Share-market performances in September varied widely again ranging from Japan’s Nikkei lifting by 5.5% and making a 27-year high, to Australia’s ASX 200 falling by 1.8%. The US S&P 500 eked out a 0.4% gain in September, notwithstanding an intensifying trade war with China and the latest 25bps rate hike by the Federal Reserve (Fed). Strong economic growth driving business profits higher continues to provide the fuel driving many share markets higher including those such as the US market that look over-valued relative to increasingly optimistic estimates of future earnings. Japan’s share market received added lift in September on mostly favourable local economic and political news as well as the near certainty that the Bank of Japan is likely to lag substantially most other major central banks reducing extremely growth-accommodating monetary conditions. The Australian share market suffered despite mostly favourable local economic data. Negative factors impacting the local market included concern that a credit squeeze hurting housing might intensify after the release of the interim report of the Hayne Banking Inquiry.
Negative investor sentiment towards the Australian share market in September did not carry through to Australian credit spreads that were relatively stable during the month. One important positive development for local credit in the month was the removal of the negative watch on Australia’s AAA sovereign credit rating by a major international credit rating agency. The improvement in outlook for Australia’s AAA rating came as the result of the announcement that the Federal Budget deficit in 2017-18 was $A20 billion less than forecast in the original Budget providing a much greater degree of certainty that Australia’s Budget position will return to surplus over the next two years.
Government bond markets came under renewed selling pressure in September especially in the US ahead of a widely expected 25bps Fed rate hike to 2.00 to 2.25% range late in the month and a growing realisation that strongly growing US economy would bump up against capacity constraints potentially lifting inflation and leading the Fed to keep pushing up the Funds rate probably again December and at least another three times in 2019. At its late September policy meeting the Fed made it plain in its GDP growth forecast revisions – upwards for 2018 and 2019 to respectively 3.1% y-o-y and 2.5% y-o-y – that it needs to keep pushing the Funds rate up towards at least a neutral setting around 3.25%.
Even though longer-term US bond yields rose in September by around 20bps (the US 10-year bond yield up 20bps to 3.06% with the 30-year yield up 19bps to 3.31%) they still have not moved up enough to adequately reflect the strength of the US economy; the increasing risk of higher US inflation; what the Fed is saying repeatedly about the likely future path of the Funds rate; or the unusually big borrowing needs of the US Administration (especially when combined with the Fed conducting the opposite of QE operations and gradually selling down its bond holdings). The risk is growing of a more pronounced lift in US Government bond yields and potential triggers abound – surprisingly high US wages and/or inflation data; a large late-cycle rally in shares causing asset allocation bond selling; a change in investment behavior of a large holder of US bonds such as China.
Rising US bond yields are likely to prime higher interest rates in Australia. In September, Australia’s 10-year bond yield rose by 14bps to 2.66% even though the RBA left the cash rate unchanged at 1.50% with no near-term prospect of a hike and positive news relating to Australia’s AAA credit rating. For the next few months Australian bond yields are likely to rise, but at a lesser pace than US bonds of comparable maturity. The yield gap at which the Australian 10-year bond trades below its US counterpart has stretched to a record 40bps and there is a strong likelihood that this gap will widen further to 50bps or more by the end of 2018.
At some point in the first half of 2019 we now see a possibility that the relative conditions in the US and Australian government bond markets could change and that Australian bond yields start to rise faster than their US counterparts. The main reason why we expect such a change in relative bond market conditions is that stronger Australian GDP growth is more likely than stronger US GDP growth in 2019. In the US, the peak boost to GDP growth from the Administration’s tax cuts is occurring now. In Australia, fiscal spending initiatives are just starting to proliferate as the Government tries to influence its chances in the approaching Federal election likely next May. In the US, eight Fed interest rate hikes since late 2015 plus higher bond yields and fixed term mortgage rates are likely to be weighing on the economy in 2019. In Australia, the cash rate has been unchanged at a record low 1.50% and until the last few months lenders have been competing borrowing interest rates lower.
The US economy is facing head-winds from past US-dollar strength and a mounting trade war. Australia has a tail-wind from a mostly softer Australian dollar this year. Australia also has a build-up of big infrastructure projects extending in to 2019 and well beyond and some signs of a revival in the resources boom are starting to show through too. Even with some softness in Australian housing and drought (moderating on recent rain) in Queensland and New South Wales, Australian GDP growth looks set to grow above 3% y-o-y in 2019 whereas US GDP growth is likely to settle back from above 3% y-o-y in 2018 to 2.5% in 2019.
The change in relative GDP growth positions in the US and Australia that we expect in 2019 is not factored in to current market pricing. The market expects the RBA to leave the cash rate unchanged at 1.50% through 2019 even in the face of more Fed rate hikes. We expect that the RBA will soon start adjusting upwards its economic growth forecasts and that will lead it to start hiking the cash rate early in 2019. We expect the Australian 10-year bond yield after tracking 50bps or more below its US counterpart in late 2018 to be back on par with its US counterpart by the end of 2019.