Bond, credit and share markets rose further in November amid rising hopes that inflation has peaked and that central banks may be able to moderate remaining rate hikes and perhaps avoid recession. Financial markets were encouraged by US, European and Australian inflation reports coming in lower than expected. Better inflation reports, however, may not persist given evidence that labour markets were still running too hot in October to permit inflation to return to central banks’ inflation targets over time. Central banks still need unemployment rates to rise to lock-in longer term low inflation and it remains unlikely that will happen without recession.
Major share markets seemed all but convinced in November that central banks will avoid recession trading on expectations of high profit growth ahead. Gains ranged from 1.1% for Japan’s Nikkei to 9.6% for Europe’s Eurostoxx 50. The US S&P 500 rose by 5.4% while Australia’s ASX 200 rose by 4.4%. Even though the US Federal Reserve (Fed) and European Central Bank’s (ECB)latest rate hikes were both 75bps, markets believe a pivot to smaller rate hikes will occur soon.
Belief that the rate pivot is imminent is grounded on the latest lower-than-expected CPI releases and comments from most senior central bankers that the time is approaching to dial down the size of rate hikes. October annual CPI readings for the US , 7.7% y-o-y (market expectation 8.0%) and Australia, 6.9% y-o-y (market expectation 7.4%), and the preliminary November CPI for the EU, 10.0% y-o-y (market expectation 10.4%). Financial markets are banking on the approaching December Fed and ECB policy meetings delivering rate hikes no higher than 50bps. The RBA is expected to deliver another 25bps rate hike at its policy meeting tomorrow.
The Fed and ECB may pivot to smaller rate hikes at their December policy meetings keeping alive through Christmas the goldilocks scenario of official interest rates peaking soon without triggering recession. Labour market readings, however, are pointing to the need for several more rate hikes to achieve inflation targets.
In the US, October labour market readings showed still strong growth in non-farm payrolls, +263,00, the unemployment rate lodged at a low 3.7%, and average hourly earnings lifting to 5.1% y-o-y from 4.7% in September. The Fed cannot say it has reached a peak for the Funds rate until there are signs of softness in the US labour market, at the very least the unemployment rate pushing up above 4.0%.
In Europe, the unemployment rate fell to the lowest reading this century at 6.5% in October while in Australia the unemployment rate edged down in October to 3.4%, the lowest rate since 1974. These very low unemployment rates in the US, Europe and here in Australia increase the likelihood of high wage growth with annual inflation remaining above central banks’ target through 2023 and 2024.
During October and November financial markets have revised down estimates of peak official interest rates facilitating rallies not only in share markets but in longer-dated government bond markets as well. In November longer-dated US bond yields fell. The 10-year US Treasury yield fell by 45bps to 3.60% while the 30-year bond yield fell by 42bps to 3.73%. Short-dated US bond yields, however, rose with the 1-year yield up 8bps to 4.70%. The more pronounced inversion in the US bond yield curve indicates that the US bond market is looking towards US recession and is strikingly at odds with the US share market’s soft economic landing scenario.
In Australia, the 10-year bond yield fell by 29bps in November to 3.46% and at month-end release of October retail sales showing the first monthly fall this year plus the lower-than-expected October CPI pushed the yield lower in early December. The RBA moved to smaller 25bps rate hikes back in October and November and is expected to deliver another 25bps at its policy meeting tomorrow taking the cash rate to 3.10%. Market expectations of the cash rate peak have lowered with one or two more 25bps rate hikes expected in the early months of 2023.
Tight Australian labour market conditions imply that the RBA may struggle to bring inflation down to target with a peak cash rate around 3.50% that the market now expects. However, it is worth keeping in mind that much suppression of demand in the Australian economy from earlier RBA rate hikes still lies ahead.
The effective lag between an RBA cash rate hike and a rise in repayment on a variable rate home mortgage is around six weeks. The rollover to higher rates on two and three-year fixed mortgages gathers pace in the first half of 2023. The RBA is saying that it needs to monitor what the effects of past interest rate rises have been when considering future rate moves. Where the RBA is unambiguous in guidance is in repeatedly stating that more rate hikes will be needed, but the timing and size of the hikes are not and cannot be set in stone. At this stage, we are penciling in two more RBA rate hikes, 25bps tomorrow to 3.10% and another 25bps in February to 3.35%.
Credit markets have been strong in November benefitting both in compression of spreads over government yields as well as the falls in government yields. The deterioration in underlying credit quality has been small so far and is unlikely to deteriorate much while employment growth stays strong and unemployment remains very low. Like the share markets, credit may rally further heading through Christmas, but beyond very much will depend upon whether central banks hint at more rate hiking and higher recession risk than markets are expecting at present.