Financial markets remained volatile in May torn between evidence of strong economic activity and concern that central bank interest rate hikes will dampen future activity and possibly lead to recession. Inflation and its many underpinnings are driving the likely course of central bank rate hikes. Views about central bank rate hikes are varied, adding to market volatility.
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In March high inflation and what central banks might do to tackle it was the dominant theme in financial markets. Government bond markets suffered their worst month in 30 years with yields up sharply responding to fear of aggressive hikes in official interest rates by central banks. The US Federal Reserve (Fed) facing sustained high US inflation caused by strong growth stretching disrupted supply chains and showing signs of being sustained by rising wages, talked about the need for regular and bigger rate hikes. It delivered at its March policy meeting a minimal 25 basis point (bps) rate hike taking the Federal Funds up to 0.25% to 0.50% range to combat US inflation at 7.9% y-o-y in February and expected to be above 8% in March.
In February volatility in financial markets increased markedly as concerns about high inflation and what central banks might do about it was overlayed by a sharp increase in uncertainty, with the outbreak of a wider war in the Ukraine. Among the issues facing investors, with no clear answers, are how the war will unfold in the Ukraine, Russia, Europe and the world; the near-term impact on inflation and growth prospects; and the impact on the plans of central banks facing potential stresses on the plumbing of the global financial system while at the same time dealing with a new factor adding to inflation.
In January the focus in financial markets was high inflation and what central banks might do about it. Inflation readings in the US, Europe and Australia matched or were higher than market forecasts. The US Fed responded talking tough policy intentions but still delaying material policy action. The Bank of England hiked 25bps, the second hike in the current cycle, but the base rate is sub 1.00% against British inflation above 5% and still rising. Australia’s Q4 annual inflation rate at 3.5% was above all forecasts but the RBA is waiting for stronger wage growth before hiking the emergency low 0.10% cash rate.
Risk assets ended 2021 on a strong note. December saw risk assets rise strongly despite the potentially growth crimping threats from rising Delta and Omicron infection rates. For the most part 2021 and December were influenced by stronger than expected economic activity and faster than expected rise in inflation with governments and central banks barely starting to stem very easy policy settings.
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.