Financial markets remained volatile in May torn between evidence of strong economic activity and concern that central bank interest rate hikes will dampen future activity and possibly lead to recession. Inflation and its many underpinnings are driving the likely course of central bank rate hikes. Views about central bank rate hikes are varied, adding to market volatility.

In the US, inflation running at 40+ year highs January through March forced the Federal Reserve (Fed) to hike 50bps at its May policy meeting and promise similar-sized hikes at its next two policy meetings. Annual US CPI inflation settling down a touch in April to 8.3% y-o-y offered a glimmer of hope that US inflation may have peaked perhaps giving the tough-talking Fed opportunity to moderate rate hikes down the track.

Elsewhere, inflation is yet to show signs of a peak forcing 50bps rate hikes at the latest policy meetings of the Bank of England, Bank of Canada and Reserve Bank of New Zealand. Inflation is high and still rising in the European Union as well, but the European Central Bank is yet to start hiking official interest facing greater recession risk than elsewhere because of energy supply shortages and sky-rocketing prices as Europe slowly cuts off its biggest energy supplier, Russia.

In Australia, inflation has not lifted to the heights experienced overseas, but it has been higher than expected by the RBA and is yet to peak forcing the RBA to announce at its May policy meeting an initial 25bps rate hike and a promise to normalise interest rates gradually.

May has been a busy month for central banks hiking rates with the promise of more to come in the months ahead. The heightened central bank activity and rate guidance has also provided hope that high inflation is being tackled and with limited damage to economic activity so far. That hope has limited the headlong selling in major share and bond markets that has featured mostly so far this year.

In May, despite volatility within the month, major share markets managed a mix of gains and losses.  The US S&P 500 ended the month flat after selling through much of the first half of the month gave way to gains later in the month. Japan’s Nikkei, Germany’s DAX and Britain’s FTSE 100 all managed gains in May of respectively 1.6%; 2.1%; and 0.8%. Australia’s ASX 200 bucked the trend elsewhere and fell by 3.0%, but it is worth keeping in mind that the Australian share market had outperformed earlier in the year. Also, the RBA’s May rate hike although smaller than that of its peers was more significant because it marked a clear change to the RBA’s earlier guidance of taking time before hiking.

Credit markets weakened through the first half of May and regained some ground later in the month, ending the month down. Australian businesses and households are well placed to deal with slowly rising borrowing interest rates. The Australian economy is still strong, evidenced by Q1 GDP, up 0.8% q-o-q, 3.3% y-o-y and an unemployment rate at a 48-year low, 3.9% in April. According to the Q1 Business Indicators company profits rose 10.2% q-o-q after rising 4.6% in Q4 2021. The most interest rate sensitive part of the economy, housing activity, has started to soften with house prices beginning to fall, but mortgage delinquency rates remain very low, and any deterioration looks set to be slow and modest at this stage.

The sharp sell-off in Government bond markets that featured earlier in the year eased in May amid recognition that central bank policy tightening activity will cap and eventually reduce inflation. The US 10-year bond yield fell by 9bps to 2.84% while the 30-year Treasury yield lifted by 5bps to 3.05%. The Australian 10-year bond yield rose by 25bps to 3.37% although this was down on its mid-month peak yield above 3.50%.

Looking ahead, while it appears that the worst of the sell-off in Government bond markets is over, we see bond yields rising again later this year towards 4.00% for the US 10-year bond yield and above 3.50% again for the Australian 10-year bond yield. These yields reflect where annual inflation is likely to settle and the monetary policy settings allowing inflation to settle in the two countries over the next two years or so.

In the US, the tightness of the US labour market with wage growth running above 5% y-o-y, less frantic price increases for goods and rising prices for services make for a complicated inflation outlook, but one where the base effect will still be in play strongly later this year and in the first half of 2023. The current 8.3% y-o-y CPI annual inflation rate subsides to around 4% by this time next year. The Fed will need to lift the Funds rate to around 4% in 2023 to ensure that 4% inflation is the staging post for lower inflation beyond and not the base for a rebound higher.

In Australia, while the annual inflation rate is yet to peak, the peak should occur later in 2022 below the US 8%+ inflation peak and ahead of a pronounced base effect pulling inflation down to around 3.50% in 2023. Inflation underpinnings are weaker in Australia than in the US. The Australian labour market is not as tight as the US labour market evidenced by annual wage growth running less than half the pace of US wage growth. While annual wage growth in Australia will rise, general wage growth is likely to peak nearer to 4% than 5%. The RBA can afford to take a leisurely approach hiking the cash rate. We see moves in steps of 25bps and brackets of three moves with pauses between.

At this stage, we see the RBA lifting the cash rate to around 1.10% by the end of this year and then to 2.10% by the end of 2023. We see a peak for the cash rate between 2.50% to 3.00% in 2024. We accept that some see the RBA tightening more aggressively and those different views may propel the Australian 10-year bond yield above 3.50% occasionally, where on our view it is in buying territory.