Financial markets traded weaker in June with the notable exception of the Chinese markets. The growing risk of recession down the track loomed large in June as high inflation prompted several big central bank rate hikes with the prospect of more to come and quickly to temper demand and cap inflation.

Central banks are powerless to deal with the supply issues fostering inflation and must use tighter monetary conditions to tailor demand growth to the limitations imposed by restricted supply to try and prevent high inflation becoming entrenched. The monetary policy task is to try and dial a soft economic landing and bring down inflation. The likelihood is diminishing of achieving both a soft landing and inflation returning to target. Inflation is too high in the near-term and to be tamed needs substantial demand curtailment. As financial markets reassess the monetary tightening that still lies ahead, the least line of resistance for most financial markets is weaker.

China’s financial markets ran against the weakening trend elsewhere in June mostly because its economy has been running weaker over the past year and its policymakers have started easing monetary conditions and are starting to boost government spending. China’s economy is not expected to recover as strongly as it has in the past, but it is coming out the other side of its downturn late this year and in 2023 when most other major economies will be weakening in response to tighter monetary tightening.

Major share market performance in June marked the contrast between those countries where weaker growth lies ahead and China where much of the weakness is behind. China’s CSI 300 index rose 9.8% in June and Hong Kong’s Hang Seng rose 2.7%. Elsewhere, falls ranged between 3.3% for Japan’s Nikkei to 11.2% for Germany’s DAX. The US S&P 500 was down by 8.4% in June completing the worst calendar year first half (-20.6%) since 1970. Australia’s ASX 200 was down in June by 8.9%, although its losses in the first half are materially less than in the US market at 11.8%.

Rising official interest rates with the prospect of more to come took a toll on credit markets in June. Spreads widened, including the spreads on Australian credit. While Australian businesses and households are relatively well placed to pay higher borrowing interest rates, the relatively quick escalation in interest rates will prove challenging to more recent borrowers led by earlier RBA guidance to expect low interest rates to persist through to 2024 at least. Given Australia’s high level of household debt, what is more certain is that the relatively big increases in borrowing interest rates will cut into loan demand adding to downward pressure on the most interest rate sensitive part of the Australian economy, housing.

Returning to monetary policy activity, it became clear in June that key central banks wanted to lift the pace of monetary tightening. The US Fed hiked its Funds rate by 75bps to 1.75% and indicated in its forecasts that the Funds rate would increase to around 3.80% over the next year.

This prospective Funds rate still looks light on, given that US CPI inflation at 8.6% y-o-y with producer price inflation at 10.8% y-o-y may not have peaked yet. In late June and early July financial markets are toying with the idea that the Fed may stop lifting rates when it gets more evidence that the US economy is starting to weaken, but that misses the point that the Fed needs to weaken demand a lot to deal with the inflation pressure that is still brewing. Inflation readings over the next few months are likely to send more high-side shocks over the bows of US financial markets trying to divine how much further the current bear market will run.

In Australia, the RBA delivered a 50bps rate hike at its June policy meeting and indicated that it needed to remove quickly emergency-low interest rates designed to counter much weaker than current strong economic conditions. The RBA also indicated that it would move the cash rate up from 0.85% after the June hike to a more normal setting around 2.50% and that could occur quickly depending upon incoming economic data.

So far this year, the economic growth pulse has been strong bolstered by pent up demand released with easing of covid restrictions, strong employment growth and low unemployment, and a record rise in Australian export commodity prices over the past year. A buildup of household savings during covid restrictions provides a war chest that may still be spent. The only sign of wavering strength is in housing activity. Otherwise, strong demand continues to add to the RBA’s challenge containing inflation.

Australia’s inflation challenge that looked less onerous than elsewhere at the beginning of June moved in towards the high inflation pack with a key wage decision. The Fair Work Commission’s decision to lift the Minimum Wage by 5.2% and higher-paid related awards by 4.6% meant that Australian low wage growth at 2.4% y-o-y in Q1 2022 is likely to run above 3.5% y-o-y consistently from Q4 2022. General wage growth above 3.5% y-o-y increases the difficulty returning annual inflation to the RBA’s 2-3% target band over time.

In June, it became clearer that Australian annual inflation will travel higher in the near-term – RBA governor Lowe indicated 7% y-o-y late this year. It also became clearer that when annual inflation moderates in 2023 and 2024 higher wage growth could prevent inflation getting down to 3% or lower. The premise for a normal cash rate around 2.50% is that inflation returns inside the 2-3% target band over the next two years or so. The RBA is likely to deliver more big cash rate hikes while the inflation-fighting task is slipping away from it as it still seems to be in early July. We expect a 50bps rate hike this week taking the cash rate to 1.35%.

More aggressive monetary tightening by the Fed and the RBA took a toll on bond yields in June. The US 10-year bond and 30-year treasury yields lifted respectively 17bps and 13bps to 3.01% and 3.18%. At one stage during the month, they were both above 3.50%. The Australian 10-year bond yield pushed close to 4.50% briefly during the month ending at 3.57%, up 20bps. The strong rallies in US and Australian bonds later in June and in early July indicate a perception in markets that the peaks in inflation and monetary policy tightening in both countries are in sight. That perception may not last beyond the next inflation readings. At this stage we expect the US Fed funds rate to peak above 4.00% and the RBA cash rate to push up to at least 2.60% by early next year.