Is There a Common Denominator Between Australia & the US?

by Stephen Vanelli, CFA, Knowledge Leaders Capital

Last night, the Reserve Bank of Australia stopped short of another 50bps hike to its overnight cash rate. The RBA’s statement contained one nugget that helps explain its decision: “One source of uncertainty is the outlook for the global economy, which has deteriorated recently.”

While Australia is a different economy with different circumstances—like higher consumer debt loads and variable rate mortgages—there are some factors in common with the US, such as the Chinese Yuan, which has been depreciating fiercely recently.

For Australia, we can see the relationship between the CNY/USD and the Australia PMI Manufacturing. A weaker CNY weighs on economic activity down under and possibly the RBA was cognizant of the built-in continuing slowdown that the CNY will cause in the months to come. All else equal, the Australia Manufacturing PMI looks set to move into recession territory by the end of the year.

The other impact of a depreciating CNY is on inflation. In the chart below, I plot the CNY/USD alongside the Australia 10-Year Government Bond breakeven inflation. Given the move in the CNY/USD, it looks like inflation is set to plunge in Australia… without the need for an additional 50bps hike.

Interestingly, the exact same impacts appear in the US when we make the same comparisons as made above. The weakening CNY looks like it has put the ISM Manufacturing index on track to decline into recession territory.

And, just like Australia, the US bond market has taken notice of the devaluing CNY/USD. The overlay of the CNY/USD on US 10-Year breakeven inflation looks very similar to Australia and suggests inflation expectations continue to erode in the months to come.

While the RBA is being somewhat criticized for slowing its roll and recognizing the global recession/deflation risks, the Federal Reserve is talking much more resolutely about the need to press on with super-sized rate hikes. But, is the Fed any more confident in its outlook than the RBA’s equivocation seemed to suggest? Most investors would likely respond that the Fed is much more resolute about its future path of rates. If that is the case then why is the Fed more uniformly uncertain about the future prospects for growth, unemployment and inflation than ever?

Perhaps the Fed and RBA have more in common than realized…they both are seeing the negative impacts of a weakening Chinese Yuan on economic activity and prices, and they both have—whether spoken or inferred—a high level of uncertainty about the future path of economic growth and inflation.

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