The Reserve Bank noted that business credit growth had picked up. Photo: Louie Douvis In the commodities markets there are some mildly positive signs. Photo: Michele Mossop
The Fed should flatten its rate-rise trajectory if US growth slows. Photo: Andrew Harrer
China’s economy is shifting towards a consumer demand-driven model.
There are many questions to be answered as the markets rally into the new year. Two of the biggest are what happens to interest rates, and what happens to commodity prices?
In mid-December, when it boosted short-term rates for the first time in almost a decade, the US Federal Reserve said it expected “gradual increases” thereafter.
The so-called “dots” that plot what members of the Fed’s rate-setting committee think will happen were not changed for 2016, however, and they chart a course that is more aggressive than the one the market has priced in. The median dot forecast is for four more quarters of a percentage point increases in 2016. Federal Funds rate futures are priced for an increase of just more than a half a percentage point over the same time.
This does not mean that the markets will throw a tantrum when the Fed announces its next rate hike, perhaps in March. A rise of almost a quarter of a percentage point in three months is basically priced in. There is potential for increasing tension during the year, however, if the Fed maintains its dot plot, and the markets decide that it should be more cautious.
After the successful launch of the new rate rise cycle in December, the gap between the dots and market prices could also close calmly, however. The Fed should flatten its rate-rise trajectory if US economic growth is slower than expected, or if inflation does not move up, as it currently predicts. If the economy does what the Fed expects, the markets should move futures prices up towards the dots.
In Australia, the Reserve Bank cut its cash rate from 2.5 per cent to 2.25 per cent in February and to 2 per cent in May. It said after its November and December meetings that an unthreatening inflation outlook might “afford scope for further easing of policy”, if it is needed.
At its current exchange rate of about US72.9¢ the Australian dollar is, however, giving more support to the economy than it was in May, when it was more than US80¢ and the Reserve Bank was saying further depreciation was “likely and necessary”.
Business credit growth also climbed out of the gutter in 2015. It grew at an unsustainably strong average rate of 19.6 per cent in 2007 before the 2008-09 global financial crisis and went negative in 2009 and 2010, after the crisis hit. It was still increasing at a rate of less than 2 per cent a year in 2013, but increased by 6.6 per cent in the year to October 2015.
The Reserve Bank noted that business credit growth had picked up when it left its cash rate at 2 per cent in December. It also said business surveys suggested a “gradual improvement” in the economy outside the resources sector. If those trends continue to build in 2016, the market will be alert for signs from the central bank that 2 per cent is as low as the cash rate goes.
In the commodities markets there are some mildly positive signs, but it is too early to tell whether prices have found a base.
The bottom of a commodity price cycle results in uneconomic production being sidelined, and there were production cuts in key commodities including iron ore, coal, oil and copper in the second half of 2015.
Iron ore production increases in the low-cost Pilbara region outweighed cuts elsewhere in that market, however, and across the resources sector companies that a year ago were producing at prices that were threatening to be loss-making stayed in business in 2015 by pulling their production costs down, extending the supply-side adjustment.
In the US shale oil belt, for example, the number of drilling rigs deployed has fallen by about two-thirds since October 2014, in the face of the oil price slump that Saudi Arabia has engineered by raising its production. The Saudi production surge was aimed at the US producers and the US market share they were winning – but US oil production is still only about 4 per cent below a high set in the first half of 2015 despite the sharp reduction in drilling activity.
There are predictions that US shale oil production will fall sharply in 2016 if oil stays at less than $US50 a barrel – West Texas Intermediate oil is about $US37.16 a barrel and has not been more than $US50 since July – but so far the US shale oil producers have been resilient.
Prices would also recover if demand for commodities picked up, but that too could be a drawn-out process.
The key market is China, and while there were some signs at the end of 2015 that its economic growth slump was bottoming, China’s economy is shifting towards a consumer demand-driven model that is less frenetic and less commodity-intensive than the heavy construction phase that preceded it. The 10 per cent-plus economic growth rate that China was achieving during the commodities boom is history, and so are the ultra-high commodity prices that accompanied it.
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