Risk assets rose mostly in June as tensions flared and settled between Iran, Israel and the US. European risk assets were the exception, giving up a little ground. While the US Federal Reserve Chairman, Jerome Powell, indicated that theFed was in no hurry to cut the current and high 4.50% Funds rate, US President Trump criticised, saying the Funds rate should be much lower and called on the Fed Chairman to resign. US risk assets stayed firm in the face of the growing dispute between the President and the Fed Chairman and seemed to greet the passage of President Trump’s ‘Big Beautiful Bill’ set to push US budget deficits (already near 7% of GDP) and government borrowings (at 100% of GDP) much higher over the next few years. In our view, current high US risk asset valuations factor in poorly the likely disruption to US and global growth prospects and the inflation outlook from the soon to be enforced US tariff changes, challenges to Fed policy independence and huge lift in already high US government debt.
Most major share markets rose in June with the US, Japanese and Australian markets touching record highs. The US S&P 500 rose in June by 5.0%, but was pipped by Japan’s Nikkei, up 6.8%. China’s share markets were stronger with the Shanghai CSI up 2.5% and Hong Kong’s Hang Seng up 3.4%. Australia’s ASX 200 was up by 1.3% in June, despite evidence of sluggish economic growth. European share markets were softer in June with the Eurostoxx 50 index down by 1.2%.
Credit markets in June mostly held ground at firm levels. Australian households appear mostly to be maintaining their existing mortgage payments rather than taking mortgage interest rate cuts in lower monthly repayments. This apparent preference to save rather than spend mortgage rate cuts is adding to the high quality of Australian mortgage debt. Rising household disposable income, helped by rising real wages, falling mortgage interest rates and lower income tax through 2024-25 mean that households are increasingly well placed to meet their high debt servicing requirements.
While risk assets showed surprising strength through June, government bond markets were comparatively firm too notwithstanding the big rise ahead in US government borrowings, the limited ability of some central banks (notably the US Fed and the Bank of England) to continue reducing official interest rates and potential lift in US inflation once President Trump’s tariffs come into full effect from early August.
US government bond yields fell in June with the 2-year bond yield down by 18 basis points (bps) to 3.72% and 10-year bond and 30-year Treasury yields down respectively 16bps and 15bps to 4.24% and 4.78%. We see US bond yields trading higher over coming months with an unsettling battle developing over the independence of the Fed setting monetary policy as well as evidence of tariff-primed higher inflation starting to show and a clearer view developing of the building mountain of US government debt ahead.
In Australia, government bonds also rallied in June with the 2-year bond yield falling by 5bps to 3.23% and the 10-year yield falling by 8bps to 4.17%. Economic data releases in June showing soft Q1 GDP growth (+0.2% q-o-q, +1.3% y-o-y), slight growth in retail sales in April (0.0% m-o-m) and May (+0.2% m-o-m) and lower monthly inflation (2.1% y-o-y in May, down from 2.4% in April) all build a case for the RBA to cut the cash rate 25bps to 3.60% at the policy meeting this week and follow up with another 25bps cut to 3.35% in August. Beyond August, we see sharply diminishing prospect of further rate cuts.
The problem is that inflation is likely to start picking up pace in the second half of this year from a base effect related change in electricity prices and fundamental effects from the renewed housing price boom and strong growth in real wages unrequited by productivity improvement.
The electricity price base effect starts with the July and August monthly CPI readings and the Q3 CPI reading. Back in the same period of 2024 the $75 per quarter electricity rebates from the Federal Government came into effect and have been responsible for electricity prices showing big price falls y-o-y in the monthly and quarterly CPI readings throughout 2024-25. On July 1st this year the quarterly $75 rebate is still in place (it will end January 1st 2026), but electricity price providers will be charging higher prices. As a result, high single digit to low double-digit y-o-y prices for electricity recorded every month and quarter in the CPI through 2024-25 turns to high single digit y-o-y increase each month and quarter in 2025-26. It becomes a double-digit y-o-y increase starting in January 2026 when the electricity rebate ends.
The base effect from changing electricity prices alone is likely to propel inflation back above 3% y-o-y in early 2026, but then add faster rising house prices in the mix as well as wages growing for more than a year at above 1% y-o-y in real terms with no material lift in productivity and we can see annual inflation getting stuck above 3% y-o-y in 2026 going into 2027. This is not the way the RBA is reading the inflation outlook just yet, but we see their view shifting as the higher inflation readings unfold through the second half of this year.
While the RBA is cutting the cash rate (probably in July and August) Australian government bond yields may hold or even better current yields. As the market view about the cash rate outlook changes, we see bond yields marking higher again with the 2-year yield nearer to 4.00% by year-end and the 10-year yield pushing back up towards 4.50%.