Most major share markets rose in July assisted by evidence that any slowing in global economic growth in Q2 was modes;, strong company earnings especially in the US; and easing international trade tensions. A notable exception to the strength in share markets was pronounced weakness in US technology shares reacting to specific problems capable of compromising future growth in earnings in the sector. European share markets showed best gains in July, led by the German DAX, up 4.1%. The US S&P 500 rose by 3.6% and Australia’s ASX 200 built on its 3.0% gain in June by lifting 1.4% in July.
Buoyant share market trading in July spilled over to a marked improvement in credit with spreads on most securities contracting. The conditions that helped risk assets to rise in July worked against government bond markets. Bond yields rose mostly in July driven primarily by concern that central banks are starting to reduce at faster pace the ocean of liquidity support formed in the wake of the Global Financial Crisis. The US Federal Reserve (Fed) has taken the lead draining the liquidity ocean and at its latest policy meeting firmed up its comments from “improving” to “strong” on US economic growth and household spending, a signal that it may step up soon the pace of interest rate hikes.
The US 10-year bond yield rose by 10 basis points (bps) in July to 2.96% and at one stage late in the month traded above 3.00%. The US 30-year Treasury yield rose by 9bps to 3.08%. US government bond yields are at risk of trading materially higher over the next few months in our view. Several signals are pointing towards higher US bond yields including the strength of the US economy (4.1% annualised GDP growth in Q2); building inflationary pressure in the US (a very tight labour market and US producer prices and CPI both pushing above 3.0% y-o-y in the near-term); and a rising US government borrowing program to fund pro-cyclical government spending projects.
The Australian government bond market is subject to different pressures to those impacting the US bond market. One locally specific theme is that the topping out of the housing market combined with a heavily indebted, income-constrained household sector implies potential downside risk to Australian economic growth prospects. The potential fragility of household spending combined with still well-contained inflation also means that the RBA is under no near-term pressure to hike the record low 1.50% cash rate. The view that the RBA is under no immediate pressure to hike rates is widely held and has helped to moderate the lift in Australian government bond yields as US bond yields have risen. In July, the Australian 10-year bond yield lifted by only 1bps to 2.64% and the negative yield gap compared with the US 10-year bond yield has widened to 32bps.
Over the past month, the Australian bond market has stuck with the idea that Australia remains a low-growth, low-inflation economy and mounting evidence to the contrary has been ignored. Almost all key Australian data points released in July have been stronger than expected and are consistent with disproving that the blip upwards in Australian annual GDP growth to 3.1% y-o-y was just a freak. Indeed, there is a strong possibility that annual GDP growth rose above 3.1% y-o-y in Q2 (data due in early September). June retail sales data released last week was again surprisingly strong, up 0.4% m-o-m. Real retail sales in Q2 rose by 1.2% q-o-q compared with 0.2% in Q1. Household consumption expenditure is likely to make a much stronger contribution to GDP growth in Q2 than it did in Q1.
Other surprisingly strong June reports released over the past fortnight or so include home building approvals, up 6.4% m-o-m; a more than doubling of the international trade surplus to $A1,873 million from $A725 million in May; employment up 50,900 and the unemployment rate down to a five-year low just under 5.4%. These stronger-than-expected data readings make it very hard to sustain the widely-held market view that the economy is at risk from soft household spending – the only reason why an emergency low 1.50% cash rate makes any senses.
Even the CPI annual inflation rate, 2.1% y-o-y in Q2, is not as low as it was a year ago (1.8%) let alone two-years ago (1.0%) when the cash rate was in the process of its last adjustment downwards to 1.50%. Also, annual CPI inflation will almost certainly rise over the next few quarters reflecting pipeline inflation pressure from rising producer prices at home and overseas. Australian final stage of production producer prices rose by 0.7% q-o-q in Q2 after lifting 0.5% in Q1. Import prices have risen even more sharply, 1.2% q-o-q in Q2 after lifting 2.1% q-o-q in Q1. In short, Australian CPI inflation is likely to rise from the impact of rising import and producer prices and that is likely to occur even if local wage rises remain subdued a little while longer.
More likely, given the strength of the Australian labour market, wages growth will accelerate soon and add to inflation pressure.
Our view is that RBA commentaries about economic conditions will soon take a firmer tone implying that the long phase of the very-low, stable cash rate is closer to ending than is widely assumed. We expect a first 25bps cash rate hike to 1.75% at the November RBA policy meeting followed by a second 25bps cash rate hike to 2.00% early next year. The common market view that the cash rate will not change in the foreseeable future is likely to be increasingly hard to sustain if Australian economic data points continue to show building economic strength as we suspect is increasingly likely.