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Market Drivers - May 2022

Volatile financial markets in April saw risk assets mostly weaken during the month and government bond yields pushed higher. High inflation readings prompted some central banks to deliver bigger interest rate hikes and the US Fed indicated that when it meets this week it may deliver a 50bps rate hike. Rising interest rates were one factor in April adding to the risk of slowing global economic growth. Other factors were the impact of the Ukraine conflict and China’s difficulty containing Omicron. Despite the increasingly gloomy global economic growth outlook, recent economic data in the US remains strong and the likelihood that annual US inflation readings peaked in March/April and will reduce for a period. This may provide the Fed with leeway to hike interest rates at a slower pace than financial markets are expecting over the next year.

The issue of high inflation and what to do about it is most acute in the United States. US inflation is higher than in other advanced economies, 8.5% y-o-y in March with core CPI inflation at 6.5%. The proportion of US inflation driven by domestic rather than international factors is higher than elsewhere. The big lift in US government infrastructure spending provides further boost to an economy already growing at a pace that is severely testing supply. Wages rising above 5% y-o-y indicate an overheating labour market. The Fed is well behind the curve dealing with inflation that has left its forecasts in tatters and is clearly running well above its 2% target for the foreseeable future.

Belatedly, the Fed is promising to lift pace withdrawing monetary policy support.  Financial markets are expecting a 50bps rate hike at the Fed’s policy meeting this week taking the Funds rate to 1.00% plus a commitment to raise the Funds rate to 3.00%+ over the next year. In our view, the Fed will have to at least deliver in line with market expectations at this meeting if it is to salvage credibility. Beyond the May policy meeting, however, the Fed may gain some flexibility from annual inflation sliding from its peak reading to reduce expectations of the pace and size of future rate hikes. In short, US financial markets are currently in their greatest lather about future rate hikes and rising bond yields, but these fears may ameliorate for a few months at least.

 Nevertheless, during April, the rising interest rate story with the Fed seemingly most behind the curve took a toll on risk assets. Among major share markets only the British FTSE 100 managed to eke out a small gain, +0.4%. Other major European and Asian share markets were down between 2.2% for Germany’s Dax and 3.5% for Japan’s Nikkei. US share market indices were down much more with the S&P 500 down by 8.8% led by tech stocks (NASDAQ fell more than 13%). The previously rich valuations in the US tech sector to be sustained needed low interest rates. The Australian share market maintained comparative outperformance in April with a small fall of 0.9% assisted by high commodity prices benefiting resource companies.

Credit spreads widened in April responding to the same concerns besetting share markets about slower economic growth ahead. It is worth noting that actual credit quality still seems strong, especially in Australia. Borrowers look well placed to cope with the early stages of rising borrowing interest rates. Variable rate home mortgage borrowers in Australia may be challenged by rising interest rates and slower growth in house prices but over the next year or so earlier past repayments ahead of schedule, a general build-up of household savings, strong employment growth and low unemployment all point to maintenance of high credit quality for longer.

Government bond markets continued to suffer worst in April from the impact of high inflation and potential central bank policy moves to curtail it. The US 10-year bond yield rose by 59bps to 2.93% while the 30-year treasury yield rose by 55bps to 3.00%. As mentioned earlier, the extreme of rising interest rate expectations may be occurring, running into the Fed policy meeting this week. If the meeting meets expectations and is followed shortly after by signs that annual US inflation has peaked, as we expect, the US bond market may be more settled in May and June with less upward pressure on yields.

In Australia, the 10-year bond yield rose in April by 29bps to 3.12%, a much lesser move than its US counterpart. Even though Australia recorded higher than expected Q1 inflation with the CPI up 2.1% q-o-q, 5.1% y-o-y and the RBA’s preferred underlying inflation measure, the trimmed mean, up 1.4% q-o-q, 3.7% y-o-y increasing the likelihood of rate hike this week, Australian inflation is currently materially lower than in the US and is less strongly underpinned.

Like in the US, Australian annual inflation has probably peaked and will start to ease as earlier high inflation readings in the base quarters for the annual inflation calculation pass. In Australia, the 1.3% q-o-q CPI rise in Q4 2021 and the Q1 2022 2.1% q-o-q rise will be the base for quarterly CPI increases in Q4 2022 and Q1 2023 that will both be much lower, taking as much as two percentage points off the annual inflation rate over the two quarters. The 5.1% y-o-y inflation rate in Q1 this year turns on base effect to 3.1% or lower in Q1 next year.

 Once the base effect has done its best cutting the annual inflation rate, the issue becomes how much ongoing inflation pressure remains in the system. That is where wage growth will matter. The next Q1 wage price index reading is out later this month and may see annual wage growth accelerate to around 2.6% y-o-y, less than half the pace of annual wage growth in the United States. Almost certainly Australian wage growth will accelerate above 3% y-o-y later this year but that would still be consistent with ongoing annual inflation around the top of the RBA’s 2-3% target range.

Australia’s current and future ongoing inflation prospects are less than in the United States but are jogging top to above the RBA’s 2-3% target band for the next two-to-three years at least.  The current 0.10% emergency cash rate is now patently too low given the current high inflation rate and where inflation may settle next year. To maintain credibility that it is maintaining inflation in 2-3% band, the RBA needs to hike the cash rate at its policy meeting tomorrow and preferably by a meaningful 40bps to 0.50% rather than a near meaningless 15bps. 

Beyond the meeting the RBA will update its economic forecasts in the Monetary Policy Statement on Friday where it will need to tweak higher again its inflation forecasts. That tweak should not set the scene for the market to lift further expectations of RBA rate hikes over the next year or so. The market is looking for the RBA to push the cash rate up above 2.00% by the end of 2022 and to 3.50% by the end of 2023. Those expectations are too aggressive given that annual inflation readings will be stepping lower in the second half of this year and early in 2023. The peaking and moderation of annual inflation will provide the RBA with cause to move slowly hiking rates. Our expectation is the cash rate will be 1.25% at the end of this year and 2.00% at the end of 2023.

Based on our view about Australian inflation and cash rate moves, it is unlikely that Australian bond yields will push up much higher.