Risk assets weakened in August as evidence of firmer US economic activity; Europe possibly avoiding recession; and slower progress containing inflation rekindled concern that central banks have not finished hiking interest rates. China and Australia went against the theme of resilient demand and stalling progress reducing inflation. China’s growth showed more softer signs in August plus a growing threat of deflation. In Australia, signs of softer labour market conditions and falling inflation increased the probability that the RBA has finished hiking rates and allowed Australian bonds to rally a little, against the trend of rising bond yields elsewhere in August.
After strong monthly gains in June and July major share markets fell in August with losses ranging between 1.0% for Australia’s ASX200 and 8.1% for Hong Kong’s Hang Seng. The US S&P 500 bolstered in June and July by increasing hopes of a soft economic landing, fell1.8% in August faltering on Federal Reserve comments that it was too early to declare victory against inflation and interest rates will stay high for longer.
The Federal Reserve’s caution that rates might need to stay high for longer placed upward pressure on US government bond yields. US bond yields out to two-years are close to 5.00% indicating that the bond market sees little opportunity for the Federal Reserve to start cutting rates in the near term. Longer-term US bond yields continued to rise in August with the 10-year bond yield up 13 basis points (bps) to 4.11% and the 30-year Treasury yield up 19bps to 4.22%. The continuing rise in US long-term bond yields above 4.00% implies that US inflation even at the bottom of the economic cycle will be higher than where it has been in the past three decades.
In contrast to rising US bond yields in August, Australian bond yields edged down after the RBA left cash rate on hold for a second month running at 4.10%. Unlike its US and European central bank peers the RBA seemed closer to declaring victory fighting high inflation saying that there is a credible path towards taking inflation down to 2-3% target range by late 2025. Data releases in August mostly supported the RBA’s declaration with employment growth taking a softer turn in July, wage growth not as high as expected in Q2 and CPI inflation in July falling below 5%.
The Australian 2-year bond yield fell by 17bps in August to 3.76% and the 10-year bond yield fell by 7bps to 3.99%. Looking ahead, the RBA will almost certainly keep the cash rate on hold at the policy meeting tomorrow and unless there is a marked and unexpected turn towards strong data relating to demand, the labour market and inflation in September and October we expect the cash rate to remain on hold through October and November.
After the RBA policy meeting tomorrow, Q2 GDP will be released on Wednesday. GDP is forecast to have risen by 0.2% q-o-q, reducing annual growth to around 1.7% y-o-y. Australia’s Q2 GDP growth is likely to be weak by international comparison (US GDP growth at 0.5% q-o-q and even sputtering Europe at 0.3% q-o-q).
Australia’s weak growth by international comparison flowing on to the greater likelihood that Australia will experience softer labour market conditions and better progress containing domestically sourced inflation than in the US and Europe means that Australia may be able to cap interest rates lower than in the US and in Europe. The continuing pressure for the US Federal Reserve, the European Central Bank and the Bank of England to lift their official interest rates higher will not apply in Australia.
One consequence of the Australian official cash rate holding at 4.10% while the US and British rates official rates push up towards 6.00% and the ECB’s official rate pushes well above 4.00% is that the Australian dollar exchange rate will come under downward pressure from time-to-time.
That downward pressure on the exchange rate is likely to be reinforced at times by periodic downward pressure on Australia’s export prices, an almost inevitable consequence of still slowing global economic growth and the problems Australia’s biggest trade partner, China, is experiencing trying to promote stronger growth against the headwinds of an imploding property sector, poor returns on physical investment and a household sector preferring to save rather than spend more.
Turning to credit markets in August, they weakened a little, taking a lead from investors’ faltering appetite for risk assets. The outlook for risk assets in general, including credit, could improve again if it seems that the US and Europe are likely to avoid recession. A soft economic landing will counter concerns swirling around high government debt and falling commercial property prices in the US.
In Australia, non-performing loans are rising and while not yet high by historical comparison, the rise is becoming more pronounced moving through the peak of rollovers of two-and three-year fixed rate mortgage contracts set in 2020 and 2021. One saving grace is that at least it seems that Australian borrowing interest rates have peaked.
Australia, however, is more at risk of experiencing recession than most other countries. A recession would accelerate growth in non-performing loans with pronounced weakness in consumer spending placing many more businesses and households under extreme financial pressure. The issue would then become one of whether inflation is falling enough to allow the RBA to consider reducing interest rates. At this stage, while inflation is showing signs of decelerating it may still take until the middle months of 2024 before the RBA can be firmly confident that inflation will return inside target band in 2025.