Risk assets rose in May as US President Trump promised to delay and wind back some of the high trade tariffs announced in March. Evidence that the US economy contracted slightly in Q1 did not dent market optimism. The risk of a trade-war induced US recession remains but appears to be diminish whenever President Trump back-tracks on earlier tariff-hike announcements. After the strong recovery in risk assets in April and May investors are in a high-risk game of US tariff announcement roulette made even riskier because of the unpredictability of President Trump’s announcements. The announcement at the weekend of a doubling of the tariff to 50% on imports of steel and aluminium to the US represents another potentially inflationary and recessionary jolt to the US economy with shockwaves extending to producers elsewhere, including Australia.
Nevertheless, for a second month strong gains were made in major share markets. In May, both the US S&P 500 and the German Dax made the biggest gains, each up 4% in the month. Japan’s Nikkei lifted 3.1% while Britain’s FTSE 100 was up 2.1% and Australia’s ASX 200 lifted by 2.4%. Unlike the US, Q1 GDP growth was stronger than expected in Europe and especially in the United Kingdom indicating some growth resilience in the early stages of the trade war. The Australian economy also appeared to continue to grow in Q1 (data out on Wednesday and expected to be around +0.4% q-o-q, +1.5% y-o-y) and had the additional comfort of a decisive election win for the Federal Government plus a 25bps cash rate cut from the RBA at its May meeting with strong indication of more rate cuts to come.
Share market strength extended to credit markets in May. Australian household disposable income continues to grow strongly in real terms assisted by strong employment growth (89,000 jobs added in April), very low unemployment (steady at 4.1%), real wage growth (3.4% y-o-y nominal growth in Q1 against 2.4% CPI) and two 25bps cash rate cuts so far this year. Notwithstanding the heightened uncertainty about Australia’s economic outlook caused by US tariff policies Australian households and businesses remain well placed to meet their high debt servicing requirements.
While investors in risk assets have become more comfortable with the risks surrounding US tariff changes government bond markets are less than comfortable remaining focused on higher inflation risk and in the case of the US a rising government borrowing requirement.
In the US, the Federal Reserve has become more concerned about the risks of softer US growth and higher inflation. As a result, it left the funds rate unchanged at its latest policy meeting at a relatively high 4.50%. US bond yields have been in an upward drift over the past two months. In May, the 2-year US bond yield rose by 30bps to 3.90%, while the 10-year and 30-year yields rose respectively by 24bps to 4.40% and 25bps to 4.93%.
President Trump’s higher tariffs, depending upon where they settle eventually, will add more than a percentage point to current 2.3% y-o-y CPI inflation over the next year or so. Inflation expectations in the University of Michigan’s survey have jumped to 6.6% y-o-y over the next year settling at 4.2% y-o-y over the next 5 years. These high expectations may prove to be exaggerated but at the very least they imply the Federal Reserve has little room to lower the funds rate the remainder of this year and will probably need to start considering rate hikes in 2026. The worsening US inflation outlook implies also that US bond yields could rise above 5.00% later this year and in 2026.
In Australia, inflation has been edging lower taking the headline CPI and underlying inflation down inside the RBA’s 2-3% target band. Lower inflation has allowed the RBA to start cutting the cash rate with the first 25bps cut to 4.10% in February and a second 25bps cut to 3.85% in May. Interestingly, the local bond market is responding little to the official rate cuts. The Australian 2-year bond yield rose by 1bp to 3.28% in May while the 10-year bond yield lifted by 9bps to 4.25%.
The risk of rising inflation in Australia is less than in the United States, but there is still a strong chance that inflation will move higher in 2026. The RBA’s latest inflation forecasts for 2026 and 2027 with inflation holding largely inside 2-3% target band look optimistic to us. Already, house prices and rents are rising again on the back of lower mortgage rates. The labour market remains very tight, and wage growth is edging higher. Productivity remains poor. The impact of President Trump’s higher tariffs is still to be felt on prices through the international supply chain and Australian prices of imported goods.
The RBA may be able to get one or two more rate cuts away before the inflation data forces it to review higher its inflation forecasts and start the clock ticking on an initial rate hike late in 2026 or in 2027. Australian bond yields should stay lower than US bond yields in our view, but there is little cause for Australian bond yields to push lower than where they sit currently and later this year we see short-term bond yields pushing up closer to 4.00% with longer-term bond yields above 4.50%.