Bond, credit and share markets fell in December amid concerns that central banks may need to underpin higher interest rates for longer to return inflation to their targets. A longer period of higher interest rates would increase the already high risk of a global recession developing through 2023. The first week of 2023 has seen markets take an optimistic turn driven by hope that inflation is starting to recede and a sign in the US that annual wage growth may have peaked.
The US Federal Reserve (Fed) has made it clear that the tightness of the US labour market is what it is watching most keenly to determine whether inflation will return to target over time. While the wage growth reading in the December payrolls report says peak wage growth has passed, the strength of other readings including strong non-farm payrolls growth (up 223,000 in December) and the unemployment rate falling to 3.5% from 3.6% in November say that US labour market conditions are still very tight.
Financial market optimism in the first week of 2023 is likely to be challenged if the Fed sticks to its script of doing what is necessary to return inflation to 2% target over time. Even if annual US CPI inflation falls again when the December reading is released later this week (market expectation +0.1% m-o-m, +6.5% y-o-y from +0.1%, 7.1% in November), low unemployment in December and annual growth in average hourly earnings although down to 4.6% y-o-y, still imply the best hope for US annual inflation is that it falls to 4% over the next year, double the Fed’s target.
The first Fed policy meeting of 2023 at the end of this month is likely to see another hike in the Fed funds rate from 4.50%, probably to 5.00% and that still may not be the last rate hike.
Back in December, financial markets were still attuned to the idea that not only the US Fed but most other central banks still had more work ahead lifting official interest rates. Major share markets mostly fell between 1.6% for the FTSE 100 and 5.9% for the US S&P 500. Australia’s ASX 200 fell by 3.6%. Exceptions to the share market losses were China’s CSI 300, up 0.4% and Hong Kong’s Hang Seng, up 5.9%, both markets responding positively to China’s rapid removal of Covid restrictions.
The prospect of more official rate hikes beyond those delivered in December also caused bond yields to rise. In December, the US 10-year bond yield rose by 27 basis points (bps) to 3.87% while the 30-year Treasury yield rose by 23bps to 3.96%. In Australia, the 10-year bond yield rose by 52bps to 4.04%. Uncertainty about how much further official interest rates may need to rise means that bond yields could rise further in the next month or two. When it becomes clear that labour markets are weakening and that official interest rates have peaked, bond yields should fall. We see longer-term bond yields in the US and Australia falling below 3.00% by the end of this year.
Credit markets weakened in December and like other markets have found a little strength early in 2023. So far, the deterioration in Australian credit quality has been modest. Essentially, very strong employment conditions are helping Australian households cope with higher interest payments on debt. It remains less certain whether Australia will experience recession in 2023 widely expected for the US and Europe. A more resilient Australian economy than elsewhere may come with the sting in the tail that the RBA has a relatively tougher task ahead bringing inflation back to 2-3% target range. The RBA’s official interest rate currently at 3.10% may not need to be raised much more, but it may need to be held at a higher rate for longer and with relatively little leeway for rate cuts further down the track.
Australian housing, the most interest rate sensitive part of the Australian economy and already the weakest part of the economy is likely to suffer further decline through 2023. Previous RBA policy actions are having lagged effect on housing. Variable interest rate mortgage borrowers are just starting to feel the impact in their monthly repayments of the November and December RBA rate decisions.
Two and three year fixed rate mortgage borrowers who entered their commitment in boom-time numbers back in 2020 and 2021 at very low interest rates face rolling over at monthly repayments double and more in the first few months of 2023. Mortgage repayment pain intensifies sharply early this year and could become acute later in the year if the labour market weakens.
At the start of 2023 the task facing the RBA remains challenging. Annual inflation may top out less than 8.0% y-o-y forecast previously courtesy of less extreme upward pressure on petrol and food prices. However, the resilience of the economy and the labour market point to inflation being stickier on the way down and unlikely to return to 2-3% target band this year or next year.
We suspect that the RBA will be unwilling to push the cash rate up too much further and at this stage we see one more 25bps hike to 3.35% in February. But the risk with not going for an inflation killing blow with cash rate hikes – that would also tip the economy in to recession – is that the peak cash rate will have to stay in place longer, probably through to early 2024.