Risk assets mostly rose strongly through January, notwithstanding the occasional sharp slip on competition from China to the supremacy of US companies developing artificial intelligence and President Trump’s tariff announcements at month-end. Government bond yields were relatively stable over the month at relatively high levels with a mix of central bank interest decisions ranging from a hike from the Bank of Japan, cuts from the European Central Bank. The RBA did not meet in January and its first meeting of 2025 in the middle of this month may deliver a cut although that expectation has provided little relief for local bond yields.
Major share markets rallied through January with some including Australia’s ASX 200 making record highs. The smooth changeover in the US from the Biden to the Trump Administration and the market’s view that on balance President Trump’s policy agenda would be pro-growth helped to boost share prices everywhere. Investors sought out shares in Europe in particular that were seemingly undervalued relative to richly priced US shares and even though Europe’s growth prospects continued to look soft relative to US growth prospects.
Share markets rose mostly in January between 1.1% for China’s CSI and 9.2% for Germany’s Dax index. The US S&P 500 rose by 1.7% while Australia’s ASX 200 rose by 3.4% and finished January on a record high 8,532. Japan’s Nikkei was an exception to the increases and fell by 0.8% m-o-m. The Nikkei’s relatively poor performance reflects that the Bank of Japan is in the process of slowly normalising interest rates and hiked its official interest rate by 25bps to 0.50% in January. Japan is experiencing a return of modest inflation after an absence of more than three decades and ultra-low interest rates aimed at combatting persistent price deflation are no longer appropriate.
Credit markets were mostly stronger too in January with yield margins over government securities running at their tightest levels in close to two decades. In Australia, although default rates are rising, the deterioration is less than experienced in phases of softer economic growth in the past. Australians are fully employed, and the unemployment rate has stayed low much longer than in the past. Also, wages are growing in real terms and real household disposable income boosted by tax cuts is growing faster than real wage growth. The household sector is well-placed to meet high debt servicing requirements.
The possibility of a lower RBA cash rate and lower bank borrowing interest rates at some stage this year reinforces the factors keeping the deterioration in credit quality relatively slow developing.
Turning to government bond markets, in the US indications from the Fed at its policy meeting in December that room was diminishing to cut rates in 2025 because of stickier inflation were confirmed at the January policy meeting when the Fed left the Funds rate unchanged at 4.50%. US government bond and Treasury yields had been mostly rising late last year as it became clearer that progress reducing inflation was stalling. The policy agenda of the incoming Trump Administration also seemed to lean towards making containment of US inflation more difficult. As a result, US government bond and treasury yields are becoming sticky around the higher yields attained late last year. The US 2-year bond yield fell 4bps in January to 4.20%, the 10-year bond yield fell 3bps to 4.54% and the 30-year Treasury yield rose by 1bp to 4.79%.
We see the Fed managing to get one or two 25bps rate cuts away this year implying the Funds rate will be 4%+ at the end of 2025. The US economy seems to be moving through a soft economic landing and by later this year growth and inflation could be accelerating implying that in 2026 the Fed will start hiking the Funds rate. Given this outlook for US growth, inflation and Fed policy, US bond rallies cannot progress far below 4% yield and the selloffs are likely to be more pronounced than the occasional brief rallies. We see US bond yields pushing upwards to 5% and more this year.
Turning to the Australian bond market, even though hopes of a cash rate cut from the RBA as soon as this month are growing, Australian government bond yields were relatively sticky in January, like those in the United States. The 2-year bond yield fell by 6bps to 3.79% while the 10-year bond yield rose by 7bps to 4.43%. While lower-than-expected Q4 inflation readings with the annual headline CPI change moderating to 2.4% y-o-y from 2.8% in Q3 and underlying (trimmed mean) declining to 3.2% y-o-y from 3.6% in Q3 provide scope for an RBA rate cut, factors that limit how much the RBA can cut the cash rate and how long the lower cash rate can last remain in play.
Even the low Q4 inflation report contained the seeds of higher inflation down the track. Many of the government initiatives aimed at cost-of-living relief reduced inflation in Q4. The housing component of the CPI, down 0.7% q-o-q was partly influenced by higher government rental support payments. The household equipment and operation component, down 0.2% q-o-q was influenced by childcare costs down 4.1% on greater government assistance. Changes to the pharmaceutical benefit scheme drove down the health component by 0.2% q-o-q and the housing component, down 0.7% q-o-q was mostly held down by a 9.9% fall in electricity prices, the continuing effect of the government’s rebate scheme.
In the absence of even more generous government cost of living relief affecting the Q3 and Q4 2025 CPIs these two quarterly CPIs will show much bigger than the 0.2% q-o-q increases in Q3 and Q4 2024 adding at least one percentage point to the annual inflation rate by the end of 2025.
Apart from this hefty base effect that will lift annual CPI inflation to 3.5% y-o-y or higher by the end of 2025, other factors likely to make it difficult to keep annual CPI inflation below 3% y-o-y are the priming of wage growth by a still very tight labour market, low productivity and domestic demand growth driven by high real growth in public sector spending and with low private sector spending growth starting to lift too.
We see little likelihood of the lower inflation recorded in Q4 persisting and that limits the RBA to probably two rate cuts this year taking the cash rate down to 4.10% and then a pause ahead of possibly hikes in the cash rate in 2026. This inflation and cash rate outlook implies Australian bond yields trading mostly in 4-4.50% range in 2025.