Financial markets rallied in January and early February assisted by signs that inflation has peaked and belief that central banks are close to the end of their rate hiking programs. Earlier concern about higher interest rates toppling economies in to recession turned in to hope that most will escape in 2023 with slower but positive growth. Lower energy prices and China’s shifting policies turning from restraint to actively promoting growth also helped to fuel optimism.
Financial market optimism in early 2023 is likely to face challenges in our view. To get inflation down to central banks’ targets needs softer demand and labour market conditions. At present, demand and labour market conditions in the US, Europe and here in Australia remain too strong for central banks to call an end to rate hikes. There is also a growing, not a lessening, likelihood that central banks will need to leave official interest rates at their peak once reached for a longer period than has been usual in the past.
Returning to the buoyant conditions in financial markets so far in 2023, major share markets showed strong gains in January ranging from 4.3% for Britain’s FTSE 100 to 10.4% for Hong Kong’s Hang Seng. The US S&P 500 rose by 6.2%, Europe’s Eurostoxx50 rose by 9.8% and Australia’s ASX200 was up 6.2%. In all these markets it was a perceived reduced risk of a hard economic landing or recession that prompted much of the buying and driving that perception of lower recession risk was a growing view that central banks are close to the end of their rate hiking cycles.
Helping to fuel belief that central banks are almost done, annual inflation rates are coming down in the US and Europe and a little more quickly than widely forecast a few months ago. The US December CPI at 6.5% y-o-y is down from over 9% in mid-2022 while the preliminary January EU CPI is down to 8.5% from a peak a few months ago above 10%. Australian annual inflation has not started to fall yet in the data, but almost certainly peaked at 7.8% y-o-y on the quarterly CPI data for Q4 2022 (8.4% y-o-y using the monthly CPI for December 2022).
The factors driving annual inflation rates down such as much-less-pronounced upward price pressure in goods prices early this year relative to early last year and lower energy prices will remain in play through to mid-2023. There are some offsets, however, with service prices mostly high and sticky. Also, underpinning the longer-term inflation outlook, in the US, Europe and here in Australia unemployment rates are sitting at multi-decade low-points consistent with sticky or rising annual wage growth. The latest January unemployment rate in the US marched down from 3.5% to 3.4%, the lowest reading since 1969.
Continuing tight labour market conditions mean that central banks still have to hike rates more to be comfortable that they have done enough to secure a return to target inflation over the next two or three years. Most central banks, including the US Fed, the ECB and the RBA are talking of more rate hikes ahead but also the possibility of an end in sight providing the data permits. The data points are still mostly leaning towards progress reducing inflation stalling at annual rates that are too high from late 2023 implying at least another two rate hikes from most central banks and risk of holding the rate peaks for longer.
However, the hope of an end in sight to rate hikes and even the possibility that some central banks could be starting to cut official interest rates by the end of 2023 seemed to drive bond market sentiment in January. Strong bond market rallies saw the US 10-year bond yield fall by 36 basis points (bps) to 3.51% and the 10-year treasury yield fall 33bps to 3.63%. The rally in short-term US bond yields was most pronounced, down 46bps to 4.66% below the Fed Funds Rate at 4.75% after the Fed’s latest 25bps rate hike and with guidance that it was not finished hiking just yet. We see the US bond market re-appraising the outlook for the Fed funds rate to at the very least a peak rate above 5.00% that stays in place for longer until the US labour market softens. US bond yields are likely to rise over the next month or two.
In Australia, even with inflation readings surprising on the high side of expectations in Q4 and December 2022, the bond market rallied in January with the 10-year bond yield falling by 52bps to 3.52%. Data points for December retail sales and the labour market showed a hint of softness. December retail sales fell by 3.9% m-o-m, but were still up 7.5% y-o-y and came after a 1.4% m-o-m rise in November. Employment fell by 14,600 in December, but the unemployment rate was steady at 3.5%. These softer readings would need to be repeated and reinforced over several months to guarantee consistent, substantial reduction in inflation removing the pressure from the RBA to continue hiking interest rates. We see such an outcome as unlikely pointing to the RBA hiking the cash rate by 25bps to 3.35% at the board meeting tomorrow and delivering at least one more 25bps rate hike beyond.
The optimism in share markets and bond markets in January carried through to credit markets in January where yield spreads narrowed mostly, albeit in thin market trading conditions. Australian credit default rates although starting to lift remain very low by historical comparison. While borrowing interest rates have lifted and are about to lift sharply especially for borrowers rolling off two-and-three-year fixed rate contracts set in 2020 and 2021 buffers from past build-up of savings, strong income growth and full-employment point to a relatively small rise in defaults even if the RBA has another couple of rate hikes to go before it is finished and the peak cash rate lasts to early 2024.