Risk assets weakened again in September as central banks reaffirmed that interest rates would need to stay higher for longer. Bond markets continued to build the growing possibility that official interest rates are likely to stay at least as high as they are currently for an extended period. More signs that US inflation has stopped falling for the time being added to upward pressure on bond yields. Wrangling over US government budget spending raised the prospect of a lengthy shut-down of payments to government workers, adding greater uncertainty to US economic prospects and another reason to sell risk assets. A temporary deal sealed at month end came after market close for the month but may provide some boost early in October.
Most major share markets extended their August falls in September. Britain’s FTSE 100 was the odd man out showing a gain of 1.9% in September. Otherwise falls in major share markets ranged from 2.5% for Europe’s Eurostoxx 50 to down 5.0% for the US S&P 500. Australia’s ASX200 fell by 3.2%. High interest rates are presenting an increasing headwind to share markets particularly amid an uncertain economic and earnings outlook.
In the US, while The Federal Reserve left its Funds rate unchanged at 5.50% in September, it also made it clear that the fight to bring down inflation still has some way to go. The latest Fed interest rate forecasts have the official interest rate lodged above 5% for at least the next year.
US headline inflation is inconveniently rising for the time being with the CPI annual rate pushing up to 3.7% y-o-y In August from 3.2% in July and 3.0% in June. It is mostly higher energy prices, especially higher oil prices that are driving up inflation and in other times the Fed might be able to pass off the rise as temporary and focus on underlying inflation which is still edging down. The core annual CPI reading, excluding food and energy prices fell to 4.3% y-o-y in August from 4.7% in July.
Current times are proving more challenging for the Fed. Constrained global oil supply is proving to be longer-lasting as two big global suppliers of oil, Russia and Saudi Arabia have different reasons to keep supply tight that ultimately converges to one reason. Both need high oil prices to stay in place. The longer high and rising oil prices persist the less reason the Fed (and other central banks including the RBA) have to be able to regard the impact on inflation as temporary.
Also, the Fed is still watching high service price inflation and a tight US labour market generating big wage claims. Inflation looks set to stay above the Fed’s 2% target for an extended period.
US bond yields lifted substantially in September and bond yields sit above 5.0% out to 2 years on the curve. The 2-year bond yield rose in September by 18 basis points (bps) to 5.04%. Longer-term US bond yields pushed up further above 4.0% with the 10-year bond yield up 46bps to 4.57% and the 30-year yield up 48bps to 4.70%. Given the stickiness of US inflation we see the Fed under pressure to keep the Funds rate at least where it stands currently (5.50%) for an extended period. With the Fed Funds rate lodged above 5.0% probably through 2024 and into 2025 see little chance of US longer-term bond yields rallying below 4.0%, other than briefly, over the next year or so and a growing likelihood they could spend some time above 5.0%. High long-term US bond yields are also likely to influence the path of longer-term bond yields elsewhere, including in Australia.
In Australia, bond yields also rose sharply in September. The 2-year bond yield rose by 32bps to 4.08% while the 10-year bond yield lifted by 49bps to 4.48%. Back in August, signs of a less tight labour market and moderating inflation allowed the RBA to declare that it could see a credible path to return inflation to 2-3% target by late 2025. That declaration now seems premature after developments through September – Q2 GDP on the strong side of expectations at 0.4% q-o-q, 2.1% y-o-y; a big employment lift in August, +64,900; rising monthly CPI inflation to 5.2% y-o-y in August from 4.9% in July; evidence of a lengthier than usual period developing in high petrol prices; and national house prices making a record high.
Moving through September those developments among others have altered market perceptions from expecting the RBA to keep the cash rate on hold at 4.10% the next few months ahead of a series of rate cuts, to the possibility of another rate hike or two ahead and no reduction from the peak until late 2024 at earliest. This change in perception about the course of the RBA cash rate has helped to pressure Australian bond yields higher matching and, in some cases beating the pace of increase in US bond yields.
Our view is that the changed market perception about the cash rate outlook is warranted for the most part. The remaining RBA policy meetings this year, including the meeting tomorrow, are likely to be line ball decisions between holding the cash rate at 4.10% or hiking further. We lean just on the side of the RBA holding the cash rate at 4.10%, but because of the tight housing and labour markets and sticky inflation there is no leeway for the RBA to start cutting the cash rate before late next year. That implies bond yields staying above 4% over the next few months at least.
Turning to credit markets in September, spreads widened reflecting the weakness in risk asset performance generally in the month. In Australia, non-performing loans are rising but remain not high by historical comparison. The peak of rollovers of two-and three-year fixed rate mortgage contracts set in 2020 and 2021has passed and most borrowers affected have been able to cope with much higher repayments partly because of the big saving cushion built up in the pandemic but also because of strong labour market conditions. Both mitigating factors are likely to fade as higher interest rates stay in place for longer.