September was a risk off month for investors as the most richly valued share markets succumbed to mounting concern about downside risks to global economic growth. Downside risks that ranged from the latest wave of Delta variant infections even in countries with high vaccination rates, to the faltering passage of US legislative bills relating to hard and social infrastructure spending and debt ceiling issues, to stubborn inflation pushing central banks to consider reducing monetary support and rising bond yields, and a range of developing headwinds to China’s economic growth prospects including a rumbling potential credit crisis centred on its biggest property development company. Set against these rising concerns the economic data releases, especially out of the US, remained consistent with strong economic growth.
Major share markets were weaker mostly in September. The previously high- flying US S&P 500 showed one of the bigger falls in September, down by 4.8% and experiencing its worst month since March 2020 at the start of the pandemic. Falls elsewhere were less pronounced ranging from 0.5% for Britain’s FTSE 100 to 3.6% for Germany’s DAX.
Australia’s ASX 200 broke an eleven-month run of increases with a 2.7% fall. The shares of major iron ore producing companies led the fall in the local market as China’s continuing crackdown on Steel production and property developers limited demand for iron ore reducing prices sharply. One major share market that went against the falls in September was Japan’s Nikkei, up 4.9%, benefitting from its relative undervaluation to other markets as well as evidence of sharper than expected economic improvement.
Credit markets weakened in September amid the general risk off sentiment among investors. The first signs that central banks may bring forward official rate hikes and rising government bond yields limited appetite to chase yield while the potential default problems and repercussions of China’s giant property development company Evergrande also promoted an upward drift in credit yield spreads.
Australian risk spreads widened in September but appear less vulnerable to substantial sell-off partly because the RBA is not among the cohort of central banks considering higher official interest rates in the near term. Another factor providing relative support to Australian credit is that Australian housing credit metrics remain strong with rising house prices, still low borrowing interest rates and concessions from banks keeping default rates on Australian home loans low.
Government bond yields moved higher through September as pressure continued to mount on central banks to respond to inflation looking stubbornly less temporary than expected. The essential cause of the bigger than expected lift in inflation in many countries around the world in mid-2021 has been fast rising demand outstripping supply of many goods. International supply chains have been disrupted by pandemic restrictions and the view of most central banks until recently has been that disruptions are temporary and supply will recover reducing inflation before it becomes entrenched. What became clearer during September was that supply disruptions are taking longer to resolve and, in some cases, such as energy supply are worsening. Also, big increases in house prices and rents will soon feed into consumer price inflation readings.
Strong economic growth also fanning higher inflation is causing a shift by some central banks towards considering a near-term lift in official interest rates. In developed economies Norway’s central bank increased its official cash rate from zero to 0.25% in September. The Bank of England at its September policy meeting heralded an official rate rise before the end of the year. The Reserve Bank of New Zealand is expected to lift its cash rate this week from 0.25% to 0.50%. The US Federal Reserve indicated at its September policy meeting both a start reducing its purchases of bonds this year and a first official rate hike before the end of 2022.
The US 10-year bond yield rose 18 basis points (bps) to 1.49% in September while the 30-year Treasury yield lifted 11bps to 2.04%. In September the stronger turn in US economic data plus the more hawkish Fed contributed to the rise in US bond yields, but also make it likely that the upward drift in yields will continue during October.
In Australia, the rise in longer-term bond yields in September was larger than the rise in US bond yields, a surprising result given that the RBA at every opportunity reinforced its guidance that the official cash rate was unlikely to rise before 2024. The 10-year bond yield rose by 33bps to 1.48%.
Part of the reason for the bigger rise in longer-term Australian bond yields came down to mixed messaging from the RBA. While it remained adamant that there could be no sustained inflation lift until wage growth supported such a lift, the reason for continuing to nominate 2024 at earliest for an official rate hike, it also saw enough reason in its optimistic view of how well the economy would rebound beyond the current lockdowns in New South Wales and Victoria to continue with its plan to reduce monthly bond purchases from $A5 billion to $A4 billion weekly in September. The RBA is in the leading group of central banks reducing bond purchases but plans to be right at the back of the central bank queue to start hiking official interest rates.
Apart from RBA mixed messaging there is also evidence in September economic reports that the Australian economy is weathering the lockdowns in New South Wales and Victoria better than expected. Retail sales fell less than expected in August, -1.7% m-o-m (consensus forecast –2.4%). Business and consumer surveys released in September were stronger than expected and the unemployment rate in August stayed surprisingly low at 4.5%. There is a springboard for stronger Australian economic growth beyond the shutdowns and it is now much clearer that those shutdowns will end during October.
While the RBA is likely to stick with its plan to keep the cash rate at 0.10% through 2022 and 2023 that may provide little protection to longer-term interest rates. Rising international longer-term bond yields, part driven by several of the RBA’s international peers lifting official rate much earlier than the RBA, will feed upward pressure on Australian long-term bond yields over the next few months.