Volatile trading was again the main feature of activity in most major share markets in December and the first three trading days of 2019. Through December sharp daily share market moves occurred around a declining trend line as two major concerns dominated – a US Federal Reserve (Fed) determined to keep hiking rates and seemingly unconcerned by share market falls and US President Trump’s determination to escalate the trade war. Both concerns prompted market reassessment of the likelihood of a US recession occurring late 2019 or in 2020. Share market movements in the major markets in December ranged from a 0.4% fall for the Australian ASX 200 to a 10.5% fall for Japan’s Nikkei. Late in December and early in January news items impacting financial markets have taken a brighter turn on balance. Fed Chairman, Jerome Powell, has indicated that the course of US monetary policy is not set in stone and the Fed is listening to messages from the markets. The US and China are about to start trade talks. The US economy is showing signs of reliance and the Peoples’ Bank of China has announced a two-step easing of monetary policy in January.

The weakness in global share markets in also reflected in weakness in credit markets in December. Spreads on Australian bank credit continued to widen influenced in part by recognition that major bank business models and funding requirements will continue to be impacted by the Hayne Royal Commission including when the final recommendations are released in March.

Government bond markets, in contrast to almost all other asset classes, rallied in December influenced by a growing view among bond market participants that the Fed monetary policy tightening had reached the point where the risk of the US economy tipping over in to recession was a real possibility. The next move by the Fed was likely to be some distance down the track and might be a cut in the funds rate. The bond market largely ignored the Fed’s mid-December 25bps funds rate hike, the ninth in the current series taking the funds rate to a 2.25 to 2.50% and bought bonds aggressively. The US 10-year bond yield fell by 30bps in December to 2.68% while the 30-year Treasury yield fell by 28bps to 3.01%.

Fed policy direction may prove to be the key factor determining whether the December rally in US bond yields can be sustained. At its December policy meeting the Fed was still indicating more rate hikes ahead although at a slower pace than in 2018. That policy guidance may have changed given Fed Chairman Powell’s comments last week and a lengthier pause may be in prospect before the next rate move. Whether the next Fed rate move beyond the pause is a hike or a cut has become difficult to judge.

The resilience or otherwise of the US economy will probably be the key factor determining the next move by the Fed. Surprisingly strong December non-farm payrolls, up 312,000 with average hourly earnings up 3.2% y-o-y indicate that the growth pulse in the US is still strong and is still building an edge of inflationary pressure. If the indications of US growth remain strong on balance over the next few months the Fed may return to hiking the funds rate later in 2019. What is more certain is the Fed is unlikely to do anything in the near term and that is relatively good news for risk assets but less good news for bonds as time passes.

The strong rally in US government bond yields in December was fully reflected in falling Australian government bond yields. Australia’s 10-year bond yield fell by 28bps to 2.31% over the month. Other positive factors for Australian government bonds included evidence of less-robust-than-expected Q3 GDP growth, up only 0.3% q-o-q, and comments from senior RBA officials that implied a still lengthy period ahead of no movement in the 1.50% cash rate and perhaps slightly less conviction that the next move when it eventually comes will be a hike.

There was also good news regarding the Federal Government’s Budget in the mid-year review. The 2018-19 Budget deficit forecast to be $A14.5bn or -0.8% of GDP in the May 2018 Budget was down in the mid-year estimates to -$A5.2bn or -0.3% of GDP. While cyclical factors influencing revenue and expenditure have driven the improvement Australia is close to achieving budget surplus, a goal that is well beyond the reach of most other developed economies in the foreseeable future. Whatever else occurs in 2019 Australia will remain a rare, undoubted AAA credit risk an underlying but important positive factor for the Australian Government bonds.

In terms of Australian monetary policy 2019 looks like a repeat of 2018 and 2017 – no change in the 1.50% cash rate. We still lean towards the next move being a rate hike but not until early next year.