The strong rally in risk assets in January continued in February amid growing conviction that interest rates would remain low. In February, US Federal Reserve Chairman, Jerome Powell spoke of the need for the Fed to be patient restoring interest rates to neutral setting and he also indicated that Fed quantitative tightening (monthly sales of bonds and mortgage-backed securities to reduce the size of the Fed’s balance sheet) might end this year. Most other central banks are also abandoning plans to slowly tighten monetary policy in favour of pausing or even hinting at the possibility of policy easing down the track. The change to monetary policy stance by the central banks since late 2018 plus some signs of progress in trade talks between the US and China are allowing markets to overcome concern about the current slower patch in global economic growth fostering a burst of buying in assets linked to growth.
Major share markets all showed strong gains again in February ranging from 1.5% for Britain’s FTSE 100 to 5.5% for the Australian ASX200. The US S&P 500 rose by 3.3% in February building on its 7.9% gain in January generating the best combined January/ February gain in 32 years. While the unusually strong gain in the US share market early this year is in part a reaction to reduced concern about Fed interest rate policy and the US trade dispute with China it is also a reflection that the long economic recovery in the US is still in good shape supported by strong growth in consumer and business spending.
The strength in global share markets carried across again in to credit markets in February. The final report of the Hayne Banking Royal Commission was released early in February and was less harsh than feared in recommendations relating to banks allowing bank credit spreads to narrow further.
Government bond markets were mixed in their reaction to sharply improving share markets. US bonds after rallying in December and January gave up a little ground in February. The US 10-year and 30-year bond yields rose by 8 basis points (bps) to respectively 2.71% and 3.08%. It is worth keeping in mind that four months ago, at the end of October 2018, when markets were concerned that the Fed would keep driving the funds rate higher, the 10 and 30-year bond yields were respectively 3.14% and 3.39% and the common view was that bond yields would rise higher.
Certainly, interest rate views in the US have shifted substantially over the last few months and to the point where lower bond yields look sustainable and capable of supporting US economic growth and driving asset allocation shifts towards growth assets. The situation would change again if US bond yields climbed back up to the yields recorded four months ago, but for the next few months at least such an increase in bond yields looks unlikely. While the US economy is growing well (at 2.6% annualised pace in Q4 2018) it is not generating upward pressure on inflation. Indeed, inflation has settled lower over recent months and a sustained burst of stronger US growth would be needed to cause the Fed to hold concern that inflation might push sustainably higher.
The conditions that might cause the Fed to return to steadily hiking the funds rate look unlikely to occur over the next six months at least. The current Fed monetary policy pause looks set to last until late 2019 and possibly longer. As a result, the outlook for US bond yields is benign, they are unlikely to move far from where they are trading currently through much of this year.
Australian bond yields are starting to move differently from their US counterparts. In February, the Australian 10-year bond yield fell by 9bps to 2.15% and by the end of the month was trading 56bps below its US counterpart. The main factor that caused the difference in bond market performance in the US and Australia in February – an 8bps rise in the US 10-year yield against a 9bps fall in the Australian 10-year bond yield – was a relatively more pronounced shift in the Australian monetary policy outlook where a long pause with the RBA calling the next move a rate hike turned in various RBA monetary policy commentaries to the next move has become an even bet – a hike or a cut.
Over the last few months the RBA has become less confident about the outlook for Australian growth. Previously the RBA forecast that economic growth would slowly pick up and run above trend later in 2019 and through 2020. In the latest February RBA quarterly Monetary Policy Statement the RBA has lowered slightly its growth forecasts mostly because of concern about the slow pick up in growth in household disposable income and the impact that might have generating relatively weak growth in household spending.
It is still possible that the pace of growth in household income may lift. The Australian labour market remains strong and there are growing pockets of labour shortage that should start to drive up wage growth. Until there is evidence of higher wage growth Australia’s growth outlook remains uncertain, less certain than the outlook for US growth where wages growth has lifted and is helping to underpin strong growth in household spending.
Our view remains that Australian household income growth and spending will pick up pace later this year. But the case needs to be proved before the RBA will come under any pressure to hike the cash rate and that is unlikely to occur before mid-2020. In short, the cash rate looks set to stay at 1.50% for at least the next year. The US federal Funds rate will also be on hold for many months, but the Fed will come under pressure to hike again almost certainly before the RBA needs to make a rate change. Australian bond yields may continue to slide further below their US counterpart and it is possible that the Australian 10-year bond yield will be trading 75-100 bps lower than its US counterpart by late 2019.