Risk assets rose in July amid signs that the US and global economies are faring better than hoped with rising US trade protectionism. The market’s ‘risk-on’ trading attitude in July could be tested in August. At the beginning of August soft, US July labour market data, and hefty downward revisions to employment growth in May and June indicted that US economic growth resilience may be crumbling presenting a disturbing outlook of weak US economic growth with high inflation. The August 1st announcement of US tariffs applying to many countries from November also provided a reminder that effective US tariff protection has risen to an 80-year high and that the worst dislocation to international trade still lies ahead. The US Federal Reserve showed again at its July policy meeting that it is constrained and cannot reduce the high 4.50% Federal Funds rate for the time being. The outlook for risk assets is challenging in our view.
Major share markets rose in July with several making record highs, including the US and Australian share markets. Gains in July ranged from 0.3% for Europe’s Eurostoxx to 4.2% for Britain’s FTSE 100. China’s share markets lifted around 3% with Shanghai’s CSI up 3.4% and Hong Kong’s Hang Seng up 2.9%. US share markets were already richly valued at the beginning of July, but the S&P 500 lifted another 2.2% in July and repeatedly made new highs through the month. Australia’s ASX 200 rose by 2.2% in July with resource stocks taking the charge at the expense of previously favoured bank stocks. Set against the buoyant share market trading conditions through much of July the first trading day of August set a sour note in US trading with several market unsettling developments including evidence that the US labour market is weaker than realised earlier, President Trump’s reaction to the weaker labour market news sacking the head of the Bureau of Labour Statistics, and his announcements of tariffs to be imposed on various countries.
Credit markets in July followed the firm lead from share markets with spreads closing in on the lowest margins over government securities seen over the last quarter century and more. Australian households remain in a strong position to meet their debt servicing, even though debt levels are high. Rising household disposable income, helped by rising real wages, falling mortgage interest rates and lower income tax through 2024-25 are enabling households to meet their high debt servicing requirements.
Risk-on trading during July generated a softer tone in government bond markets. High and rising levels of government debt, notably in the US, as well as accumulating evidence that progress reducing inflation is stalling are also making it difficult for key central banks, such as the US Federal Reserve, to lower official interest rates. The Federal Reserve has left its Funds rate on hold at a relatively high 4.50% at both the June and July policy meetings and even with the latest soft signs in the US labour market may still be stymied on rates because of the risk of rising inflation ahead.
US government bond yields rose in July with the 2-year bond yield up by 24 basis points (bps) to 3.96% and 10-year bond and 30-year Treasury yields each up 13bps to 4.37% and 4.90%. We continue to see US bond yields trading higher over coming months with evidence of rising US inflation showing in coming months, and especially after higher tariffs show through in imported consumer good prices beyond November.
In Australia, government bond yields also rose in July, in part driven by the RBA’s surprising decision to leave the cash rate unchanged at 3.85% at the July policy meeting. The 2-year bond yield rose by 12bps to 3.35% and the 10-year yield rose by 10bps to 4.26%.
The Q2 CPI report released last week showed headline inflation up 0.7% q-o-q, 2.1% y-o-y, from +0.9% q-o-q, 2.4% y-o-y in Q1. Underlying (trimmed mean) inflation rose 0.7% q-o-q, 2.7% y-o-y in Q2 from +0.7% q-o-q, +2.9%y-o-y in Q1. These readings show inflation inside the RBA’s 2-3% target band through the first half of 2025 and provide reason for the RBA to cut the cash rate by 25bps to 3.60% at the interest rate setting meeting next week. There are still reasons, however, for the RBA to go very cautiously cutting the cash rate further beyond the August policy meeting.
The main reason for caution is that annual inflation will rise through the second half of 2025, possibly back above the top of the RBA’s 2-3% target band. The rise in inflation will be due to a statistical base effect with the 0.2% q-o-q CPI increases in Q3 and Q4 2024 unlikely to be so low in Q3 and Q4 2025 – around 0.7% looks likely in each quarter. The RBA will need to be comfortable that lift back up to 3%+ inflation will diminish through 2026 if it is to cut the cash rate much below 3.60%.
If anything, the growth and demand outlook in Australia seems to be improving. All housing indicators are rising strongly. Also, the latest retail sales figures for June were surprisingly strong, up 1.2% m-o-m, after rising 0.2% in May. Strengthening demand while productivity is still weak could mean the base effect lift in inflation in the second half of 2025 turns to more sustained inflation lift in 2026. While this concern remains in play, the RBA has to stay cautious cutting the cash rate.
Our view remains that there will be only one more cash rate cut to 3.60%, with an outside possibility of one more beyond to 3.35% and then a lengthy period on hold ahead of the next rate hiking cycle. This cash rate outlook implies a fair value for 2-year bonds near 4.00% and 4.50% for 10-year bonds.