The rally in risk assets continued strongly again in March with almost all major share and credit markets making gains. Economic...
The rally in risk assets continued strongly again in March with almost all major share and credit markets making gains. Economic indicators released in March in the US and Australia were mostly quite firm reducing the likelihood of recession soon. Inflation has fallen in most regions, but progress is showing signs of stalling and firmer economic readings imply that central banks still have work to do to get inflation back to their targets.
Government bond yields edged a little lower in March amid hope that most major central banks will start to cut interest rates from the middle of this year. The increasing risk is that rate-cutting hopes may be dashed if growth stays strong enough to underpin inflation at levels above the central bank’s targets.
Major share markets performed strongly in March with several, including the US S&P 500 and Australia’s ASX 200 making record highs during the month. Performances ranged from flat performance (0.0% change) for China’s CSE to a 4.6% gain for Germany’s DAX. The US S&P 500 rose by 3.1% while Australia’s ASX 200 rose by 2.6% and at one stage traded above 7,900 for the first time.
The strong performance by share markets was again reflected in rallying credit markets. While concerns remain about weak US commercial real estate and regional banks there is also a belief that the banking authorities including the Federal Reserve can and probably will use bespoke initiatives to support the balance sheets of banks that may experience difficulties. Also, while inflation is not back to the Federal Reserve’s target, it is low enough to provide some leeway to deploy lower interest rates to help deal with any financial crisis that may arise.
In Australia, households and businesses are under pressure from comparatively high interest rates but continue to cope better than might have been expected given predominantly floating interest rates on borrowings and a high household debt burden by international comparison. High and rising house prices mean that the still small cohort of households defaulting on home loans are not making losses on home sales.
Also, strong employment growth, low unemployment and rising wages allow most households to cope with higher interest rates, even though they are not happy about them. Narrowing Australian credit spreads may continue while the economy remains out of recession. Economic releases in March indicate that the risk of recession in Australia has lessened.
Government bond markets in March rallied a touch and traded on the premise that rate cuts are approaching in the US from the middle of this year and in Australia late this year. These expectations of rate cuts approaching seemed to be fanned by official comments from both the Federal Reserve and the RBA at their respective March policy meetings. Both of those policy meetings left official interest rates changed at 5.50% for the US funds rate and 4.35% for the Australian cash rate but there were indications that rates could be cut this year if progress continued reducing inflation towards the Federal Reserve’s target of 2% and the RBA’s 2-3% target range. Both central banks seemed less hawkish, allowing government bonds to rally a touch.
The US 2-year bond yield fell slightly in March by 1basis point (bp) to 4.62% while the 10-year bond and 30-year treasury yields fell by 6bps and 4 bps to respectively 4.20% and 4.34%.
Australian bonds rallied a little more than their US counterparts with the 2-year bond yield down by 4bps to 3.75% and the 10-year bond yield down by 17bps to 3.96%. The small March rallies in both bond markets seem at risk of retracing in April mostly because data releases in both the US and Australia since the Federal Reserve’s and RBA’s March interest rate setting meetings have taken a stronger turn that could limit progress reducing inflation in the months ahead.
In the US recent releases of upwardly revised Q4 GDP (3.4% annualised growth from 3.2%), a stronger Q1 2024 GDP tracker from the Atlanta Fed (now 2.8% annualised), strong February personal spending, up 0.8% m-o-m, and the March ISM manufacturing purchasing managers’ index breaking above 50 (50.3 from 47.8 in February) all point to strength in the US economy consolidating. All the February inflation readings in the US released in March point to annual inflation being sticky at 3.2% y-o-y for the February CPI and 2.8% y-o-y for the personal consumption expenditure price deflator. If these strong growth/sticky inflation readings persist it is unlikely that the Fed will be able to start cutting rates in June as the US bond market is hoping.
In Australia, since the RBA’s interest rate setting meeting, the February CPI holding at 3.4% y-o-y provides some hope that the RBA can bring inflation back inside target next year, but only if economic conditions stay comparatively soft.
Since the RBA meeting there has been evidence that growth may be strengthening. Retail sales rose by 0.3% m-o-m in February after lifting 1.1% in January. The labour market appears to be tighter than previously thought with employment up 116,500 in February and up a revised 15,300 in January (reported initially at +500). The unemployment rate fell to 3.7% in February from 4.1% in January. The greater tightness of the labour market increases the risk that high wage settlements (above 4% y-o-y) will continue for longer making it more difficult to get inflation lower over coming months.
Our view remains that the RBA will not be able to start cutting the cash rate until December at earliest and that date may need to be pushed out further into 2025 if growth and inflation prove to be more resilient than expected. Given our cash rate outlook Australian bond yields below 4% look vulnerable and likely to retrace upwards.