Although the US economic recovery is late stage there are signs that another burst of faster GDP growth is imminent. Indeed, when the advance reading of Q2 GDP is released at the end of July it could show an almost doubling in annualised growth to over 4% from 2.2% in Q1. Many recent business surveys from the US point to strength in sales, a very tight labour market and a strong likelihood that wages will be bid up more aggressively. The risk of a secular rise in US inflation is also increasing and the headline CPI is already up to 2.8% y-o-y in the latest May reading. Unsurprisingly the Federal Reserve (Fed) at its latest policy meeting last week announced a 25bps increase (the seventh since late 2015) to 2.00% in its Funds rate and is heralding another two rate hikes before the end of 2018.
One growing risk that is still barely recognised in the US bond market is that the Fed is not moving aggressively enough to contain the inflationary pressure building in a US economy showing increasing signs of over-heating. At some point rising inflation will force the Fed to catch up with rate hikes moving the Funds rate up at every six-weekly policy meeting rather than every second meeting as it is doing at present.
There are signposts to watch that in our view could lead the Fed to move more aggressively lifting the Federal Funds rate by more than currently indicated. Over the next month or two the US unemployment rate falling to 3.6% or less with annual growth in average hourly earnings pushing above 3% y-o-y are two important signs. Q2 annualised GDP growth pushing above 4% in late July is another together with headline CPI inflation pushing above 3% y-o-y with underlying US inflation measures pushing up towards 2.5% y-o-y over the next two or three months.
Given the improvement in many US economic readings and employment and business surveys in April and May it is much more likely that the signs listed above will continue to show through the summer and autumn months in the US and that by Q4 2018 the Fed will be lifting rates more aggressively. The current timetable for the Fed Funds rate to move from 2.00% to 3.00% is at some point in the second half of 2019, but that may turn to early 2019 and with a risk that the Funds rate could be at 4.00% by the end of 2019.
US government bonds are barely pricing the Fed’s current trajectory of Fund rate hikes. If that trajectory becomes more aggressive as we suspect it may over the next few months there is a growing risk of a much more pronounced sell-off in US bond yields – especially short-dated US bonds. Over the next year, US short-term bond yields above 4.00% (currently around 2.50%) with longer term yields close to 4.50% (currently around 2.90%) will not only reset borrowing costs and financial asset prices in the US but will reverberate around the world, including in Australia.
In Australia, the RBA is still taking its time to be convinced that upward pressure will build in Australian wages and inflation. The RBA still sees some slack in Australia’s labour market evidenced by an unemployment rate around 5.5% that could fall to 5.0% or lower before wages generally lift in a fashion threatening higher inflation. Interestingly, the latest unemployment rate for May was down to 5.4% and the unemployment rates in Australia’s most populated states are lower still, 5.1% in Victoria and 4.9% in New South Wales. The low unemployment rate pressure point on wages and inflation may not be all that far away although perhaps not early enough to warrant our forecast that the RBA will need to hike its cash rate in August or September. We are inclined to push the first RBA rate hike back to November 2018.
When the RBA delivers its first interest rate hike may become irrelevant for many Australian borrowers. The more relevant factor may well prove to be the US summer of strong economic data and higher inflation readings prompting higher US bond yields and more aggressive policy tightening by the Fed. The funding costs of Australian banks are already suffering the order of upward pressure more commonly associated with an RBA 25bps cash rate hike. The large offshore component of Australian bank’s funding is likely to suffer much greater upward pressure over the next few months as US interest rates rise.
While the banks in the wake of the revelations from the Banking Royal Commission are more reluctant than usual to announce increases in their lending rates because of higher funding costs they cannot hold out forever, especially as it becomes clearer that the funding pressure will become worse and for a protracted period.
The capacity-constrained US economy’s late cycle growth spurt and its impact on US interest rates could prove to be more important to Australian borrowers than any interest rate move by the RBA.