The Australian economy is more than a month into the rebound after the lockdowns in New South Wales, Victoria and the ACT. However, most of the official economic data...
Conflicting influences on financial markets through October increased volatility, but with most risk asset markets recovering their losses from the previous month. Australian financial markets went against the improving trend, with a late month sharp lift in government bond yields caused by a higher-than-expected rise in Q3 underlying inflation. The broad-based lift in underlying inflation added fuel to views in local interest rate markets that the RBA will need to change its guidance that official interest rates will hold down at 0.10% until 2024. The market forced the 3-year bond yield above 0.70% at month end, well above the RBA’s 0.10% target rate.
The surge in inflation around the world is still viewed by many central banks as a temporary problem, caused by supply chain problems in manufactured goods meeting unusually high demand for manufactured goods during Covid restrictions. Supply chain issues are taking longer to resolve than initially expected by central banks, but resolve eventually they will and some reprieve from high goods price inflation is likely to occur in 2022. Inflation pressure is changing though. High house prices and rents are starting to feed inflation. Service prices are showing the first signs of increasing and wage pressures are increasing, noticeably in the US and Europe and even in Australia.
Where central banks are starting to either withdraw monetary accommodation or indicate that they will soon start to withdraw accommodation it is against a backdrop of fading but still strong economic growth. It is an environment where many companies are experiencing strong sales volume plus ability to price higher. Higher borrowing interest rates will raise costs but profits still have momentum. Mostly strong Q3 earnings reports from US companies in October helped push even the richly valued US share markets to new record highs.
Among major share markets the US S&P showed the biggest gain in October, up 6.9%. Gains elsewhere ranged from 1.5% for Japan’s Nikkei to 5.0% for Europe’s Eurostoxx 50. Australia’s ASX 200 was the odd man out with a month-end selloff on higher interest rate concern causing the ASX200 to fall 0.1% over the month.
Higher Australian interest rate concern also caused late-month weakness in Australian credit. While local credit was softer, international credit influences improved in October with fading concern surrounding the US government debt ceiling and legislative negotiations of the Biden Administration’s social and hard infrastructure spending proposals. China’s giant property developer, Evergrande avoided default for another month raising hope of some more permanent resolution.
Rising government bond yields remained in focus in October as pressure continued to mount on central banks to respond to inflation looking higher and stubbornly less temporary than expected. The inflation shocks were evident locally in October. A much higher than expected Q3 CPI report in New Zealand (+2.2% q-o-q, +4.9% y-o-y) added to the inevitability of the RBNZ hiking its cash rate 25bps to 0.50% with the promise of more rate hikes to come. The New Zealand inflation report and rate move emboldened the Australian bond market to challenge the RBA’s 0.10% three-year bond yield target on the basis that inflation pressure in Australia is building and is unlikely to subside as comfortably as the RBA is forecasting in 2022.
Australia’s Q3 CPI report (CPI +0.8% q-o-q, 3.0% y-o-y; underlying inflation +0.7% q-o-q, +2.1% y-o-y) highlighted that the RBA will need to make substantial upward revisions to its inflation forecasts in the quarterly Monetary Policy Statement out on Friday. In the previous Monetary Policy Statement released in August the RBA forecast Q4 2021 CPI at 2.5% y-o-y and underlying inflation (trimmed mean) at 1.75%. More telling for the RBA’s commitment to keep the cash rate unchanged at 0.10% to 2024 was its Q4 2023 inflation forecasts of 2.25% y-o-y for both the headline CPI and underlying inflation. Both will need to be revised upwards to around 3% to have any credibility making it impossible for the RBA to argue credibly that the cash rate will stay down at 0.10% through to 2024.
The fracturing of the RBA’s inflation forecasts and rate guidance during October caused Australian bond yields to lift more sharply than their counterparts overseas. The US 10-year bond yield rose by 6 basis points (bps) to 1.55% while Australia’s 10-year bond yield rose by 60bps to 2.08%. the 3-year bond yield soared above the RBA ceiling rate of 0.10% to 0.71%. These local bond yield increases during October are exceptional and have undoubtedly pushed up too far too fast in the near-term creating conditions for bargain hunting. Some pull-back in yields is likely but probably setting a base before yields push up again. Quite simply the conditions pushing bond yields higher – less temporary and higher than expected inflation plus central banks scrambling to adjust their guidance on bond-buying support and official interest rates – will persist over coming months.
The RBA has a scrambling adjustment of its own to make tomorrow. Melbourne Cup Day monetary policy meetings have often proved eventful in the past. The one tomorrow will need to review the RBA’s latest thinking on the inflation outlook and determine whether the RBA can continue to target the three-year bond yield at 0.10%. The best option might be to make the yield target less explicit and promise buying intervention when the RBA deems the yield movement unreasonable.
The guidance on the cash rate will also need to change if the RBA concedes that inflation is running higher than previously expected. The RBA has made the point repeatedly that without higher wage growth it can read through upward blips in inflation. Past wage growth has been slow (1.7% y-o-y in Q2 2021) but there is increasing evidence of wage disputes and some wage settlements that point to a marked rise over the next six months. Law firms are becoming outlier pace setters with 10% pay increases for staff in some.
We expect the no cash rate hike before 2024 guidance to be altered tomorrow, but we also suspect the RBA will hold out on delivering a first-rate hike until the second half of 2022. Admitting to the need to hike rates is going to be an unusually difficult process for the RBA mostly because the household sector is so heavily indebted. Small increases in borrowing interest rates could translate into rising bad debts in the household sector and a stalling housing sector. Big increases in borrowing interest rates would be much worse. The RBA has to change its rate guidance but it will be in no rush act quickly or in large measure. The first rate hike when it arrives, probably in the second half of 2022, is likely to be only 15bps to 0.25% and rate hikes beyond will be small and staggered.