory levels are both likely to drive iron ore and coal prices lower.

China M1 Money Supply Growth

Australia has survived the last decade on Mr Micawber style economic management, with something always turning up at just the right moment — like the massive 2009-2010 stimulus on the chart above — to rescue the economy from disaster. But sooner or later our luck will run out. As any trader will tell you: Hope isn’t a strategy.

“I have no doubt I shall, please Heaven, begin to be more beforehand with the world, and to live in a perfectly new manner, if — if, in short, anything turns up.”

~ Wilkins Micawber from David Copperfield by Charles Dickens

Gold bullish as Dollar finds support

10-year Treasury Yields are consolidating around the 2.5% level. Upward breakout is likely and would signal an advance to 3.0%.

10-year Treasury Yields

The Dollar Index has found support, with a large engulfing candle at 100. Recovery above the descending trendline would suggest a fresh advance, with a target of 108*. Reversal below 99 is unlikely but would warn of a test of primary support at 93.

Dollar Index

* Target calculation: 104 + ( 104 – 100 ) = 108

China’s Yuan continues to weaken, with USDCNY in a strong up-trend. Shallow corrections flag buying pressure. 13-week Twiggs Momentum oscillating above zero indicates a strong up-trend.

USDCNY

Spot Gold is testing support at $1240/$1250 an ounce. Recovery above $1260 is likely and would signal an advance to $1300.

Spot Gold

APRA fiddles while housing risks grow

From Westpac today (emphasis added):

….With the Reserve Bank sharing our caution around 2018, along with ample capacity in the labour market (unemployment rate is 5.9% compared to full employment rate of 5.0%) and stubbornly low wages growth, there is only scope to cut rates. But as we have argued consistently, a resurgent housing market disallows such a policy option. Indeed, the minutes refer to “a build- up of risks associated with the housing market”. A tighter macro prudential stance seems appropriate.

Indeed, as we go to press, APRA has announced new controls, restricting the “flow of new interest-only lending to 30 per cent of total new residential mortgage lending” with a particular focus on limiting interest only loans with a loan-to-value ratio [LVR] above 80%. Currently, “interest-only terms represent nearly 40 per cent of the stock of residential mortgage lending by ADIs”, so this policy will restrict the terms at which a marginal borrower can access credit (investors and owner-occupiers). APRA also noted that they want banks to manage growth in investor credit to “comfortably remain below the previously advised benchmark of 10 per cent growth”. This is not a hard change to the target as had been mooted recently in the press (some suggesting the 10% limit could be as much as halved), but it does suggest lending to investors will continue to grow at a pace meaningfully below 10%. Looking ahead, the next RBA Stability Review (April 13) may provide more clarity on the macro prudential policy outlook and potential triggers for further action. For the time being though, the 2015 experience offers an understanding of the potential impact of this further tightening.

To head off a potential bubble burst, the RBA and APRA need to drastically slow house price growth. I am sure the big four banks are urging caution but they would be the worst hit by a meltdown. What APRA is doing is fiddling around the margins. To make housing investors think twice about further borrowing, APRA needs to cut the maximum LVR to 70%. And half that for foreign borrowers.

More evidence of a bull market, except in Australia

One of my favorite indicators of financial market stress is Corporate bond spreads. The premium charged on the lowest level of investment-grade corporate bonds, over the equivalent 10-year Treasury yield, is a great measure of the level of financial market stress.

Moodys 10-year BAA minus Treasury yields

Levels below 2 percent — not seen since 2004 – 2007 and 1994 – 1998 before that — are indicative of a raging bull market. The current level of 2.24 percent is slightly higher, reflecting some caution, but way below elevated levels around 3 percent.

The Financial Stress Index from St Louis Fed measures the degree of stress in financial markets. Constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. The average value of the index is designed to be zero (representing normal market conditions); values below zero suggest low financial stress, while values above zero suggest high market stress.

St Louis Financial Stress Index

Current levels, below -1, also indicate unusually low levels of financial market stress.

Leading Index

The Leading Index from the Philadelphia Fed has declined slightly in recent years but remains healthy, at above 1 percent.

Philadelphia Fed Leading Index

Currency in Circulation

Most recessions are preceded by growth in currency in circulation falling below 5 percent, warning that the economy is contracting.

Currency in Circulation

Current levels, above 5 percent, reflect healthy financial markets.

Australia

On the other side of the Pacific, currency growth is shrinking, below 5 percent for the first time in 7 years. A sustained fall would warn that the economy is contracting.

Australia: Money Supply

Further rate cuts, to stimulate the economy, are unlikely. The ratio of Household Debt to Disposable Income is climbing and the RBA would be reluctant to add more fuel to the bonfire.

Australia: Household Debt

There is no immediate pressure on the RBA to raise interest rates, but when the time comes the impact on the housing market could be devastating.

Gold rallies as Dollar falls

The Dollar Index rally is falling despite rising interest rates. Chinese sell-off of foreign reserves to support the Yuan may be a factor.

Dollar Index

Spot Gold rallied off support at $1200/ounce. Recovery above $1250 would confirm an up-trend, with the next target at $1300.

Spot Gold