Most central banks indicated in May that it is too early to declare that they have done enough to bring inflation down to their respective targets, notwithstanding signs of slowing economic growth and a government debt ceiling scare in the United States that could have precipitated more growth-crimping financial market turmoil. In early-June the US debt-ceiling crisis has been resolved (for perhaps the next two years) and attention is returning to whether inflation is reducing enough to give central banks any leeway to stop hiking rates. During May government bond yields lifted indicating that bond markets are adjusting their rate views for the US, Europe and also for Australia to one of perhaps more rate hikes to come and peak official rates staying in place for longer.
In the US bond market, the 10-year bond yield rose in May by 22 basis points (bps) to 3.64% while the 30-year Treasury yield rose 19bps to 3.86%. The rise in yields was more pronounced for shorter-dated bonds with the 1-year yield up 43bps to 5.17% and the 2-year yield up 39bps to 4.40%. The yield rises came in a month when the Fed continued to hike the funds rate another 25bps to 5.25% indicating that future rate moves will be data driven but that it was unlikely to be in a position to start cutting rates for some time.
Essentially, the US bond market is starting to recognise that if a US recession lies ahead requiring the Fed to reverse direction on interest rates, that point is still some time ahead and meantime inflation remains sticky enough potentially to require the Fed to hike rates further. If recession is darkening the US economic outlook, getting there is an unusually slow process in this cycle. The past build-up of savings combined with a persistently tight labour market mean that the first signs of weakness in demand for goods in the US have still to feed through and squash very strong demand for services and the labour needed to provide those services.
The increasingly inverse-shaped US bond yield curve has been pointing to recession for several months, but recession has yet to materialise in the data. Q1 2023 GDP was soft, 1.3% annualized growth, but with Q1 consumption spending up a still strong 3.8% annualized. Employment growth remains strong with non-farm payrolls up 339,000 in May after an upwardly revised 294,000 increase in April. The unemployment rate rose to 3.7% in May but needs to push above 4% to indicate the start of any real softening in US labour market conditions.
US inflation on all measures is running above 4.5% y-o-y in May and progress reducing it is slow putting the Fed’s 2% inflation target a distant hope for 2025 or 2026. It is a close call whether the Fed hikes the funds rate again next week, but the pattern of US data showing growth fading slowly, a still very tight labour market and sticky inflation point to one more rate hike at least for this cycle and then a protracted stay at the rate peak and not much leeway to reduce rates beyond.
In Australia, the RBA surprised many early in May by not extending the April rate pause and hiking the cash rate by 25bps to 3.85%. While the RBA sees inflation coming down it remains too high (7.0% y-o-y on the Q1 2023 CPI and 6.3% y-o-y on the March reports that the RBA had to hand at the time of the May policy meeting). The RBA indicated that it might need to hike rates further although that would depend upon data reports relating to the relative strength of demand, the labour market and inflation and how they sit with its latest economic forecasts. The May rate hike surprise and indications that the RBA may need to hike further gave the Australian bond market cause to lift yields. In May, the 2-year bond yield rose by 51bps to 3.54% while the 10-year yield rose by 25bps to 3.58%.
Data reports and economic announcements since the May RBA policy meeting have made it a close call whether the RBA hikes the cash rate again at its policy meeting this week. There has been some evidence of slowing demand (retail sales were flat in April after rising only 0.4% m-o-m in March) and a hint of a less tight labour market (total employment fell 4,300 in April with the unemployment rate rising to 3.7% from 3.5% in March).
However, there has also been evidence of strong housing demand lifting house prices and signs that wage growth is on the brink of becoming an inflation-sustaining problem. The Q1 2023 wage price index report showing annual wage growth up at 3.7% y-o-y from 3.3% y-o-y in Q4 2022 casts doubt on whether annual wage growth will only rise a little more to a peak 4.0% y-o-y by the end of this year in the RBA’s latest May economic forecasts. Indeed, the early-June Fair Work Australia decision lifting from July 1 award pay rates linked to the national minimum wage by 5.75% and the minimum wage by 8.6% (a decision affecting a fifth of the Australian workforce) all but guarantees that the wage price index will blast above 4% y-o-y later this year.
The RBA’s publicly stated concern is that while productivity is unusually low wage increases around 4% and higher stand to keep inflation higher for longer. The latest monthly CPI reading for April showing annual inflation rising to 6.8% y-o-y from 6.3% is also likely to highlight that the inflation fight still has some way to go. Even if the RBA decides on balance to leave the cash rate at 3.85% this week there remains a strong likelihood that it may need to hike the cash rate further over coming months and at the very least the cash rate is destined for an unusually lengthy stay at its peak.
Turning to risk assets, markets paid some attention to recession risk in May, but alleviated in early-June by the US debt-ceiling agreement. Major share markets were mixed-strength in May with losses in Australia, ASX 200 down 3.0%, China, CSI 300 down 5.7% and Hong Kong’s Hang Seng down 8.4%, and Europe, Eurostoxx 50 down 3.3%, but with end-month gains lifting the US S&P 500 to +0.3% for month and Japan’s Nikkei to +6.1%. Early June has seen most share markets rally strongly on the US debt-ceiling deal. Elevated valuations imply that share markets are taking the delayed recession risk in the world’s major economies including the US as no recession ahead. Increasingly share markets are banking on a soft economic landing that seems a precarious view as central banks look like holding interest rates higher for longer to beat inflation down.
Credit markets were comparatively steady in May but may also be challenged if central banks hike rates much further. In Australia, non-performing loans are rising, but are not yet high by historical comparison. The rise in non-performing loans may become a little more pronounced over coming months amid the peak of rollovers of two-and three-year fixed rate contracts set in 2020 and 2021, perhaps a further rate hike or two from the RBA, and some edging up in the unemployment rate.
Returning to our RBA rate view we still believe the RBA is at or very close to the peak cash rate for this cycle at 3.85%, or 4.10%. The peak cash rate, once in place, is likely to stay in place for many months while the RBA becomes comfortable that wage growth is consistent with its inflation target.