Financial assets mostly rallied in December, retraced some ground in the first week of 2024, but have recovered again since. Belief that central banks will start cutting official interest rates this year, beginning as early as March by the US Federal Reserve, is underpinning the strength in financial markets. That belief extends to expectations that rates will be cut several times and substantially by the end of 2024. Economic and geopolitical developments in December and the first half of January, however, are flashing warnings that rate cuts if they come this year may be later and more modest than expected currently.
In the US, data released since the beginning of December show an economy still growing relatively strongly with a tight labour market and progress reducing inflation starting to flatline well north of the Federal Reserve’s 2% target. The advance Q4 2023 GDP report due later this month is likely to show annualised real growth close to 3%. The December Non-farm payrolls report showed strong employment growth, up 216,000 and firm wage growth with average hourly earnings up 0.4% m-o-m, 4.1% y-o-y (November +0.4% m-o-m, +4.0% y-o-y). The unemployment rate was low and steady in December at 3.7%. US CPI inflation in December was higher than expected, up 0.3% m-o-m taking annual inflation up to 3.4% y-o-y from 3.1% in November.
The less than encouraging December US CPI report is tempered by signs of falling goods prices. US producer prices showed back-to-back 0.1% m-o-m falls in November and December and the annual change at +1.0% y-o-y in December is low. Low goods prices will help to temper the influence of high and sticky service prices in the CPI. But all told, US annual CPI inflation looks stickier above 3% over the next few months and that could become much stickier if escalating tensions in the Middle East hinder international and make it more expensive.
In Australia, expectations of rate cuts this year are more modest than in the US and are not expected to begin before the middle of the year. On balance, the economic data since the beginning of December show not quite as robust Australian economic growth as in the US, but a still tight labour market and inflation while reducing still high by international comparison.
Australian Q3 GDP released back in early December showed real growth up 0.2% q-o-q and up 2.1% y-o-y. While the growth rate was quite soft in Q3 it seems to have firmed in Q4. Mid-quarter November reports show solid housing activity with home building approvals up 1.6% m-o-m, after rising 7.2% in October and the value of new home loans up 0.5% m-o-m after rising 5.6% in October. November retail sales rose 2.0% m-o-m to a record high, boosted by the run of sales promotions in the month. Employment rose 61,500 in November and with a record high 67.2% labour force participation rate. These reports relating to housing, retail spending and employment seem to indicate GDP growth around 0.5% q-o-q in Q4 (data to be released in early March) with annual real GDP growth around 1.7% y-o-y.
Monthly CPI inflation fell a little more than expected in November to 4.3% y-o-y from 4.9% in October helped by lower petrol prices and moderating goods price inflation. The reduction in inflation will likely continue to show in the December and Q4 CPI reports out later this month paving the way for the RBA to leave the cash rate on hold at 4.35% at the first policy meeting for 2024 in early February.
Beyond early February, still quite strong Australian economic growth and tight labour market conditions make it unlikely that the RBA will be able to start cutting the cash rate before the end of 2024 or early 2025.
For the time being financial markets are still much more optimistic about when rate cuts can start and their likely size. Back in December that helped deliver strong share market gains. Outside China, major share markets rose between 0.1% for Japan’s Nikkei and 7.3% for Australia’s ASX 200. The US S&P 500 rose by 3.8%.
Credit spreads rallied and narrowed in major markets including Australia in December and government bonds rallied sharply for a second consecutive month. In the US, bond yields fell around 40 basis points (bps) across the curve. The US 2-year and 10-year bond yields fell 44bps to 4.24% and 3.88% respectively while the 30-year Treasury yield fell 46bps to 4.03%.
In Australia, bonds also rallied around 40bps in December with the 2-year bond yield down by 40bps to 3.70% and the 10-year bond yield down 46bps to 3.95%.
Bond yields have backed up in the first half of January to around 3.80% for the 2-year bond yield and 4.07% for the 10-year bond. These yields look low given an economic outlook that only seems to permit a delayed start to rate cuts – perhaps in Q4 this year – and because of sticky inflation, modest potential for rate cuts in the year beyond Q4 2024.