Most major stock markets rallied in January driven still by what seem to be incompatible views that growth is proving resilient, notably in the US, but central banks can pivot relatively soon and start cutting interest rates. Stock markets in China and Hong continued to go against the rallying trend elsewhere beset by their own problems with property developers and their financiers.
Government bond markets in January are still pricing in several interest rate cuts by major central banks but occurring not as early and by as much as previously expected. The central banks continue to caution that while interest rate cuts may come next, inflation has not fallen consistently to the point where any cuts are imminent. Financial markets look set for a volatile run ahead, as views shift about how soon central banks can start cutting rates.
Also in January, the broadening Middle East conflict has come close to shutting the international shipping route through the Suez Canal and the Red Sea. Shipping container costs have escalated sharply and threaten to reverse the substantial moderation in goods price inflation experienced in 2023 that was mostly responsible for bringing CPI inflation down in many countries and particularly Australia.
In the recent “lower than expected” Australian Q4 CPI report showing CPI inflation at 4.1% y-o-y, goods price inflation was 3.8% y-o-y, while services price inflation was 4.8% y-o-y. The comparison showing how much of the reduction in Australian inflation comes down to overseas rather than domestic factors show starkly with tradables inflation at 1.5% y-o-y in Q4 2023 but non-tradables inflation at 5.4% y-o-y. In short, locally generated inflation remains uncomfortably high in Australia implying that the RBA will need to hold the cash rate at least where it is at 4.35% well into the second half of 2024 and perhaps beyond.
The Australian bond market in January remained focused mostly on how soon and how much the RBA can start cutting interest rates helped by softer December employment (-65,100), a big fall in December retail sales (-2.7% m-o-m) and the lower December (3.4% y-o-y) and Q4 (4.1% y-o-y) headline CPI readings. The Australian 2-year bond yield fell by 10 basis points (bps) in January to 3.70% while the 10-year bond yield edged down 1bps to 3.94%.
Australian bond yields below 4.00% may not last much beyond the various RBA announcements this week from their new two-day interest rate setting meeting, the usual 2.30pm Tuesday (6th February) rate announcement but with more detail including the RBA economic forecasts, more detailed information on reasons for the decision and voting at the meeting.
It looks like a communication nightmare for the first go until the new rate setting procedures settle into a groove. The main message, however, is likely to be that while there is little reason to push the cash rate any higher, progress reducing inflation is likely to slow and become bumpier through 2024 warranting the cash rate staying at its current level for several months.
In the US, even though the Federal Reserve’s funds rate at 5.50% is materially higher than Australia’s cash rate, the reasons to start cutting the rate soon are diminishing. GDP growth (3.3% annualised in Q4 2023) is still strong in the US and underpinned by robust consumer spending. Unlike Australian households, US households are experiencing strong growth in household income. Real wages are rising with the latest January 2024 annual growth in average hourly earnings up 4.5% y-o-y set against the latest December 2023 CPI at 3.4% y-o-y.
Employment is still rising at a pace more normally seen in boom-time with non-farm payrolls up 353,000 in January after an upwardly revised 333,000 increase in December. Consumer sentiment and confidence have both risen strongly in late 2023 and early 2024 indicating that growth in consumer spending is unlikely to slow in the next few months. The Fed would seem to need to hold the Funds rate at least where it is facing renewed disruption to global supply chains limiting supply and adding to import prices and strong US and consumer demand.
Yet the US bond market in January continued to toy with the idea that the Funds rate will be cut at least three times in 2024 and more in 2025 with the 12-month bond yield down 5bps to 4.71% and the two-year bond yield down 3bps to 4.21%. Some caution showed about longer-term US rates in January with the 10-year bond yield up by 3bps to 3.91% and the 30-year Treasury yield up 14bps to 4.17%. US bond yields appear too low given the growing possibility that the Fed will need to hold the Funds rate at 5.50% through to the second half of 2024 and perhaps longer if growth stays strong.
Credit markets were mostly a little firmer in January notwithstanding growing issues relating to commercial property in the US and deep, entrenched issues in China’s property market. In Australia, while households have been stretched by high mortgage interest rates, for the most part they are coping helped by strong employment growth, rising wages and the prospect that interest rates may have peaked for this cycle. Default rates have lifted but still modestly compared with earlier cycles.
Returning to the RBA rate outlook, our view has altered slightly. Previously we had penciled in another 25bps cash rate hike for the meeting this week. That now seems unlikely in the wake of mostly softer economic readings including the lower-than-expected CPI prints for Q4 and December 2023 and we see the RBA on hold at 4.35%. The underlying inflation pressure from domestic factors remains high however and that implies no likelihood of the RBA being able to start cutting rates until late this year. We see a first 25bps rate cut probably in December to 4.10%.