Risk assets rallied in August and government bond yields fell as key central banks indicated that supporting growth is vying with the need to go the last mile battening down inflation to their various targets. Australia’s RBA remained an odd-man-out still toying with the idea of hiking the cash rate amid concern that inflation is still sticky and taking longer than forecast previously to come down inside target range. While other central banks cautiously cut official interest rates over coming months, we see the RBA sticking with its guidance and not cutting until next year.
In the US, the Federal Reserve Chairman, Jerome Powell, said that the time has come to start cutting the Funds rate at the next policy meeting this month. There are signs that the pace of US economic growth is moderating, and that inflation is trickling lower although the Fed’s 2% inflation target still looks difficult to achieve. Just the hint of US rate cuts at a time when US economic growth is still running close to long-term trend has been enough to propel the US share market higher carrying most other major share markets with it.
Major share markets, after a weak start to August bounced up strongly over the remainder of the month for the most part. Other than China’s CSI, which fell by 1.9% in August, other markets rose by between 1.2% for Britain’s FTSE 100 and 7.6% for Japan’s Nikkei. The US S&P 500 rose by 3.9% and Australia’s ASX 200 was up 1.9%. The recovery in most share markets has been sharp from the big falls in late-July and early-August pointing to increasing volatility rather than strength based on an improving outlook for earnings.
Credit markets mostly rose again in August and in line with stronger share markets. Australian households are being challenged by high interest rates on their high borrowings and while default rates are starting to climb most households remain well placed to meet their high debt-servicing commitments. Australian small businesses are finding debt-servicing harder facing not just high borrowing interest rates, but also generally higher costs and flagging demand.
US and Australian government bond yields fell in August. The US bond market was helped by the near guaranteed prospect of a 25bps Fed rate cut at the approaching September FOMC meeting, even though the prospect beyond the next meeting is a slow and soft rate cutting cycle.
The US 2-year bond yield fell by 34 bps in August to 3.92%, while the US 10-year bond yield fell by 13bps to 3.90%. It is worth noting that US bond yields were even lower early in August when the market briefly factored in a US recession ahead. Recession fears were quickly alleviated by data reports showing that while US economic growth is moderating it is still running around 2% annualised growth pace. US bond yields are too low in our view given that the Federal Reserve is unlikely to be able to cut the Funds rate much below 4.00% in the approaching rate cutting cycle.
The fall in Australian bond yields, like in the US, was most pronounced at the beginning of August when concern was at its height about weakening international and local economic growth. Australian bond yields still fell over the month with the 2-year bond yield down by 17bps to 3.66% and the 10-year bond yield down by 10bps to 3.96%. Australian bond yields look too low given the persistent warnings from the RBA, largely ignored by the bond market, that it will be at least 6 months before the RBA may be able to consider cutting the 4.35% cash rate.
The latest quarterly Monetary Policy Statement released in early August shows that the RBA now forecasts a longer period before inflation comes consistently inside 2-3% target band – not until 2026 as opposed to the second half of 2025 in the RBA’s May forecasts.
The August forecasts also show demand growth continuing to outstrip output growth, persistently poor productivity and a still tight labour market. Data reports since the release of those forecasts confirm the RBA’s forecasts are on track, notably wage growth unchanged at 4.1% y-o-y in Q2 and employment rising rapidly still in July, up 58,200 after a 52,300 gain in June. Annual inflation fell in July to 3.5% y-o-y, but not as much as it should have given the temporarily inflation-reducing impact of various government cos-of-living subsidies.
We see the RBA still committed firmly to doing what is necessary to bring inflation down within 2-3% target. At present that requires continuing contractionary monetary policy – a cash rate of at least 4.35%. It is unlikely that the RBA will have available data reports showing a less tight labour market, diminishing wage pressure and demand growth in line with output growth until February next year at the earliest. That is why we see the cash rate holding at 4.35% through to February and possibly even May next year.