Share-market performances in August varied widely ranging from the US S&P 500 making a record high during the month and up 3.0% to the European Eurostoxx 50, down by 3.8% and the British FTSE 100 down by 4.1%. In the US more signs of strong economic activity carrying through to higher company earnings and sales helped to lift the share market. In Europe, banks were in the spotlight amid concern about contagion from deteriorating emerging economies struggling to meet their high foreign debt obligations. In Britain, Brexit and the risk of not having an exit agreement in place in 2019 is coming in to focus. In Australia mostly stronger profit reports lifted spirits and offset temporary gloom surrounding the challenge to and toppling of Prime Minister, Malcolm Turnbull. His successor, ex-Treasurer Scott Morrison is viewed by financial markets as a relatively safe set of hands in the circumstances. The ASX 200 traded near a 10-year high and was up by 0.6% in August building further on its gains in July and June of respectively 1.4% and 3.6%.
While the US and Australian share markets traded firmer in August the buoyancy did not carry through to Australian credit spreads that traded a touch wider in August. Sovereign risk in several emerging markets was a more prominent concern in August with unease spurred by country-specific problems in key markets such as Argentina and Turkey made worse by the stronger US dollar as emerging countries with high levels of US dollar denominated foreign debt struggle to meet their commitments.
The mixed performance of risk assets fostered some safe-haven buying of government bonds and bond yields retraced some or all the lift experienced in July. The rally in government bonds occurred despite most key central banks reaffirming their plans to start reducing monetary accommodation in the case of the European Central Bank (ECB) or continue reducing in the case of the US Federal Reserve (Fed). The RBA reaffirmed its longstanding monetary policy position in various commentaries during the month – the cash rate is staying on hold at a record low 1.50% in the near term, but the next move eventually will be a hike. During August the US 10-year Treasury yield fell by 10 basis points (bps) to 2.86% while the 30-year yield fell by 6bps to 3.02%.
The rally in US bonds in August seems unsustainable mostly because there are few signs that the strength of the US economy is starting to fade, and the risk continues to mount of US inflation bursting higher in an increasingly capacity-stretched economic environment. The increasing borrowing requirement to fund the spending plans of the Trump Administration present another upward pressure point on bond yields. We see occasional stronger-than-expected data points relating to employment and inflation driving upward corrections in US bond yields over the next few months. The same data points are also likely to keep the Fed on track to hike the Funds rate at least twice more this year.
The Australian government bond market continues to be driven by different pressures to those impacting the US bond market, although the differences are less pronounced than they were a few months ago. Australian economic data points through July and August have mostly come in stronger-than-expected. One prominent concern 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 may soon fade. Retail sales improved relatively strongly in April, May and June and consumer sentiment readings are travelling close to a four-year. The change of Prime Minister in August and policy uncertainty engendered by it may dent business and consumer sentiment but probably not enough to derail the positive growth momentum building in the Australian economy during 2018 so far.
As mentioned earlier, the RBA is still holding the cash rate at 1.50% and looks set to stay on hold through the remainder of this year, at least. The difference in cash rate outlook between the US – up 50bps in two tranches of 25bps to 2.25% by year-end with the Australian cash rate unchanged at 1.50% – still provides a compelling reason why Australia’s 10-year bond will perform better in local currency terms than its US counterpart. That was the case again in August when the Australian 10-year bond yield fell by 12bps (US -10bps) to 2.52%. However, the weaker Australian dollar in August against most major currencies including the US dollar and Japanese yen meant that bond investors overseas would have seen better returns from investing in US bonds than Australian bonds.
Also, while Australian government bond yields fell in August and the RBA left the cash rate unchanged more Australian financial institutions announced increases in their lending interest rates. Lending interest rates in Australia are moving up because of influences the RBA cannot control. Australian lending institutions are reliant on foreign investors for 30% and upwards of their total funding. Interest rates are rising overseas, especially in the US. Making matters worse the Australian dollar is depreciating and last month there was a widening in Australian credit spreads too. Funding cost pressures for Australian lenders look set to build up further over the next few months and the risk is that they will announce more hikes in lending interest rates even if the RBA leaves the cash rate unchanged.
Rising lending interest rates may delay when the RBA needs to deliver its first interest rate hike but are unlikely to rise enough to avoid the need for a hike at some stage. They are also most unlikely to be enough to lead the RBA to cut its cash rate in compensation. The Australian economy is growing close to 3.0% y-o-y. Inflation is finding a foothold around 2.0% y-o-y and looks set to push on the RBA’s forecasts towards 2.5% next year. A “normal” lending interest rate for these economic conditions should be nearer to 6%. The official cash rate that goes with that lending rate is hard to determine in a world where funding costs are being driven up by offshore pressure, but it is materially higher than the current 1.50% cash rate, not lower. Our view remains that the RBA will start hiking the cash rate in 2019 and we have a first 25bps lift to 1.75% penciled in for February.