Risk assets mostly rallied and sharply in November based on views that the US economy may experience a soft landing and that the US Federal Reserve and other major central banks may have finished hiking interest and could start to reduce interest rates before long. Senior central bank officials, including Fed Chairman Jerome Powell pushed back pointing out that while interest rates may have peaked the difficulty getting inflation down to their targets still imply that rates stay high for a protracted period and the risk that higher official interest rates may be needed cannot be ruled. The RBA went against the grain that rates have peaked hiking the cash rate in November and pointing to the stickiness of high inflation.
Despite central banks’ cautious comments, financial markets were undeterred backing their seemingly incompatible views of growth holding up out of recession but inflation and interest rates coming down through 2024. Credit and bond markets rallied along with most major share markets during the month.
Several major share markets experienced big gains in November including the German Dax up 9.5%, the US S&P 500 up 8.9%, Europe’s Eurostoxx 50 up7.9% and Japan’s Nikkei up 6.0%. Less substantial gains were recorded by Australia’s ASX 200, up 3.6%, tempered by the RBA rate hike as well as Britain’s FTSE 100, up 1.8% with the Conservative Government seemingly floundering for direction.
Still comparatively weak economic growth prospects for China counted against the CSI 300 in the month, down 2.1% as well as Hong Kong’s Hang Seng, down 0.3%.
Credit markets gained on the back of rising share markets as well as falling bond yields in November. In Australia, reports from the major banks indicated that their mortgage borrowing clients are coping with higher interest rates. The number of distressed borrowers has lifted, but not to the levels seen during the Covid lockdown period. Strong employment growth supporting household income as well as refinancing options and interest rate competition among lenders and surprising strength in mortgage offset account balances have all helped to counter pressure on borrowers from rising interest rates.
Government bond markets rallied strongly in November on growing belief among investors that official interest rates have peaked. US 2-year bond yields fell 40bps to 4.69% indicating at least for the moment that investors see the Federal Reserve reducing the Funds rate from its current 5.50% to around 4.50% over the next two years. Longer-term US bond yields fell more than 2-year yields with the 10-year bond yield down by 61bps to 4.32% and the 30-year yield down 60bps to 4.49%.
Comments by senior Federal Reserve officials indicating that official interest rates may have peaked fueled the bond rally as did a slide in US CPI inflation to 3.2% y-o-y in October from 3.7% in September and some signs that tight labour market conditions may be loosening. Set against these bond bullish factors and ignored by the market, the Fed also stressed that getting inflation down to 2% target would be a long and bumpy process needing rates to stay high for a lengthy period. Also, it was still prepared to lift rates if needed. The big US bond market rally in November has left the market vulnerable if growth or inflation indicators show any sign of strength.
Australian government bond yields also fell sharply in November and surprisingly given that the RBA hiked the cash rate 25bps to 4.35% at its policy meeting and admitted that inflation was staying higher for longer than forecast previously back in August. The RBA also made it clear that it has a low tolerance for inflation above its 2-3% target hanging around for too long and that domestic factors were playing a strong part keeping inflation high. Bonds rallied in the face of the warnings with the 2-year yield down by 35bps to 4.10% and the 10-year bond yield falling by 51bps to 4.41%.
The RBA is data watching to determine whether it needs to hike the cash rate further. Any signs that demand is holding firm, the labour market is staying too tight, or inflation is not decelerating in line with its latest forecasts could pressure the RBA to hike again. During November, the October labour force report showing a 55,000 lift in employment and the labour force participation rate lifting to a record 67.0% attest to a still very tight labour market, even though the unemployment rate edged up one notch to 3.7%.
Wage growth also accelerated in Q3 by 1.3% q-o-q, 4.0% y-o-y, effectively on the threshold of supporting too high inflation while labour productivity is still in deeply negative growth territory. The October labour force report and Q3 wage price index report together present a case for the RBA to hike rates this week. That pressure to hike has changed to pause after the 0.2% m-o-m fall in retail sales and the reduction in annual inflation evident in the October monthly CPI down to 4.9% y-o-y from 5.6% in September.
It is worth noting that anecdotal evidence points to bumper “Black Friday” sales in late November that could promote a strong lift in November retail sales, beyond normal seasonal influence. Also worth noting is that the improvement in inflation in October was less impressive in underlying terms. Excluding volatile items the CPI reduced from 5.5% y-o-y in September to 5.1% in October and the trimmed mean measure only edged down to 5.3% y-o-y from 5.4% in September.
There is a high chance that data reports between early December and the first RBA interest rate setting meeting for 2024 in early February will show enough evidence of firm enough demand to make reducing inflation down to target a slow and bumpy process. We pencil in one more rate hike taking the cash rate to 4.60% in February where the rate will need to stay until at least Q3 2024 to ensure demand is soft enough to bring inflation down to 3% by late 2025.