Risk assets mostly rallied further in July although by month-end potential challenges to the rally started to form in the shape of Federal Reserve (Fed) reluctance to cut US interest rates as aggressively as factored in by markets and tweets from President Trump ramping up the US trade war with China. The Fed cut the funds rate 25bps to 2.25-2.50% range at its end-July policy meeting but declared the cut a mid-cycle rate adjustment, not the beginning of a run of rate cuts the markets were seeking. The more conciliatory tone of post G7 meeting comments from President Trump relating to US/ China trade talks ended abruptly with the President’s latest tweet threatening to impose tariffs on remaining imports from China unaffected by earlier tariff increase announcements. The less growth-accommodating Fed rate outlook and the elevated trade war threat increase the risk of a correction to the rally in risks assets.
Returning to the month of July, most major share markets experienced further gains in July with the US S&P 500 and the Australian ASX 200 making record highs during the month. Among the major share markets Europe was weaker with the Eurostoxx50 down by 0.9% but gains in other markets ranged from 0.5% for the US S&P 500 to 2.5% for the ASX 200. The ASX 200 has rallied every month so far in 2019 and finally pushed above its previous record high set back in November 2007. Very strong growth in mineral export prices over the past year together with the more recent turn by the RBA cutting its cash rate in both June and July have helped the Australian share market to out-perform so far this year.
Australian credit markets rallied strongly again in July taking their lead from rising share markets as well as easier Australian monetary conditions. The RBA started to move position on interest rates in May indicating that while the labour market was strong it could do better still and without untoward upward pressure on inflation. The RBA cut the cash rate 25bps to 1.25% at its early June policy meeting and followed up with a further 25bps cut to 1.00% at its early July meeting. Comments by senior RBA officials in July, including by Governor Phillip Lowe, indicate that the RBA is prepared to cut the cash rate further if needed. The most recent Australian economic reports indicate that need may be fading.
Australian data reports released in July relating to housing and inflation were relatively firm. Housing auction clearance rates continue improving and housing prices are rising again, albeit modestly, in Sydney and Melbourne. Home buying activity looks set to lift further over the remainder of this year assisted by personal tax cuts; reductions in home loan interest rates in June and July; and relaxation of bank home loan lending requirements.
At the same time Q2 inflation was not quite as low as expected with the CPI up 0.6% q-o-q lifting annual inflation to 1.6% y-o-y from 1.3% in Q1. The risk of annual inflation lifting quickly above 2% y-o-y is still small but not quite so remote a risk as when the RBA board met in early-July and cut the cash rate again.
The next Australian GDP report for Q2 due in early September also looks stronger boosted by a better household spending contribution (real retail sales rose 0.2% q-o-q after falling 0.1% in Q1) and still strong net exports. Q2 GDP growth looks like being around 0.6% q-o-q, the strongest quarterly growth rate since early last year and holding the promise that monthly employment growth readings will stay strong and will help to lift annual wages growth slowly while also starting to reduce the unemployment rate again.
If Q2 growth pans out as indicated, The RBA is unlikely to feel the need to lower the cash rate further in the next few months. If the signs of improvement in the Australian economy gain more traction through Q3, as seems increasingly likely, the RBA may leave the cash rate unchanged at 1.00% throughout the remainder of this year and through much of 2020 as well.
Going back to July results in investment markets, global government bond markets were still factoring in a gloomy global economic growth outlook that would require central banks to ease policy, although the late-July Fed policy meeting called into question quite how much monetary policy easing might occur. In the US, the 10-year bond yield was unchanged at 2.01% while the 30-year yield fell 1basis point (bp) to 2.52%. US bond yields have fallen further early in August after President Trump’s trade tweets, but in time are more likely to back up and reflect the Fed’s warranted cautious approach to policy easing in an economy where the household sector is still well-placed to spend freely.
In Australia, the 10-year bond yield fell by 14bps to 1.18% at the end of July. The local bond market was assisted in July by a second consecutive 25bps cut in the RBA’s official cash rate and RBA comments that the cash rate could be cut further in need. As in the United States, the threat of a worsening trade war between the US and China has helped bond yields fall further early in August. However, the improvement in local economic indicators in July and the likelihood of more improvement in coming months make the latest bond rally look very stretched and vulnerable to set-back. The risk in the Australian bond market is that yields have fallen too far given the latest economic developments at home.