Here comes the slowdown in the Australian economy Bill Evans has been warning about

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For several months Westpac’s chief economist Bill Evans has been warning that the prospects for the Australian economy next year are looking “discouraging”, and now Westpac’s Leading Index — a forward-looking indicator on how the economy is likely to perform in the future — appears to be backing up that view.

The six-month annualised growth rate in the index, a guide as to the likely pace of economic activity looking three to nine months into the future compared to historic norms, fell heavily in May, sliding to 0.62% from 1.01% in April.

Source: Westpac

While it still remains in positive territory, pointing to above-trend growth in the second half of the 2017, it now sits well below the recent cyclical peak of 1.59% struck in December last year, indicating that momentum is likely to weaken heading into 2018.

“The Leading Index has been pointing to above trend momentum since late last year but the latest updates suggest the growth pulse is moderating heading into the second half of 2017 highlighting downside risks to the 2018 growth outlook,” said Matthew Hassan, senior economist at Westpac.

“The shift mainly reflects a less supportive backdrop for Australia’s commodity prices and in global financial markets.”

Indeed, according to Hassan, commodity prices and steepening global yield curves — the two factors that drove the improvement in the index in the second half of last year — have now done a complete about-face, dragging the index lower.

“After surging 44% between June and February, Australia’s commodity prices have declined 10% over the last three months. The turnaround has taken 1.17 percentage points off the Leading index growth rate since the end 2016,” he says.

A flattening in global yield curves, suggesting that the outlook for global economic growth and inflationary pressures is weakening, has also had a large impact, slicing 0.42 percentage points from the index.

“After widening significantly over the second half of 2016, the yield gap has narrowed sharply in 2017, led by lower 10yr bond rates as markets have pared back expectations for growth stimulus policies in the US,” said Hassan.

As seen in the table below, those two components have been a major factor behind the recent reversal in the index.

Source: Westpac

Despite the risks to Australia’s growth outlook, should the loss of momentum in the index be reflected on the ground, Westpac retains the view that the Reserve Bank of Australia is unlikely to move official interest rates anytime soon.

“Recent comments indicate that policy is firmly on hold with the Bank expecting growth to increase gradually to an above trend pace,” says Hassan.

“We expect the Bank to leave rates unchanged over the rest of 2017 and throughout 2018.”

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