As July turned to August, signs of weaker US economic growth ahead, highlighted that central bank rate cuts come at a price – faltering economic growth and weaker company earnings. The upside is that there is more room for government bond yields to push lower, even though the borrowing requirements of some highly indebted Governments, including the US, continue to rise.
Major share markets mostly traded stronger in July although have lost their July gains and more in early August. In July, Australia’s ASX 200 gained most, up 4.4%, as a lower-than-feared Q2 inflation report seemed to remove the possibility of an August rate hike by the RBA. The US S&P 500 rose by 1.1% with an improving prospect that the Federal Reserve may start cutting the Federal Funds rate in September, but the market was reminded unpleasantly in early-August that a weakening US economy means that the Fed may be falling behind on delivering cuts that could avoid recession. The German Dax, Britain’s FTSE 100 and China’s CSI all lifted in July by respectively 1.5%; 2.5%; and 2.2%. Japan’s Nikkei went against grain of market increases in July and fell by 1.3%.
Credit markets mostly rose in July, taking the lead from stronger share markets. In Australia, notwithstanding the pressure from high borrowing interest rates, credit spreads narrowed in July helped by high and still rising house prices, rising but still comparatively low loan default rates, and still low unemployment.
Australian households remain well placed to meet their high debt-servicing commitments although Australian small businesses are finding debt-servicing harder facing not just high borrowing interest rates, but also generally higher costs and flagging demand. The diminishing likelihood of any more RBA rate hikes may help local credit market prospects although potentially marred by the possibility of a softer economic growth outlook on the back of deteriorating economic conditions overseas.
US and Australian government bond yields fell in July. The US bond market was helped by the growing prospect of a Fed rate cut in September reinforced at the press conference after the late July FOMC meeting (decision to hold the Funds rate unchanged at 5.50%) when Fed Chairman, Jerome Powell, said that the committee would be able to start looking at cutting rates at the next meeting.
The US 2-year bond yield fell by 49 basis points (bps) in July to 4.26%, while the US 10-year bond yield fell by 37bps to 4.03%. The rally continued strongly in the first two days of August with the 2 and 10-year yields falling to respectively 3.88% and 3.79% as weaker than expected labour market data (the US unemployment rate lifted to 4.3% in July from 4.1% in June and 3.7% at the end of 2023) implied that US soft economic-landing prospects are turning harder and possibly to recession.
The Australian bond market had been marching to a different beat to the US bond market moving into July with concern that higher and stickier Australian inflation compared with the US experience might place the RBA as the odd man out needing to hike rather than cut interest rates. Australia’s key Q2 CPI report showed that while inflation is still high – CPI up 1.0% q-o-q lifting annual inflation to 3.8% y-o-y from 3.6% in Q1 but with underlying inflation lower at 0.8% q-o-q for both the trimmed mean and weighted median and respectively reducing annual inflation readings to 3.9% y-o-y from 4.0%, in Q1, and 4.0% y-o-y from 4.4% in Q1 – it may have improved enough to take an August rate hike off the table.
Australia’s 2-year and 10-year bond yields fell in July by respectively 33bps to 3.83% and 25bps to 4.06% and have rallied a little further in early August.
Although the RBA may not hike the cash rate at the interest rate setting meeting this week, we still see little likelihood of the RBA being able to start cutting interest rates over the next six months at least. Inflation, although not as bad as feared, is still sticky and well above the RBA’s 2-3% target.
Several local factors point to a long struggle to get inflation down to target range. Wage growth is hovering around 4% y-o-y and productivity is still poor. Annual growth in final stage producer prices lifted to 4.8% y-o-y in Q2 from 4.3% in Q1 implying consumer price increases in the pipeline. Unlike the US, recession risk is small in Australia and aggregate demand growth may be improving with retail sales up 0.5% m-o-m in June after lifting 0.6% in May and home buying indicators still firm.
A weaker global economic outlook will make some difference to Australia’s growth prospects but not enough in our view to shift the RBA away from its view and forecasts that local inflation will not return to 2-3% target before late next year and that timeframe remains uncomfortably long. The RBA will still need to hold the cash rate at least at 4.35% through to early- or mid-2025 and that means Australian bonds cannot rally as far as US bond yields with the advantage of the Fed cutting the Funds rate perhaps twice later this year.
Australian bond yields may benefit from occasional safe haven buying as risk assets come under selling pressure. However, the likelihood of the local cash rate holding at 4.35% for at least the next 6 months means that local bond yields below 4% are unlikely to be sustained.