Risk assets have rallied every month so far in 2019 and April proved to be one of the strongest months so far assisted by signs of a halt in slowing of the pace of global economic growth; low interest rates; some signs of progress in US/ China trade negotiations; and a six-month extension before Brexit comes to a head again. The rally extended in early May, although President Trump’s attempt to hurry along trade talks to a conclusion by threatening over the weekend to resume increases in US tariffs is likely to generate uncertainty in the near-term and at worst a more sizeable threat to the rally in risk assets if his intervention causes trade talks to flounder.
Nevertheless, major share markets all gained strongly in April with the US S&P 500 making a record high during the month and up 3.9% in April and Australia’s ASX making a 10-year high in the month and up 5.2% in April. Among other major share markets gains in April ranged from 1.9% for the FTSE 100 to 7.1% for the German DAX. Despite the strong share market gains there is little sign of interest rates lifting. In most countries, including the US and Australia, inflation continues to hold down allowing central banks to keep policy interest rates low and stable. Barring exceptional threats to global economic growth (President Trump’s latest import tariff posturing could become such a threat depending upon how China responds) the least line of resistance for risk assets remains upwards.
Credit markets shared the improvement in share markets in April and yield spreads are approaching very narrow levels. Government bond yields are holding down although with some drift higher in US yields after their strong rally in March. The US 10-year Treasury yield rose by 9 basis points (bps) to 2.50% in April but after falling by 30 basis points (bps) in March. The 30-year Treasury yield rose by 12bps to 2.93% reversing less than half of the 27bps yield fall in March. Two points are worth noting about US bond yields in April. The first is the modest steepening in the yield curve in the month leaving the brief curve inversion that occurred in late March an anomaly and an implausible precursor of a US recession. The second is that the US bond market is accepting the Federal Reserve’s guidance on rates, no change in the 2.25% to 2.50% Funds rate likely for some time. As a result, there is no strong reason for bond yields to push up far even as risk assets rally in response to a US economy that continues to grow and without a near-term threat of higher inflation.
In Australia, government bond yields are anchored even more firmly than in the US. Unlike the US where household sector spending is growing quite strongly assisted by decade-high wages growth; fifty-year low unemployment; and fast rising household wealth, household spending growth in Australia is comparatively soft. Since mid-2017, the downturn in house prices has been a dampening factor on household spending. What offsets there have been to help lift household spending – unemployment around an 8-year low and a slight drift upwards in low annual wages growth – have barely been gaining traction.
Soft household spending growth has been the main factor generating weak quarterly real GDP growth reports through the second half of 2018 helping to keep annual inflation tracking lower than expected. Weak Q4 GDP growth and low Q1 inflation have increased calls among analysts during April for the RBA to consider cutting the 1.50% official cash rate. The calls for a lower cash rate helped to hold down Australian bond yields. The 10-year government bond yield drifted up in April by only 1bp to 1.78%, yielding 72bps less than its US counterpart.
In the wake of the low Q1 CPI report, 1.3% y-o-y down from 1.8% in Q4 2018, it is possible that the RBA may consider a rate cut although we still believe that the probability is not high. Reasons that may cause the RBA to exercise caution include first the likelihood that neither Q1 GDP growth nor the Q2 CPI will be as soft as their respective previous quarterly readings. Q1 GDP (due early in June) looks set to receive a boost from better household consumption spending and net exports at the very least based on much stronger monthly reports of international trade and retail sales in January and February.
The Q2 CPI (due late July) loses the dampening impact of a sharp fall in petrol prices that contributed most to holding down the Q1 CPI. If the RBA cuts the cash rate its primary reasons for cutting could be evaporating by mid-year. Other reasons reinforcing the risk of cutting include the likelihood that wages growth will continue to drift higher (much higher if Labor is elected at the coming election and pursues it higher wages policy); households are about to receive sizeable tax rebates regardless of which party wins the election boosting spending in the second half of 2019; competition is already forcing down home loan interest rates and mortgage refinancing activity taking advantage of lower rates is starting to provide space in household budgets to spend more; and the housing market is showing tentative signs of bottoming out according to auction clearance results as well as housing finance data.
Looking overseas, every major economy has reported Q1 GDP better than expected (the EU was the latest to join with Q1 GDP up 0.4% q-o-q, 1.2% y-o-y). The global economy is showing signs of improvement, an unusual time to cut rates.
It is still possible that the RBA could cut the cash rate but there are several good reasons listed above why the line of least regret for the RBA is to leave the cash rate unchanged. Our view remains that the cash rate is likely to stay at 1.50% until mid-2020.