The risk asset rally continued in May on the back of more signs of quickening global economic growth and little sign that global policymakers will stop stimulating growth. Rising inflation is a potential spoiler of robust growth prospects if policymakers react by tightening. The guidance from most major central bankers, however, is that the current inflation blip is temporary and that a sustainable lift in inflation requiring tighter policies will not happen until labour markets tighten and drive-up wage growth. In the US, Europe, much of Asia and Australia that implies policy support for economic growth continuing for the next year or two at least.
The Covid-19 pandemic also became less of a threat to global growth prospects over the past month notwithstanding higher infection rates and more virulent variants in India and at home a return to lockdown in Victoria. Rising vaccination rates allowed two early pandemic hotspots, the US, and the UK, to return nearer to normal life and with confidence that regression to lockdown is increasingly unlikely. In Victoria, the current lockdown looks like being the last widespread lockdown with vaccination gathering pace through May and early June.
Good economic news and hope on the pandemic front combined in May to generate another strong month for major share markets. Gains in May ranged between 0.5% for the US S&P 500 to 1.9% for both the German DAX and Australia’s ASX 200. The Australian market was buoyed on a diet of strong economic numbers, news of more government budget spending and confirmation that the RBA is sticking to guidance of no rate hikes before 2024 even as it continues to upgrade its forecasts of growth and employment. The ASX 200 moved into record high territory in May and has improved further early in June.
Credit markets were also stronger again in May as investors chased yield where they could find it and were comfortable in the knowledge that default risks were low and falling in a strong economic growth environment. Australian credit remained well supported in May. Default rates on Australian home loans continue to fall helped by household income growth, low borrowing interest rates, a falling unemployment rate and rising house prices.
One important and positive surprise in May was that government bond yields edged lower even as debate increased in markets about whether inflation is lifting. The US April inflation readings were higher than expected with the headline and core annual CPI readings at respectively 4.2% y-o-y and 3.0% and forecast to rise again with the May reading. Strong demand and supply bottlenecks are causing producer prices to rise faster around the world. Producer prices in April rose by 6.2% y-o-y in the US, by 6.8% y-o-y in China and in March by 4.3% y-o-y in Europe. Despite the bigger than expected blip in producer and consumer prices bond markets are accepting the proposition from the central banks that high inflation is temporary and will settle lower next year.
The US 10-year bond yield fell by 4 basis points (bps) in May to 1.59% while the 30-year treasury yield fell by 2bps to 2.28%. The Federal Reserve left the funds rate unchanged at 0 to 0.25% in May and still expects that low rate to continue to 2023 while forecasting booming US economic growth. While the low official interest rate is not for moving near-term, there was more talk among various Fed officials about the need to start tapering bond purchases. Strong US economic numbers over the northern summer months may lead to the Fed tapering its bond purchase program. Add some high monthly inflation readings and the risk rises of a bond market sell-off over the next few months.
In Australia, bond yields also fell in May with the 10-year bond yield down by 5bps to 1.69% and still rallying in early June. The rally occurred notwithstanding several factors that might otherwise drive-up bond yields. The early May Federal Budget increased government spending even while forecasting stronger economic growth. The Q1 GDP report was expected to be strong and came in even stronger than expected at +1.8% q-o-q, +1.1% y-o-y. Housing activity and house prices continued to rise fast in May and the unemployment rate in April fell by more than the RBA and market expected to 5.5%.
Amid signs of stronger than expected economic growth capable of generating demand that could pull inflation higher in the near term the RBA remains adamant that sustainable inflation will not occur while there is excess capacity in the labour market and wage pressure is subdued. The Q1 wage price index released in May showed wages up 0.6% q-o-q and 1.5% y-o-y still at least a year away from lifting to 3%+ y-o-y, territory consistent with annual CPI inflation sitting consistently inside the RBA’s 2-3% target band.
The risk is that Australian GDP and employment growth continue to outstrip the RBA’s forecasts and pressure the RBA to change its rate guidance from no cause to hike rates until 2024 at earliest to a need to start raising rates in 2023. The first hint of a change in rate guidance will come with a change to the RBA’s bond buying program. Tapering the bond buying program could be heralded at the July board meeting.
The Australian bond market will soon be on a slow count-down to a first hike in rates that we think will occur in the second half of 2023. Lenders have already started to lift their 4 and 5-year fixed lending interest rates expecting a higher official cash rate in 2024 and beyond. We expect 2 and 3-year fixed lending rates to lift soon as well as expectations of a higher cash rate edge into 2023.
This painstakingly slow tightening of monetary conditions with gradual bond purchase tapering eventually extending to small, slow baby step increases in official interest may trigger occasional bond market sell offs. They should be modest, brief, and unlikely to upset an economic growth environment that will continue to support risk assets for several more months at least in our view.