Risk assets were stronger in February despite the occasional soft patch driven mostly by periodic uncertainty about President Trump’s policy program. More signs of stronger economic growth, especially in the United States, kept the reflation trade alive. Also, although there are signs that inflation may rise on increasing energy and factory prices internationally and some wage pressure in the likes of the US, bond yields were comparatively stable through the month. While the US Federal Reserve is warning that it may need to lift the funds rate faster than it did through 2016, it has still to deliver. Meantime global share markets continue to perform well with brief dips quickly turning to bouts of renewed buying. Among major share markets gains during the month ranged from 0.4% for Japan’s Nikkei to 3.7% for the US S&P 500 that continued to make a series of record highs. The Australian ASX 200 rose by 1.6% in February.

Australian credit spreads continued to tighten over the month reflecting improving Australian business conditions. Government bond yields again showed relatively little movement over the month even though there are accumulating signs that central banks are moving towards a phase of stable or rising official interest rates reflecting a world of increasing growth and inflation too. The US Federal Reserve is providing indications that it is likely to hike its funds rate 25bps at its mid-March policy meeting and that more rate hikes may follow later in the year, albeit well-spaced. The US bond market, however, is not factoring in more aggressive Fed policy tightening just yet. The US 10-year bond yield fell in February by 4bps to 2.41%, while the 30-year Treasury yield was down by 6bp to 3.00%. The Australian 10-year bond yield rose by 1bp in February to 2.72%.

Returning to factors influencing US financial markets, the strong rally in shares post Trump-election victory is showing signs of becoming more erratic. The US share-market rallies when President Trump is on a coherent pro-growth message, as he was in his first address to Congress, but also falters on signs of Presidential indiscipline and lack of power to act because of poor functioning relationships with the bureaucracy, Congress and the courts. Signs of better US economic growth, continue to show, lifting investor sentiment even in the face of inconsistent signals from President Trump. Consumer confidence and sentiment remained close to cycle highs in February and surveys of manufacturing and non-manufacturing businesses are pointing to strong expansion. The February ISM manufacturing and non-manufacturing indexes rose to respectively 57.7 and 57.6, strong readings implying expansion. Supporting stronger US growth is good growth in employment. The latest nonfarm payrolls report for January showed a big step up to +227,000 from +157,000 in December. The February report, due later this week, is expected to show a near +200,000 gain too.

The US economy growing well is using up spare capacity fast and even though the latest wages growth readings were a touch softer than expected there is now little doubt that US inflation, already tracking around 2.3% y-o-y will move higher. The Federal Reserve has indicated three rate hikes through 2017, but the risk is that there will need to be more if the economy continues to gather momentum, inflation rises and if President Trump delivers fiscal stimulus to an economy already growing close to capacity. Fed Chairman, Janet Yellen, warned late last week that the funds rate would need to be hiked at a faster pace than in 2016 (only one 25bps hike to 0.75% delivered in December). Increasingly, the risks seem skewed to the upside for US bond and Treasury yields.

In China, while the Peoples’ Bank of China has edged towards tightening policy with minor mostly 10bps increases to some of its official interest rates, it is unlikely that the policy tightening cycle will be more than modest in scale. China is trying to achieve a difficult economic policy balancing act. It wants to sustain stable GDP growth around 6.5%, a target reaffirmed at the start of the latest Peoples’ Congress meeting, while at the same time progressing a number of economic reforms – tempering excessive residential property construction and speculation; improving the quality of bank lending; winding out the worst, most inefficient State-Owned Enterprises; closing the heaviest polluting industries and becoming greener – that would seem to mean weaker growth for a period. For the time being, the limited range of economic releases after the Lunar New-Year holidays point to GDP growth holding the level achieved through 2016 – around 6.7% y-o-y, although because of the substantial conflicts in China’s economic policy aims the risk remains of a pull-back in growth towards mid-year and beyond official intentions.

In Europe, most economic readings are pointing to relatively stable economic growth. Q4 2016 on revision was adjusted down slightly to 0.4% q-o-q the same as in Q3 and resulting in annual growth of 1.7% y-o-y, down slightly from 1.8% in Q3. The latest revision of GDP, however, included separate country GDP growth rates and the big three Euro-area economies, Germany, France and Italy all improved compared with Q3. The mainstay of European growth remains robust international trade, but other signs of strength are starting to show over recent months including CPI inflation, up to 2.0% y-o-y in February and an unemployment rate holding down at 9.6% in both December and January. Europe still faces difficult national elections that could throw up results capable of fracturing the European Union. Britain’s exit from the EU is also still a negotiating nightmare. Nevertheless, the underlying economic readings are improving for the most-part improving making Europe’s relatively under-valued share markets tempting for investors and adding another potential pressure point to rising bond yields.

The Australian economy, rebounded sharply in Q4 2016 with real GDP growth up by 1.1% q-o-q, 2.4% y-o-y after -0.5% q-o-q, +1.9% y-o-y in Q3. Just about everything that weakened in Q3 strengthened in Q4 including housing activity, government spending, business investment and net exports. The stronger quarter was funded in large part by the household sector running down its savings (borrowing even more). Wages growth was a notable weak part of the Q4 GDP report falling 0.5% q-o-q in real terms. Whether the household sector can continue grow its spending on housing and consumer goods and services given weak income growth is becoming an issue. Also there is the associated question of whether extremely high levels of household debt could become a major future constraint on economic growth?
While household sector finances and borrowings may at some stage tip Australian growth lower in the near-term economic growth still has momentum from improvement in international trade, better business conditions and profitability, and somewhat stronger growth in employment too. The RBA in its economic forecasts (the latest set produced in the February quarterly Monetary Policy Statement) continues to take a “glass more than half full view” of Australia’s economic prospects, views low inflation sub 2-3% target range persisting, but it also becoming more concerned about medium-term risks to economic growth from high levels of household debt. The RBA is increasingly of a view that it does not want to add to growth in household debt and asset inflation in parts of the housing market by pushing interest rates lower, even though very low inflation would seem to permit lower interest rates.

It seems to us that the RBA will take a lot of convincing that further cash rate cuts are needed. Instead, the RBA is likely to keep the cash rate on hold at 1.50% for an extended period and the next rate change when it comes is more likely to be a hike. At this stage, we are penciling in a 25bps hike to 1.75% in Q1 2018.