Government bond yields fell sharply in March reflecting a marked change in market view towards believing central banks’ official interest rates are at, or close to their peak, and will be cut two or three times over the next year. Falling bond yields are heralding recession with collapses and rescues of US and Swiss banks during the month bringing to sharper focus the risk of weaker economic growth ahead. Major share markets, in contrast, took comfort from the notion that official interest rates are close to peaking and rallied through the second half of the month seeming more confident that central banks will avoid recession. Central banks, however, even while dealing with banking spot fires, have not changed their guidance materially. They mostly continued to hike official interest rates in March and although conceding they are closer to the end of their rate hiking cycle they still worry about high inflation.
Bond yields fell sharply in March with news of difficulties affecting some US regional banks, most notably the large Silicon Valley Bank. The US authorities, including the Federal Reserve announced promptly specific measures to deal with the particular problems of the affected banks. In Switzerland, Credit Suisse experienced difficulties too and the response by the Swiss authorities while positioning the bank for sale, left the hybrid securities issued by the bank without support. While banking problems seemed contained by month-end, they also seemed to add downside risk to economic growth prospects already dampened by the rapid rise in official interest rates.
The US 10-year bond yield fell by 43 basis points (bps) to 3.47% while the 30-year Treasury yield fell by 26bps to 3.65%. Shorter-term US bond yields fell by respectively 39bps for the 1-year yield and 79bps for the 2-year yield to 4.59% and 4.03% sitting well below the Fed’s funds rate (hiked by 25bps to 5.00% at its March policy meeting) and signaling that the US bond market expects the Fed to cut the Funds rate around 50bps over the next year extending to cuts of 100bps over the next two years.
The Federal Reserve is not providing a clear signal that it has finished hiking interest rates and recent US economic readings are still pointing to an overly-tight labour market that will make returning inflation to the Fed’s 2% target a difficult task. The March US bond rally is at risk of reversing some of its gains in our view as it becomes clear that persistent US economic strength at the very least means the Fed will need to hold official interest rates for an extended period at their peak once reached.
In Australia, government bond yields also rallied sharply in March with the 10-year yield falling by 56bps to 3.29% and at the short-end of the yield curve, the 2-year bond yield falling 79bps to 2.94%. The RBA has a stronger case than the US Federal Reserve to consider a pause in its rate-hiking program. Australian economic indicators are showing more signs of softening than US economic indicators under pressure from rising interest rates. Essentially, Australian households are more heavily indebted than their US counterparts and are more susceptible to movements in variable borrowing interest rates and short-term fixed borrowing interest rates than borrowers in the US who are mostly long-term fixed rate borrowers.
Also, much of the ten consecutive rate hikes delivered by the RBA through to March is still in the pipeline for borrowers. With already some evidence of slowing economic activity in Australia and the likelihood of more slowing ahead, there is case for the RBA to pause and take stock. After the early-March policy meeting when the RBA hiked 25bps to 3.60%, the minutes of the meeting show the board considering a pause at its next meeting in April. That meeting tomorrow is a line-ball call between a pause at 3.60% and another 25bps hike to 3.85%. Whatever, the decision, the RBA is clearly close to the rate peak for this cycle.
The Australian bond market, however, is looking for a sharp reduction in the cash rate over the next year or two. That seems unlikely. There are factors in play that will make reducing Australian inflation to the RBA’s 2-3% target difficult. The first factor is the push for higher wages to compensate for past very high inflation seemingly supported by the Federal Government. The second is stickily high housing costs as the post-pandemic rush to bring in migrants to help fill labour market shortages adds demand to housing in chronic under-supply. We see the RBA needing to hold the cash rate at its peak in to 2024 and even when it starts to cut rates, the room to cut looks small.
Turning to risk assets, March was a month in two parts for major share markets. US banking problems caused markets to fall in the first half of the month, then a strong rally set in as the authorities seemed to deal effectively with the banking problems and strong belief set in that official interest rates were close to a peak. European and US share markets managed to more than offset early big losses with strong rallies later in the month. The US S&P 500 showed the biggest gain in March, up 3.4%. The Eurostoxx 50 index rose 1.8% while other markets, including the Australian ASX 200 did not rally enough later in the month to offset early-month losses. The ASX 200 fell by 1.1% in March, while Britain’s FTSE 100 suffered the biggest loss, down by 3.1%.
The US and Swiss banking issues in March, although largely resolved, took a toll on credit markets where yield spreads, including Australian yield spreads, widened. Australian banks remain very strong and suffer none of the issues that caused problems for some US regional banks and Credit Suisse in March. Also, Australian credit default rates although starting to lift remain very low by historical comparison. While borrowing interest rates have lifted and are still lifting sharply for borrowers rolling off two-and-three-year fixed rate contracts set in 2020 and 2021 buffers from past build-up of savings plus the expectation of the rate changes ahead at roll-over mean that there is little reason to expect an untoward lift in default rates over coming months.
The key to whether default rates will lift more sharply is how much loss of household income occurs because of rising unemployment. At this stage, employment continues to grow, albeit more slowly on average early this year than in the closing months of last year, but still fast enough to keep the unemployment rate close to a half-century low-point of 3.5% in February.
Our current view that the RBA is at or very close to the peak cash rate for this cycle at 3.60%, or 3.85%, implies only slow lift in the unemployment rate. However, the RBA will need the unemployment rate to push above 4.0% if it is to ensure that inflation eventually returns to 2-3% target range. The likely slow rise in the unemployment rate is another reason to expect that the peak cash rate, once achieved, will be in place for many months.