Changing views about how high interest rates might rise caused bond yields to lift in February and mixed results for major share markets. US economic readings were stronger than expected for the most part and reduction in inflation was less pronounced than expected implying that the peak in the Federal Reserve’s funds rate might be higher than expected earlier and further away. In contrast, Australian economic readings in February hinted at softening economic activity that in our view might lead the RBA to complete its program of interest rate hikes by May.
Government bond yields pushed up in February driven largely by changing market views that the Fed would need to hike the funds rate to at least 5.25% and possibly to 6.00% to bring inflation back to 2% target. Data reports showed a 3.0% m-o-m surge in US retail sales in January, the unemployment rate falling to a new half-century low-point of 3.4%, and annual inflation only edging down to 6.4% y-o-y (headline CPI) from 6.5% in December. The combination of strong spending, a tight labour market getting even tighter, and inflation proving to be stickier than expected meant that even after the Fed’s most recent 25bps hike in the Funds rate to 4.75% more hikes are needed.
US bond yields rose in February, reacting to the data showing still robust US economic activity pressuring the Fed to hike more. The 10-year bond yield rose by 39 basis points (bps) to 3.90% (briefly touching above 4.00% at the start of March) while the 30-year Treasury yield rose by 28bps to 3.91%. In early March, some leading indicators of US economic activity have come in softer than expected, notably February consumer confidence coming down to 102.9 from 106.0 in January, causing bond yields to retreat from recent peaks.
Most US economic readings remain firm, however, especially those relating to the tightness of the labour market. The Fed needs the US unemployment rate to rise to contain wage growth and inflation. Until there are signs of a rising US unemployment rate, we see the Fed continuing to issue hawkish guidance on the US interest rate outlook. We see the US 10-year bond yield pushing above 4.00% again over the next few months.
Whereas the balance of economic readings in the US are still strong, the balance in Australia is shifting towards weaker. The RBA’s interest rate hikes to date although less in size than those delivered by the US Fed have acted to temper demand more quickly and sharply. Australia’s still mostly variable interest rate full recourse home mortgage market has seen Australian housing activity turn down more sharply than US housing on relatively smaller hikes in official interest rates. Much higher household debt in Australia relative to the US is also causing relatively greater sensitivity to official rate hikes.
Australian GDP growth moderated from 0.7% q-o-q in Q3 2022 driven by domestic demand to 0.5% q-o-q in Q4 driven by external demand. Retail sales were erratic over the turn of the year, down 4.0% m-o-m in December but rising 1.9% in January. The labour market is looking less tight with total employment falling in December and January, the unemployment rate lifting to 3.7% in January and off its lowest reading of 3.4% back in October. Wage growth is not quite as strong as expected at 3.3% y-o-y in Q4 based on the wage price index and the set of economic forecasts provided by the RBA in early February in the quarterly Monetary Policy Statement now look too high relating to 2023 employment growth and wage growth and too low relating to the unemployment rate.
Australia’s 10-year bond yield currently around 3.82% is sitting 13bps below the US 10-year bond yield currently at 3.95%. We see that yield margin below the US 10-year bond yield widening markedly over the next month or two as upward pressure continues on US bond yields whereas the pressure is tending in the opposite direction on Australian bond yields.
Rising interest rates reflecting stronger than expected economic activity in the US and Europe led to a mixed performance for major share markets. Major share market performance in February ranged from -9.4% for Hong Kong’s Hang Seng index to +1.8% for Europe’s Eurostoxx 50. The US S&P 500 was down by 2.6% but has rallied in early March. Australia’s ASX 200 fell by 3.2% as the prospect of the RBA hiking rates by more than previously expected increased the likelihood of the Australian economy experiencing recession. Market expectations are very fluid at present and softer Australian economic readings early in March tempering rate hike views have allowed the ASX 200 to rally.
The softness in the US and Australian share markets in February together with higher interest rates saw credit markets a little weaker with yield spreads a little wider. 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 imply that the feared cliff may be more of a gentle slope.
The key to whether default rates will lift more sharply is how much loss of household income occurs because of rising unemployment. Even though total employment has slipped in December and January, it is unclear whether this is mostly an unusual and exceptional turn-of-the-year occurrence this year with more people than usual between jobs. The rise in the unemployment rate so far is not of an order that would materially lift loan default rates. However, the more that the RBA hikes interest rates going forward the greater the risk of a material lift in the unemployment rate (towards 4.5% or higher) that would add to loan defaults.
Our current view of one or two more rate hikes with a cash rate peak of 3.60% or 3.85% will take the Australian economy to the boundary of recession later this year. A cash rate peak above 4.00%, however, would make recession and an unemployment rate above 4.50% inevitable in our view.