The recessionary consequences of central banks fighting to contain high inflation loomed large again in September causing most financial assets to sell off. The US Federal Reserve hiked another 75bps in the month taking the Funds rate up to 3.25% and indicated higher rates persisting for longer to deal with an inflation problem becoming entrenched by high US wage growth and rising prices of services. Other major central banks, including the RBA, hiked between 50bps and 100bps in September, all promising more rate hikes ahead. The rapid rise in interest rates with more increases ahead has increased markedly the likelihood of recessions ahead in the US, Europe and probably Australia as well.
Financial markets are starting to factor in recession ahead but the process has some way to go. Longer-term government bond yields typically fall in recession as a turn or pivot towards central banks starting to cut interest rates comes into view. Longer-term bond yields were still rising in September and sharply. The US 10-year bond yield rose by 64bps to 3.83% while the 30-year Treasury yield rose by 49bps to 3.78%. In the US, the Fed talking openly about the imperative of containing inflation and how the higher interest rates needed to contain inflation will hurt implies the pivot to easing policy is slipping further away.
The continuing strength of the US labour market in September and evidence in the August CPI release that annual inflation at 8.3% y-o-y is not moderating as much as hoped with a second wind developing from higher service prices also illustrated that the Fed will need to push the Funds rate well north of 4.00% with some analysts starting to view a peak above 5.00%. The rate forecasts of senior Fed officials at the September policy meeting point to a near 4.50% Funds rate by early-2023 with the Funds rate holding close to 4.00% over the next two years.
Barring a marked weakening turn in the US labour market and inflation US bond yields are in our view likely to rise further in this cycle, probably to 4.50% or higher for the 10-year bond yield.
The sell-off in US government bonds in September was mirrored in deteriorating European government bond markets with most countries experiencing a rise in 10-year bond yields between 50bps and 70bps. In part, the increases in European bond yields reflected confirmation that the European Central Bank is becoming more aggressive tackling high European inflation. The ECB hiked 75bps in September taking its deposit rate to 0.75%. The release of the preliminary September CPI showing higher-than-expected 10.0% y-o-y annual inflation points to much more rate-hiking work ahead for the ECB even though recession is an imminent risk from energy-supply disruption.
A bigger bond market sell-off was suffered in the UK in September. The British 10-year bond yield soared 117bps to 4.08% and the deterioration was only tempered briefly by the Bank of England stepping in to buy bonds. Britain is suffering 10% annual inflation that is becoming entrenched. Rather than facilitating a clamp on demand that might turn the inflation tide the new British Government led by Prime Minister Liz Truss has boosted government spending and borrowing on a massive scale. While the Bank of England is trying to apply the monetary policy brake (erratically now it has had to buy bonds at the same time as it hikes official interest rates), the Government is pressing down hard on the fiscal accelerator.
The sell-off in Australian bonds in September was modest by international comparison. The 10-year bond yield rose by 22bps to 3.88%. The RBA is in the same position as its peers internationally needing to hike rates more to contain inflation but Australian inflation, although high, is lower than in the US and Europe and seems less entrenched. The new monthly ABS CPI showed annual inflation at 7.0% y-o-y in July and moderating from the impact of lower petrol prices to 6.8% y-o-y in August. The Q3 CPI reading out later this month will show annual CPI inflation around 7.0% y-o-y up from 6.1% y-o-y in Q2 and annual inflation looks set to push close to 8.0% y-o-y in Q4 before receding next year.
The RBA still needs to push the cash rate up to around 3.10% by the end of this year and, given the resilience of consumer spending and the tightness of the labour market, a peak cash rate around 3.50% may be needed to ensure inflation recedes over time to 2-3% target range. We see the moderation in Australian annual inflation being quite a slow affair through 2023. Service prices are rising offsetting the impact of stabilising and in some cases falling goods prices. A slow prospective moderation in inflation implies that the cash rate once at its peak will stay at its peak for longer. That means it will be many months before the bond market can look confidently at a pivot point in the RBA cash rate. The bond yield peak for this cycle still lies ahead.
Turning to risk asset markets, the bear market growled on through September. Major share markets fell between 5.2% for the Australian ASX200 and 11.5% for Hong Kong’s Hang Seng. The US S&P 500 fell by 9.3% as the Fed talked more openly about the cost to the US economy of higher interest rates needed to contain inflation. The equity bear market seems likely to run further until company earnings expectations reflect the recession that lies ahead in 2023 in the US, Europe and much of the rest of the world.
In credit markets, yield spreads widened in September and combined with rising official short-term interest rates and rising longer-term government bond yields total yields are starting to look more attractive although still fall well short of current annual inflation rates. Australian credit quality remains strong largely reflecting the strength of economic activity, especially the strength of the Australian labour market with the unemployment rate still near a 48-year low 3.5% in August. Rising home mortgage interest rates are taking a toll on housing activity – house prices, home loan demand and home building approvals – but are yet to turn very low mortgage default rates that have been protected so far by high household savings and near full-employment. That protection to credit quality is likely to fade as the full impact of past rate hikes and those coming are felt late 2022 and through the first half of 2023.
Concerning the Australian cash rate outlook, we have tweaked our forecasts higher. We see a 50bps rate hike tomorrow taking the cash rate to 2.85% and a further 25bps hike in November taking the cash rate to 3.10%. At this stage we see the RBA pausing in December before delivering two final 25bps rate hikes in February and March next year taking the cash rate to 3.60% where it will stay for a year through to early 2024. When the cash rate cuts come, they are likely to be modest given the stickiness of the inflation outlook. At this stage, we see the cash rate at 3.10% at the end of 2024.