Risk assets had a strong month in June undeterred by rising official interest rates and higher government bond yields. Economic data releases in the US during the month show an economy still a long way from recession fostering hope that even if interest rates have a little further to rise and stay at their peak for longer than usual, a rare soft landing for the US economy is possible. China’s economic recovery from earlier restrictions is proving lack luster. Europe is in mild recession and in Australia the risk of recession is increasing. European and Australian risk assets seem impervious to mounting downside risks to economic growth prospects and company earnings, at least for the time being.
Major share markets mostly rose strongly in June with the notable exceptions of China’s CSI index, down 0.5%, and Hong Kong’s Hang Seng, down 0.2%. Elsewhere, gains ranged from 0.8% for Australia’s ASX 200 to 6.5% for the US S&P 500. Over the Australian financial year, the gains in many major share markets have been impressive and seemingly at odds with sharply rising interest rates and concerns of recession ahead. In 2022-23 in own-currency terms the ASX 200 rose 10.1%, but that gain was far out-paced by the 17.6% gain in the US S&P 500, and even bigger gains in Europe’s Eurostoxx 50, up 27.6% and Japan’s Nikkei, up 28.0%.
In contrast to the strong performance in share-markets in June, government bond yields continued to rise reflecting that central banks are still mostly hiking official interest rates and because of sticky inflation, when official interest rates peak, they are likely to stay at their peak for longer.
The US Federal Reserve (Fed) was a rarity in June pausing rate hikes and leaving its funds rate at 5.25%. The Bank of England, European Central Bank and RBA all hiked their key policy rates respectively by 50bps to 5.00%; 25bps to 3.50%; and 25bps to 4.10%. Even though the Fed left the funds rate on hold, it warned that getting inflation down to 2 % target would take a long time and implied two more rate hikes in the current cycle. Most shorter maturity government bond yields out to two years moved sharply higher steepening the inversion in bond yield curves and marking the bond market’s belief that recession lies ahead.
In the US bond market, the 12 month and 2-year bond yields lifted respectively 22bps to 5.39% and 50bps to 4.90%. Yield increases were less pronounced for longer-date US bonds with the 10-year yield up 20bps to 3.84% and the 30-year Treasury yield flat at 3.86%. The US bond yield curve is steeply inverse out to 10-years and while bond yield curve inversion does not always end in recession, the Fed promising to keep lifting rates one year after US inflation peaked back in mid-2022 would still seem to make a US recession later this year or in 2024, a high risk and a risk that the US share market is ignoring.
Australian government bond yields also rose sharply in June after the RBA delivered another 25bps rate hike at its early June policy meeting. Essentially, the RBA is singing from the same song book as other major central, while inflation is moderating (the May CPI showed a bigger-than-expected fall to 5.6% y-o-y from 6.8%) it remains too high and the path down to 2-3% target remains too long and uncertain risking destabilising inflation expectations. The RBA can pause from hiking rates if recent economic data permits, but more rate hikes are likely to be needed to ensure it meets its inflation target.
The Australian 2-year bond yield rose 67bps to 4.21% in June while the 10-year bond yield rose by 44bps to 4.02%. In 2022-23, the RBA’s official cash rate has risen 350bps to 4.10% while the 2-year bond yield has risen 159bps and the 10-year bond yield only 36bps. Australia’s bond yield curve has only started to invert over the past month or two.
The inverted bond-yield curve recession signal is less pronounced in Australia than in the US which is probably explained by the much more aggressive lift in the Fed’s funds rate over the past year. However, Australia has higher household debt exposure than the US and it is predominantly floating rate debt as opposed to long-term fixed rate debt in the US. Recession risk would seem to be higher in Australia than in the US. That higher recession risk implies potential for longer-term Australian bonds to rally even if one or two more RBA rate hikes are in the offing causing shorter-date bond yields to rise.
Turning to credit markets, they were mostly stronger in June, taking a lead from stronger share markets. The improvement is at odds with evidence of tightening bank lending conditions and rising official interest rates. Borrower distress is evident and rising among households and businesses in the US, Europe and Australia.
In Australia, non-performing loans are rising and while not yet high by historical comparison, the rise may become more pronounced over coming months amid the peak of rollovers of two-and three-year fixed rate contracts set in 2020 and 2021.
Also, another factor that may accelerate growth in non-performing loans is if the RBA remains determined to reach its 2-3% inflation target in a reasonable time frame. It is hard to see how low inflation will be achieved without at least one or two more RBA rate hikes increasing the likelihood of recession and causing the unemployment rate to rise to at least 4.5% over the next year.
Returning to our RBA rate view, we note that comments from senior RBA officials during June have stressed, even more, the importance of getting inflation down to 2-3% target in a reasonable time frame. Rising house prices and the still very tight labour market point to a too long battle to get inflation down, even allowing for the reduction annual inflation in May to 5.6%. We pencil in two more rate hikes in the current cycle taking the cash rate up to 4.60% in September or October and then a long stay at the peak until mid-2024 before the RBA has any opportunity to start cutting the cash rate.