Government bond markets and major stock markets maintained different outlooks for the global economy in April. Bond yields sitting below current official interest rates and the inverted US bond yield curve point to recession ahead and of an order that will force central banks to start cutting official interest rates later this year. The strong performance by most share markets in April points to a different outlook, no recession and, if anything, resilient economic growth supporting rising corporate earnings. Either the bond or the share markets are riding for a fall and over the next month or two it could be both.

One factor key to how to both shares and bonds traded in April is a view that central banks have finished, or are nearly finished hiking interest rates. This belief has been fostered by some signs that growth is slowing in the US, Europe and in Australia and that annual inflation is past its peak and on the decline. Opposing this view, most central banks remain adamant that there is more work to do to ensure inflation returns to their targets and in most economies labour conditions remain tight enough to mean that it will be many months before central banks can be sure that wage growth will not foster prolonged high inflation.

Turning to what bond yields did in April, US bond yield movements were mixed with short-term yields rising or relatively stable after the banking crisis scare in March pushed them down well below the 5.0% Federal funds rate. The US 12-month Bond yield rose 15 basis points (bps) in April to 4.74% while the two-year yield fell by 2bps to 4.01%. The US 10-year fell by 5bps while the US 30-year yield rose 2bps to 3.67%. The inversion of the US bond yield curve and yields all sitting below the funds rate indicate recession forcing the Fed to start cutting rates soon.

Yet when the Fed’s policy setting group meets this week it is likely that the Fed will hike rates another 25bps to 5.25% and still remain comparatively hawkish at the very least indicating that rates will need to stay high for some time. The forces driving the Fed to remain hawkish and being ignored by the bond market looking for a quick pivot to rate cuts all relate to the stickiness of inflation – the March core annual CPI that actually rose one notch to 5.6% y-o-y; the March core personal consumption expenditure deflator (the Fed’s preferred inflation measure) only edging down to 4.6% y-o-y; and all key US wage measures running above 4% y-o-y. The stickiness of underlying inflation forces indicating that inflation may take longer to return to the Fed’s target of 2% imply the Fed has more work to do raising rates and shorter-term US bond yields should push higher for a period before they can realistically factor in the Fed reducing rates.

A similar story for bond yields also applies in Europe (the ECB meeting this week will likely hike the deposit rate another 25bps to 3.25%) and here in Australia too. During April the 2-year Australian government bond yield rose by 9bps to 3.03% while the 10-year bond yield rose by 4bps to 3.33%. Both yields sit well below the current RBA cash rate at 3.60% and imply a quick turn towards cutting the cash rate by the RBA.

Driving market expectations of early rate cuts starting later this year are the pause by the RBA at its April policy meeting with many expecting another pause at its policy meeting this week and a Q1 CPI print indicating that annual inflation has peaked and is starting to fall. The CPI rose by 1.4% q-o-q in Q1 taking annual inflation down to 7.0% y-o-y from 7.8% in Q4 2022. Underlying inflation (trimmed mean) rose less than expected in the quarter by 1.2% q-o-q causing annual underlying inflation to fall to 6.6% y-o-y from 6.9% in Q4 2022. Even with the fall in annual inflation in Q1 2023, it remains too high and unlikely to fall to the RBA’s 2-3% target range over the next two years or so unless demand in the Australian economy continues to soften.

In particular the RBA needs to see a period of less tight labour market conditions otherwise wage growth inconsistent with achieving the inflation target may become a problem. The February and March labour market readings both showed strong growth in employment (over 50,000 in each month) and the unemployment staying down near its lowest point since 1974 at 3.5%.

The RBA will need to see how the tight labour market is translating to wage growth over the next quarter or two before it has any chance to rest easy that high inflation is not feeding high wage claims. Annual growth in the wage price index (around 3% y-o-y in Q4 2022) needs to settle around 4% later this year to be consistent with the RBA achieving 2-3% inflation by mid-2025. Until the RBA sees evidence of restrained wage growth it is unlikely to be able to start cutting interest rates and the evidence is unlikely to be available in the remainder of this year or in early 2024.

At this stage, the RBA will need to keep the cash rate at least at the current 3.60% the remainder of this year extending in to early 2024.

Turning to risk assets, major share markets rallied mostly in April with gains ranging from 1.0% for Europe’s Eurostoxx 50 index to 3.1% for Britain’s FTSE 100. The US S&P 500 rose by 1.5% and the Australian ASX200 rose by 1.8%. Paradoxically the share markets that fell in April were China’s CSI 300, down 0.5% and Hong Kong’s Hang Seng down 2.5% in the one region that is most likely to experience accelerating economic growth in 2023 in a world where tight monetary conditions are otherwise pointing to slowing economic growth, or outright recession. Most share markets continue to fail to build in the down turn in company earnings that is likely to occur as global economic growth falters – an unpleasant necessity if there is to be a return to low inflation.

Credit markets also mostly improved in April, notwithstanding lingering doubts about whether the banking problems in the US and Switzerland had been tamed entirely. What is more certain is that Australian banks and financial institutions remain very strong. Non-performing loans are rising in Australia, but off a very low base and remain 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 mean that for most borrowers 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 fast and unemployment is very low.

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. The peak cash rate, once in place, is likely to stay in place for many months while the RBA becomes comfortable that wage growth is consistent with its inflation target.