Risk assets rose in March amid growing signs that global economic growth will power ahead this year and next. The growth signals from the US are especially strong with employment booming, the passage of President Biden’s $US1.9 trillion stimulus package and the promise of a further $US2 trillion plus in infrastructure spending still to come. Central banks, including the Federal Reserve (Fed), reiterated their commitment to low interest rates and bond-buying support for fiscal stimulus programs. The main spoiler of the strong growth outlook remains Covid-19 flare-ups and shutdowns but even that negative force tempered by growing if erratic vaccination rates.
Another potential spoiler of the positive impact of quickening economic growth on risk assets are periodic increases in longer-term government bond yields. The US bond market and the Federal Reserve are at odds in their views about the outlook for inflation. Even with strong US economic growth the Fed does not expect any inflation problem before 2023 at earliest. The Bond market is looking for an earlier build-up of inflation pressure and is trying to express that view in higher longer-term bond and treasury yields.
Occasional spikes in bond yields will go together with lower risk asset prices. However, strong economic growth and growth in corporate earnings continue to quicken and provide cause to not only buy dips in risk asset prices but also to push the value of risk assets to new highs.
In March, major share markets rose strongly and continue to rise at the beginning of April. In March gains ranged from 0.6% for Japan’s Nikkei to 8.9% for Germany’s DAX. The US S&P 500 rose by 4.2% while Australia’s ASX200 rose by 1.8%. Going back a year to end-March/ early-April 2020 share markets were near their pandemic-recession low-points. The extraordinary rallies since are reflected in annual gains ranging from 23% for Britain’s FTSE 100 to 83% for the tech stock laden US NASDAQ. The broader US S&P 500 index is up 61% while the ASX200 is up 32%.
In contrast to the strong gains in share markets, credit markets were virtually unchanged in March. US credit is sensitive to rising longer-term government bond yields. Australian credit remains well supported by comparison with the US market. The Australian housing market and the economy generally continue to improve and reduce home loan default rates offsetting the potentially negative impact on home loan default rates from reduced government income support payments and the ending of the holiday on home loan repayments provided by lenders to many borrowers during the pandemic.
In government bond markets, the experience in the US and Australian markets diverged in March with the sell-off in longer-term bonds continuing in the US, but abating in Australia. The US 10-year bond yield rose in March by 34 basis points (bps) to 1.74%, while the 30-year Treasury yield rose by 26bps to 2.41%. In Australia, the 10-year bond yield fell by 9bps to 1.81%. Factors allowing the Australian 10-year bond to rally in the face of the US sell-off included the RBA’s constant reaffirmation that it will work to hold down the cash rate and 3-year bond yield at 0.10% until at least early-2024 and indications of less aggressive fiscal stimulus ahead in Australia than in the US.
In Australia, the economy is recovering faster and more strongly than Treasury allowed in its budget forecasts. The better-than-expected economic recovery so far encouraged the Government to stick with its plan to end its main income support program, Job-Keeper, at the end of March. Even while the program was running the stronger economic recovery meant that the numbers of people on Job-Keeper and Job-Seeker were less than Treasury forecast.
The stronger recovery also started to generate greater tax revenues than expected. The underlying budget deficit in 2020-21 is shrinking substantially relative to initial forecast even with the additional government spending initiatives announced since budget time. Australia’s fiscal stimulus is past its peak and diminishing.
In the US, the opposite is occurring and the fiscal stimulus which was bigger than Australia’s to start with as a percentage of GDP is continuing to build and with it the US government borrowing program. Moreover, the US fiscal stimulus is impacting a US economy that is likely to grow faster than the Australian economy in 2021. It is hardly surprising that the pressures in the two bond markets are diverging.
How long the divergence lasts between longer-term US and Australian bond yields may depend upon at what point the Fed and the RBA start to change their guidance on short-term interest rates. The Fed is indicating no pressure to lift its funds rate, currently 0-0.25% before 2013 at earliest while the RBA is talking about no pressure to hike until 2014 at earliest.
With both the US and Australian economies growing faster than expected generating more rapid than expected growth in jobs and sharper than expected reduction in unemployment it is unlikely that spare labour market capacity will be sufficient to keep inflation capped much beyond 2021. We see both the Fed and the RBA needing to change their rate guidance next year with the Fed under more pressure than the RBA to make its change first.
We still believe that the RBA’s 0.10% cash rate and 0.10% 3-year bond yield cap are in no doubt through 2021 and into the first half of 2022. That should prevent longer-term Australian bond yields from rising much even when US bond yields rise more aggressively. Fed and RBA bond buying will temper and at times part reverse rising bond yields but the strong economic growth outlook will push bond yields higher over time.