In January the focus in financial markets was high inflation and what central banks might do about it. Inflation readings in the US, Europe and Australia matched or were higher than market forecasts. The US Fed responded talking tough policy intentions but still delaying material policy action. The Bank of England hiked 25bps, the second hike in the current cycle, but the base rate is sub 1.00% against British inflation above 5% and still rising. Australia’s Q4 annual inflation rate at 3.5% was above all forecasts but the RBA is waiting for stronger wage growth before hiking the emergency low 0.10% cash rate.
With inflation running ahead of central banks’ policy responses markets are beginning to sense that official interest rates will need to rise more to catch up. Government bond yields are rising. The US 10-year bond yield rose by 27bps in January to 1.78% and in early February has pushed above 1.90%. The US 30-year Treasury yield lifted 21bps in January to 2.11% and is now trading above 2.20%. In Australia, the 10-year bond yield lifted 25bps in January to 1.91% and currently is close to 2.00%.
We see US and Australian longer-term bond yields pushing higher over the next few months to reflect both high inflation and where official interest rates may settle over the next two or three years – at least 3.00% in the case of the US Federal funds rate and close to 3.00% for the RBA’s cash rate. Our two-to-three-year official interest rate forecasts assume that as supply chains unbung and consumer spending becomes less heavily stacked towards purchase of goods, annual inflation in the US and Australia falls back from the lofty heights in the first half of 2022 to around 3% in 2024.
In the next month or two we see a possibility of inflation pressure and associated market speculation about higher interest rates worsening before it settles. Tensions on the Russian/Ukrainian border could escalate, and force international energy prices higher.
During January, rising bond yields and the prospect of higher official interest rates exposed the lofty valuations of some share markets. Most major share markets suffered their worst monthly fall since the beginning of the Covid-19 outbreak in early 2020. Falls ranged between 2.6% for Germany’s DAX to 6.4% for Australia’s ASX 200. The US S&P 500 fell by 5.3%.
One share market that managed to post a gain in January was Britain’s FTSE 100, up 1.1%. The gain in the British share market occurred against a backdrop of a mounting British Government leadership crisis and back-to-back Bank of England rate hikes. The out-performance of the FTSE 100 reflects its relative undervaluation compared to other major share markets and investment flows rotating in favour of perceived value. Rotation from over-valued investment markets to relatively under-valued markets may continue to feature in the months ahead.
While risk assets are having to adjust to a more challenging interest rate outlook most major economies continue to perform well. There are lumps and bumps in activity associated with waves of Covid but the underlying trend in growth remains strong. Businesses and households in the US and Australia have savings buffers to cope with at least the first percentage point in borrowing interest rates. The likely resilience of the real economy provides a counterpoint to the threat of rising interest rates and spells high volatility in risk asset prices rather than a persistent bear market.
Credit spreads widened in January more particularly spreads on lower-rated paper. Australian credit spreads, while starting to widen should still be supported by sound local fundamentals. Australian mortgage-backed paper for example still looks very sound. Most housing borrowers are ahead of their borrowing schedules. While house prices are starting to rise more slowly, there is little likelihood of outright price falls in the next few months. The unemployment rate, beyond possible Omicron-related brief increases in January and February, looks set to push down to a historic low below 4% by mid-year. These factors are consistent with strength, not weakness, in the mortgage-backed paper space.
Returning and finishing with the RBA and what to expect for the official cash rate we highlight the RBA’s latest ‘central scenario’ economic forecasts published in the quarterly Monetary Policy Statement last week. The RBA is forecasting underlying inflation (trimmed mean) and CPI inflation both at 2.75% and higher through to the furthest forecast point in June 2024. That looks like inflation persistently at the upper end of the 2-3% target band the key requirement for the RBA to start lifting the 0.10% cash rate.
In addition, the RBA forecasts the unemployment rate falls to 3.75% in December 2022 and stays at that effectively full-employment rate for the remainder of the forecast period. Annual wage growth according to the RBA’s forecasts pushes up to 3% by June 2023 and 3.25% by June 2024.
In short, the RBA already has inflation persistently high end of target zone and expects the labour market conditions to underpin inflation later in 2022. While the RBA Governor indicates that the RBA Board is prepared to be patient before hiking the cash rate, that patience will be tested every time a monthly labour force report or quarterly report of wages and inflation confirms the RBA’s forecast line. If the reports come in higher than the RBA’s forecast line, as we think likely over the next few months, the RBA Board’s patience will dissolve.
We see the Q4 wage index out later this month plus the March and April labour force reports (out mid-April and mid-May) plus the Q1 CPI report out in late April all increasing the pressure on the RBA to consider a rate hike. The pressure could build to force a May rate hike, but August still seems more likely. Once the RBA starts to hike it is reasonable to expect them to deliver two or three rate hikes at successive Board meetings before pausing for a few months. At this stage we see the cash rate at 0.75% by the end of 2022 and 2.00% by the end of 2023.