Financial markets rallied strongly in July with the notable exception of the Chinese markets. The bond, share and credit buying spree drew on perception that peaking inflation may give central banks cause to reduce the size and pace of future rate hikes, even though big rate hikes were delivered by several central banks in July. Most commodity prices weakened in July on softening global demand increasing the likelihood that annual consumer price inflation will moderate in coming months. Annual inflation in 2023, however, still looks set to base above central banks’ targets implying to us that any pause or moderation in rate hikes over the next few months will be temporary.
There are some signs of slowing economic growth in the United States exaggerated in the Q1 2022 and Q2 GDP reports showing annualised growth of respectively -1.6% and -0.9%. The US economy meets the condition of back-to-back negative growth quarters constituting a technical recession, but many other indicators still point to economic strength – real household consumption up 1.1% annualized within Q2 GDP after rising 1.8% in Q1; household income up more than 10% y-o-y with wages up more than 5%; an unemployment rate at 3.6% in June down from 3.9% in December last year with non-farm payrolls rising 372,000 in June and 384,000 in May compared with monthly increases in the early-to-mid 200,000 range late 2021 and early 2022.
What appears as a mild US recession in the Q1 and Q2 GDP reports will likely be revised to a false alarm as more complete data comes to hand. That is not to say that the US economy will escape recession down the track, the work that the US Fed still has to do to return inflation to a 2-ish % annual trajectory over the long-term means somehow dialling down annual wage growth to around 3% and dialling up the unemployment rate to around 4%. A Fed funds rate around 4% is likely to be needed to achieve these numbers still 150bps or so above the 2.50% funds rate after the 75bps rate hike delivered at the July policy meeting.
For the time being, financial markets are factoring in less central bank rate action ahead and that could sustain rallies until checked by evidence that progress reducing inflation is less impressive than expected.
Mean time, major share market performance in July was strong with mostly gains ranging from 3.5% for Britain’s FTSE 100 to 9.1% for the US S&P 500. Australia’s ASX 200 rose by 5.9%. Exceptions to the strong gains were the Chinese share markets with the Shanghai CSI 300 index down 6.6% and Hong Kong’s Hang Seng down by 7.8%. China’s residential property construction sector downturn continues to drive large corporate debt defaults, concern about China’s banks and rising social unrest.
Most credit markets rallied strongly too in July. The sense that interest rates had risen too far too quickly in May and early June powered a chase for yield promoting sharp contraction in yield spreads. The main exception to the credit rally was Chinese credit beset by concerns about real estate and real estate development companies.
Government bonds rallied as well in July with yields tumbling. The US 10-year bond yield fell by 36bps to 2.65% while the US 30-year Treasury yield fell by 17bps to 3.01%. Australia’s 10-year bond yield fell by 52bps to 3.05%. Market perception that the US Fed may go easier hiking official interest rates in the months ahead applied to perception about what the RBA may do as well.
Over the past month the market’s view of how high the RBA may need to lift the cash rate has changed from close to 4% to 3%. Driving that view change has been revision of the market’s perception of how high Australian inflation may go and when it is likely to decline. The market is looking for annual inflation to peak below 7% and probably in the current quarter (Q3 2022). It is worth noting that the market is for the first time this cycle calling inflation lower than official estimates. Commonwealth Treasury is looking for inflation to peak at 7.75% in Q4 2022 and the RBA when it releases its August Monetary Policy Statement on Friday will also forecast an inflation peak around 7% in Q4.
Tomorrow, the RBA at its August Monetary Policy Meeting is expected to hike the cash rate by 50bps to 1.85% and will comment on the most recent Q2 CPI reading released last week showing headline CPI inflation up 1.8% q-o-q, 6.1% y-o-y with underlying (trimmed mean) inflation up 1.5% q-o-q, 4.9% y-o-y. High inflation was broadly spread among the major CPI sub-categories with five of the eleven major categories showing quarter-on-quarter inflation of 2.0% or more. The RBA may point to the current pull-back in petrol prices ( perhaps the main reason why market inflation forecasts are moderating) as some cause to hope that a peak in annual inflation is in in sight, but it will still have valid cause from the details of the Q2 CPI to pitch a higher inflation peak later than the market has started to forecast.
Our view is that the RBA wants to achieve a more normal cash rate setting relatively quickly. A more normal setting is around 2.50 to 3.00%. If the RBA hikes 50bps tomorrow to 1.85%, that implies another 50bps to 2.35% in September and perhaps one or two 25bps rate hikes beyond to complete the process. We see this pattern of rate hikes challenging the July optimism in financial markets, perhaps not immediately, but when it becomes clearer that further RBA rate hikes are likely in September and October.
We see the cash rate at 2.60% by year-end and then needing to be held at that level or higher through 2023. That would seem to be the minimum monetary policy change necessary if the RBA is to return inflation sustainably inside 2-3% target band in the next 2-3 years.