In October and early November, financial markets toyed with the idea that central banks may be approaching the end of the rate hiking cycle fostering erratic rallies in several major share and bond markets. These rallies seem to be built on shaky ground given that the latest inflation readings in the US, Europe and Australia all came in higher than expected and most central banks continued to hike interest rates aggressively.
While hinting that at some stage interest rate hikes will be smaller, most central banks are also talking about interest rates staying higher for longer to combat slow-to-recede high inflation. The sharp increases in official interest rates to date are making recessions much more likely in the US and Europe in 2023, but a soft global economic landing, not recession, is factored in to analysts’ still high company earnings forecasts for 2023.
Stubbornly high inflation and the difficulties forecasting it, plus central banks struggling to know how high they will need to push up interest rates to contain inflation imply at the very least periodic high volatility in share and bond markets. It is also likely, in our view, that the high point in this cycle for bond yields and the low point for share markets still lies ahead.
While we still see high inflation and rising official interest rates generating lower prices for financial assets over the next few months, our outlook is at odds with the optimism in financial markets in October. Most major share markets rose in October with gains ranging between 2.9% for Britain’s FTSE 100 and 9.4% for Germany’s DAX. The US S&P 500 was up 8.0% and the Australian ASX 200 was up 6.0%. Going against the rising trend in share markets in October, China’s CSI 300 fell by 7.8% and Hong Kong’s Hang Seng was down by 14.7%. Both markets were influenced by signals from the authorities that China will continue to use lockdowns as its main tool to contain covid outbreaks, although late last week there were signs of relaxation to this directive.
Government bond markets were mixed in October. The US bond market rallied early in the month but gave up ground on evidence of stickier high inflation in the September CPI, 8.2% y-o-y with the core CPI, excluding food and energy prices, at 6.6%. While the prices of goods are stabilising and receding for some categories, service price inflation is gathering pace, notably the cost of shelter. The US 10-year bond yield rose in October by 22 basis points (bps) to 4.05%, while the 30-year Treasury yield rose by 37bps to 4.15%. Shorter term US bond yields pushed up above 4.50% factoring in that the Fed may need to hike the Funds rate, currently 4.00% after the 75bps hike last week, close to 5.00% in the next few months.
Australian bond yields rallied in October after the RBA surprised at its policy meeting early in the month and hiked the cash rate by 25bps to 2.60% rather than the 50bps hike widely expected. The smaller-than-expected RBA rate hike added traction to the developing ‘central banks are pivoting to smaller rate hikes’ view in markets. The Australian 10-year bond yield fell by 12bps to 3.75% in October.
The RBA hiked again by only 25bps to 2.85% last week, notwithstanding a higher-than-expected Q3 CPI report the week before, 7.3% y-o-y with underlying inflation (trimmed mean) at 6.1% y-o-y. The Q3 CPI report has led the RBA to lift higher its inflation forecasts in the November Monetary Policy Statement to a peak of 8% y-o-y CPI in Q4 2022 with lesser than previously forecast moderation to 4.7% y-o-y in Q4 2023 and 3.2% y-o-y in Q4 2024. The latest RBA inflation forecasts imply that the RBA needs to hike the cash rate further (it has admitted as much in the statements accompanying both the October and November rate hikes) and will need to leave the cash rate higher for longer.
Even though the RBA faces a less onerous inflation outlook than the US or Europe implying that the Australian cash rate will peak lower than in the US or Europe, the RBA cash rate is likely to peak above 3% (our tentative forecast 3.35% peak from February 2023 extending in to 2024). Borrowing interest rates will move higher in lagged response and will eventually extend the weakness in mortgage borrowing and home buying activity to general household spending.
Currently, household spending is strong (September retail sales were up 0.6% m-o-m, 17.9% y-o-y and needs to soften to help bring inflation under control. Post-pandemic-lockdown spending euphoria still fueled by low unemployment and high household savings built up in lockdown is proving to have a long and strong tail in the face of rising borrowing interest rates. At some point, higher borrowing interest rates will cut in to the strength in household spending, but it is proving hard to forecast when that will happen.
The near certainty that household spending growth and general economic activity will slow, but with uncertainty about when and by how much slowdown will occur and the consequences for the most interest-rate sensitive part of the economy, home mortgage borrowing and mortgage default rates presents a challenging outlook for credit. Most Australian credit indicators rallied in October although Australian deposit institutions paid wider deposit margins.
Over the next few months, progress containing inflation is likely to be the key influence on financial markets. If inflation outcomes continue to stay high relative to expectations, expectations about how high central banks will need to hike rates will increase too, adding to the risk of recession.