Risk assets had another strong month in July assisted by signs of moderating inflation and signs that the US economy may achieve a soft landing. While most central banks, including the US Federal Reserve, the European Central Bank and the Bank of England, hiked rates in July and early August, there is growing confidence among analysts that the peak in official interest rates is close. In Australia, where the RBA decided at its early-August policy meeting to leave the cash rate unchanged at 4.10% for a second consecutive month, falling inflation is leading some to believe that the cash rate is already at a peak and attention is turning to when rate cuts might start in 2024.
The growing possibility of a soft landing in the US helped to boost investors’ risk appetite in July. Major share markets mostly rose strongly in July with the only exception a flat performance for Japan’s Nikkei index. Elsewhere gains ranged from 1.1% for Europe’s Eurostoxx 50 index in July to 5.7% for Hong Kong’s Hang Seng. The US S&P 500 rose by 3.1% while Australia’s ASX 200 rose by 2.9%. In early August, sharemarkets have given up some of their July gains on news of a credit rating downgrade for the US by Fitch.
In contrast to the strong performance in share-markets in July, government bond markets were mixed with shorter-dated bonds rallying on the firming prospect that official interest rates may be close to their peak for this cycle, but longer-term bond yields edging higher on recognition that even when official rates start to decline, they may not fall far.
The US 12-month and 2-year bond yields fell in July by respectively 15bps to 5.24% and 3bps to 4.87% while the 10-year bond yield rose by 14bps to 3.98% and the 30-year treasury yield rose by 17bps to 4.03%. If the soft-landing scenario for the US economy continues to firm the US bond yield curve will continue to move away from its current inverse shape with shorter-dated bond yields rallying periodically but with longer-term bond yields holding current yields or rising further.
It is worth noting that the actions of most central banks are not yet ratifying the notion that official interest rates have peaked. The US Fed hiked 25bps to 5.50% in July and indicated that it was still watching sticky inflation. The ECB and Bank of England both hiked 25bps to respectively 3.75% (ECB deposit rate) and 5.25% (Bank of England’s base rate) and both gave firm guidance of more rate hikes ahead.
In Australia, the 2-year bond yield fell in July by 28bps to 3.93% while the 10-year bond yield rose by 4bps to 4.06%. The RBA left the cash rate unchanged at 4.10% after the early-August policy meeting indicating that it is watching data to monitor slowing demand growth as well as progress reducing inflation. The quarterly Monetary Policy Statement showed minor tweaks to the RBA’s economic forecasts compared with the May Statement and the RBA still expects annual inflation to slide inside 2% -3% target band by the second half of 2025.
Before the August policy meeting the Q2 CPI release showing a greater-than- expected reduction in annual inflation to 6.0% y-o-y from 7.0% y-o-y in Q1 gave credence to the RBA’s statement that inflation is moderating. The release of real Q2 retail sales data showing a 0.5% q-o-q reduction and down 1.4% y-o-y, the first annual y-o-y reduction outside the pandemic period since the 1991 recession, indicates that weak demand should continue to contain inflation going forward. One issue with the otherwise brightening inflation outlook remains the tight labour market and the potential for higher wage growth to prevent inflation falling sustainably inside target range.
The RBA says that it will continue to monitor closely developments in the labour market including wage growth relative to productivity change. Already wage growth is too high if low productivity fails to return to pre-pandemic levels. Our view remains that the RBA may still need to deliver one or two more rate hikes before it is done, and it will be labour force and wage reports that will drive when those hikes occur.
Turning to credit markets in July, they mostly strengthened, taking a lead from investors’ stronger appetite for risk assets in general. The improvement is likely to face challenges over coming months even if key economies such as the US achieve a soft landing. As the Fitch downgrade to the US credit rating showed, many countries are running unsustainably high levels of government debt given growing upward pressures on government spending. The US also has a growing problem of sharply lower commercial property prices with potential for rising defaults in the sector.
In Australia, non-performing loans are rising and while not yet high by historical comparison, the rise is becoming more pronounced amid the peak of rollovers of two-and three-year fixed rate mortgage contracts set in 2020 and 2021.
Also, another factor that may accelerate growth in non-performing loans is the pronounced weakening in retail spending placing many small businesses under extreme pressure. One saving grace is that employment growth is still strong, and the unemployment rate is very low. But that saving grace is also the reason why the RBA may need to hike rates further to ensure low inflation is accomplished. In the next few months, the economy may need to be pushed closer to the brink of recession and that may challenge recent optimism in the share and credit markets.