Risk assets were mixed-strength in January with strong gains in most markets, but also pockets of weakness in the British and Australian share markets. A key influence on risk assets during the month was more signs of firm global economic growth. US and Continental European economic readings were mostly very strong. With continuing strong economic growth government bond yields moved noticeably higher through January presenting a restraining influence on the rally and potentially sowing the seeds of a downward correction if bond yields continue to rise. The US Federal Reserve’s first monetary policy meeting in 2018 and last under retiring Chairman, Janet Yellen, did not change the Federal Funds Rate, but the firmer tone of its language on the US inflation outlook has increased the likelihood of a rate hike at its March meeting.
For the US share-market strong growth still trumped rising bond yields in January and the S&P 500 was the best-performing share-market, up 5.6% in the month. Europe’s Eurostoxx 50 and Japan’s Nikkei also performed well, up respectively 3.0% and 1.5%. The relative weakness of Britain’s FTSE 100, down 2.0% in the month and Australia’s ASX 200, down 0.4%, seemed to come down to less impressive growth prospects, still Brexit- hampered in the case of Britain and restrained in Australia by a building housing correction combined with too high household debt.
Australian credit spreads continued to tighten over the month still taking a lead from the strength of global risk assets and a continuing hunt for yield by investors even amid signs of one of the more significant upward corrections in Government bond yields of recent years. The US 10-year Treasury yield rose by 30bps in January to 2.71% and in the early days of February has pushed up further to 2.84%. The US 30-year Treasury yield moved up by 19bps in January to 2.93% and has pushed up since to 3.09%. These big upward movements in US Treasury yields have occurred even though the Fed left the Funds rate unchanged at the end-January policy meeting.
Notwithstanding the absence of a Fed policy rate change it seems likely that the market has changed view significantly about what it expects the Fed to do this year moving from firmly believing that the Fed would fall short of its guidance on delivering three 25bps rate hikes this year to now considering that three rate hikes will be the minimum with the next hike a near-certainty in March. Strong economic data, stimulus from legislated tax cuts and evidence of rising pressure on US inflation (most recently from annual growth in average hourly earnings lifting to 2.9% y-o-y in January) are all working to persuade the market that interest rates are likely to move up.
The current move upwards in US bond yields could turn out to be temporary if US growth and inflation pressure fade and the Fed softens guidance on hikes in the Funds rate. Counting against this view is that momentum in global economic growth appears to be gathering pace. US GDP growth in Q4 although only 2.6% annualized had the hallmarks of much stronger underlying growth with domestic sales up by more than 4%. In China GDP growth held up at 6.8% y-o-y in Q4 and in Europe growth improved to 2.7% y-o-y. More importantly GDP growth is shaping up at least as strongly in these countries and regions. Pressure is building up almost everywhere on existing capacity. In this strengthening global economic growth environment, it is unlikely that growth in the US will fade.
In short, it seems very likely that a 25bps rate hike in the Funds rate to 1.75% will delivered at the Fed’s March policy meeting and also at least another two 25bps rate hikes will be delivered after its March meeting and before end 2018. On the basis of these firm expectations, while US Treasury yields have lifted quite sharply in January and early February they may lift further over coming months increasing the likelihood that higher bond yields trump strong growth promoting a relatively pronounced downward correction in share-markets.
In Australia, there were signs that growth prospects have improved in January, but not to the point of increasing inflation pressure just yet. The Q4 CPI and underlying inflation measures came in a touch below expectations at 1.9% y-o-y for the CPI and an average 1.9% y-o-y too for the two main underlying inflation measures, the trimmed mean and the weighted median. Annual inflation still sits below the bottom limit of the RBA’s 2-3% target range and is likely to stay below the range or at the bottom of the range for another quarter or two. In time, inflation is likely to lift, but unlike many of its peer central banks overseas there is no compelling reason for the RBA to start hiking its cash rate over the next few months.
Australia cannot escape the global upswing in government bond yields led by the US, but lack of pressure on the RBA to deliver a cash rate hike in the near-term is causing a gentler climb in government bond yields than is occurring in the US. In January, Australia’s 10-year bond yield rose by less than its US counterpart, by 18bps to 2.81% and continues to climb by less early in February. If the RBA at its first policy meeting for 2018 to be held tomorrow leaves the cash rate unchanged at 1.50% and indicates no urgency to hike the rate, as seems likely, Australia’s 10-year bond yield is likely trade below the US 10-year Treasury yield and could potentially stay below for much of this year.
In time, stronger growth is likely to promote a build-up of inflation pressure in Australia too. We do not see that higher inflation pressure being recognised in the RBA’s economic forecasts until August at earliest. At this we pencil in two 25bps RBA rate hikes in 2018, the first in August with a second possibly in November. We see the cash rate at 2.00% by the end of 2018. It is worth keeping in mind that the US Fed is likely to have delivered another two rate hikes (the sixth and seventh in the current series that started back in December 2015) before the RBA delivers its first