It’s no wonder Westpac’s Bill Evans is now telling the world we will get four rate cuts by the end of the year from the Reserve Bank. He and other economists have looked at the increasing inverse sharp of the interest rate curve in local money markets and taken fright.

An inverse yield curve is when longer term rates are lower than the short term rate: in this case, Australian 10 year bond yields are now under 3% while the RBA’s cash rate is 3.75%. That has been developing for the past month or more, but the signal got really strong this week as 10 year yields fell to 2.89% (a fall of 0.75% in May alone). It is usually a sign the markets see a recession ahead and that rates will be cut in the future to soften the impact of the slowdown and to stimulate recovery.

This inverse structure is more noticeable in Australia than in other countries. For example, the key short term official rate in the US is the 0% to 0.25% rate, but 10 year bonds are yielding a record low of 1.57% so the curve is still positive, meaning investors see the economic growth. It’s a similar situation in the UK and German markets: 10 year and other bonds yields are at record lows, but that is still above the 1% rate for the European Central Bank in the case of Germany, and well above the 0.50% in the UK (UK 10 year gilts are yielding around 1.5%).

You’d expect recessionary Greece, Spain and Italy to see a negative yield curve, but their 10 year yields are above 5% to 6% (and 20% and more in the case of Greece where there is no longer a real market) compared to the ECB rate of 1%. But that’s because of the rising fear of default. Those economies are in the dumps and should be stimulated by lower long term rates. But that flexibility was surrendered when the eurozone was formed and the euro started.

Bond yields here are being driven lower not just by fears about a recession or the impact of Europe, which Mr Evans and others seem to believe, but also by the demand from investors for a safe haven. The fear of recession or collapse in the eurozone and Europe, which in turn is sending investors into cash or investments that are safe (AAA rated) and paying a decent return like Australian bonds.

It’s why 70-80% of all Commonwealth bonds on issue are now owned by offshore investors, and why a third or more of all state government bonds have been snapped up by foreigners. They would not be buying if they thought there was a risk of recession alone.

And if you consider at our economic outlook, why would they? The picture is far better than the one painted by Mr Evans who looked solely at the patchy nature of the domestic, non-mining economy.

“You can’t ignore what’s going on in the market. There’s a fair degree of disquiet,” Mr Evans said. ”Monetary policy is too tight given the shock to confidence and fragility of the economy. Retail has lost its momentum, house prices have edged off, capital spending is quite soft excluding mining.”

Evans is displaying some convenient amnesia there. His bank, Westpac, and the others have eaten a lot of the 1% in rate cuts by the RBA since last November. To be consistent, you’d hope he’d at least admit that his bank and others have played some part in reducing consumer confidence by trying to protect their profit margins. And by calling for more rate cuts to stimulate spending in retailing and housing, Evans is also talking his own book, because increased spending would mean more lending by banks such as Westpac.

Comments from Mr Evans and others about the worsening state of the economy have also played a role. He has been making gloom and doom forecasts and calling for rate cuts since late last year (which in turn feed through into the Westpac/Melbourne Institute of Consumer Confidence). This can be what economists call a negative feedback loop, that a series of negative comments reinforce the feeling of doom and gloom (just as positive comments can feed a boom or bubble in a positive loop).

But here’s the important issue, one that everyone commenting on the “patchwork economy” from the Prime Minister down should understand. The size of the mining boom is so great that there’s a real issue about whether we should be trying to stimulate the non-resources sector.

The capital expenditure figures for the March quarter were a record, and even though there was a sharp fall in manufacturing investment in the quarter and in the figures forecast for 2012-13. The size of the spend in mining and resources is simply staggering at an expected $118 billion, a 44% jump, and a record total actual spend of $40 billion, regardless of the slowdown in spending in manufacturing (down 21%). Total investment is projected to rise 23% to $178 billion in 2012-13.

Can Evans and others assure us that the economy can handle that level of spending and kick start demand in retailing. the home building and construction sectors without sparking a rise in costs and inflation? That’s the question the RBA has to confront. Mr Evans and others in the business community who call for monetary stimulus for the domestic economy would be the first to moan if the RBA tried to do that and we saw a surge in labour and material costs and a jump in inflation in the next year to 18 months.

Everyone is busy lamenting the “patchwork economy” but the truth is, there will be a high price – literally – to pay if we try to pump up the non-resources sector while we digest a truly historic investment boom.

Peter Fray

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