During August, sentiment in financial markets took a bearish turn as the US Federal Reserve slapped down the market’s notion that...
During August, sentiment in financial markets took a bearish turn as the US Federal Reserve slapped down the market’s notion that an end to rate hikes was in sight, instead warning that it would do whatever was necessary to bring down inflation. The idea that rising official interest rates could hurt many and result in recession came back into focus with the warning in a keynote speech by Fed Chairman, Jerome Powell, at the Jackson Hole Symposium of Central Banks.
Other downside risks to the global economic growth outlook also returned to sharper focus in August. Risks such as China’s growth-crimping policies relating to the containment of covid and the excesses in its property sector. Mounting recession risk in Europe as it grapples with the problems of limited energy supplies before the return of cold weather in the northern hemisphere winter. The prospect of weaker economic growth and hard-to-contain inflation caused bond and share markets to weaken from mid-August.
In the US, good economic news became bad for financial markets implying the need for the Fed to wield a heavier interest rate stick to fight inflation. While economic readings have turned mixed-strength, the labour market remains robust with non-farm payrolls up 315,000 in August after increasing 526,000 in July. Wage growth remains above 5% y-o-y.
As long as the US labour market stays strong the Fed will continue to fight an uphill battle to bring annual inflation still near 9% y-o-y down to its target 2% over a reasonable timespan. It is also fighting the inflation battle against counter-productive spending initiatives supporting demand by the Biden Administration, such as waiving student debt.
At the Fed’s September policy meeting, it may need to deliver a third consecutive 75bps rate hike taking the Funds rate up to 3.25% to match its inflation-fighting talk and that still will not be the end of the rate hikes with the cycle-high likely to be 4% or more over coming months.
The Fed is not alone delivering big rate hikes to deal with the inflation threat. Annual CPI inflation is above 10% in the UK and above 9% in the EU and will move much higher with rising energy prices heading into winter.
The Bank of England at its August policy meeting had to ignore weak British economic growth and fire off a 50bps rate hike taking the Base Rate to 1.75%. The European Central Bank meets this Thursday and is likely to deliver a second consecutive 50bps rate hike taking its Deposit Rate up to 0.50%. Recession-risk is very high in the UK and the EU but the Bank of England and European Central Bank have no option but to fire at high inflation because to do otherwise would be to lay in store a much more damaging war of attrition against entrenched high inflation down the track.
A return to realising what lies ahead to contain inflation halted the July through mid-August bear market rally in share markets and bond markets. Big early-month gains in major share markets were cut down to small gains in August for the ASX 200, +0.6%, and Japan’s Nikkei, +1.0%, and losses elsewhere ranging from -1.1% for Hong Kong’s Hang Seng to -5.2% for the Eurostoxx 50. The US S&P 500 was down by 5.2%.
Government bond yields rose sharply in August reflecting the change in view to central banks needing to hike more and hold rates higher for longer to contain inflation. The US 10-year bond yield rose by 54bps to 3.19% while the 30-year Treasury yield increased by 28bps to 3.29%. Australia’s 10-year bond yield rose by 61bps to 3.66%.
In credit markets, Australian yield spreads were a touch narrower over the month but were widening by month end from their narrowest points. Credit quality remains strong largely reflecting the strength of economic activity, especially the strength of the Australian labour market with the unemployment rate at a 48-year low 3.4% in July. Rising home mortgage interest rates are taking a toll on housing activity – house prices, home loan demand and home building approvals – but are yet to turn very low mortgage default rates still protected by high household savings and near full-employment.
The RBA, like central banks in North America and Europe, faces the challenge of tackling inflation running too high. It has some advantages compared with its North American and European peers. Annual CPI inflation may peak lower, around 8% later this year. Past annual wage growth has been lower at 2.6% y-o-y in Q2. But those advantages are eroded by a stronger near-term demand outlook (Q2 GDP growth out this week will be positive for the quarter and show real annual growth around 3.5% y-o-y; July retail sales were very strong up 1.3% m-o-m, 16.5% y-o-y) and signs that wage growth is about to accelerate and perhaps with changes to the wage negotiating framework likely to generate higher wage growth than in the past.
A need to return interest rates to at least neutral setting (cash rate around 3%) relatively quickly means that the RBA is likely to deliver another 50bps cash rate hike tomorrow, taking the cash rate up to 2.35%. Barring an unlikely sudden and sharp weakening in labour market conditions or unexpected inflation reduction, the RBA will need to hike the cash rate to 3% at least by early 2023.
Given the cash rate outlook, Australian Government Bond yields should trade in 3- 4% yield range through to at least early next year in our view. We also see the cash rate holding at its peak level – say 3.10% - for many months through 2023 and possibly early 2024 reflecting the long period ahead before it will be possible to say with any conviction that the current inflation surge will return to the RBA’s 2-3% target band.