Risk assets rallied further in May despite April economic readings reflecting a sharp reduction in economic activity around the world resulting from restrictions aimed at containing the spread of COVID-19. In late March and April, financial markets started to look through the recession caused by COVID-19 restrictions towards the recovery beyond. This continued in May, assisted by more signs that the peak had passed in the first wave of new COVID-19 infection numbers and mortality rates; easing restrictions including in China, the United States, Europe and Australia; and increasing recognition that the stimulus plans of governments and central banks stood a good chance of promoting the start of economic recovery later in 2020.
Major share markets rose strongly in May with gains for the month ranging from 2.9% for the British FTSE 100 to 8.3% for Japan’s Nikkei. The US S&P 500 rose by 4.5% in the face of bad economic news showing -5.0% annualised GDP growth in Q1 2020 and an unemployment rate soaring to 14.7% in April from 4.4% in March.
Australia’s ASX 200 lifted by 4.2% in May, assisted by a sharp rally in previously weak major banking stocks amid earlier than previously expected lifting of some covid-19 restrictions and hope that Australia’s economic downturn and associated lift in problem bank loans might be less severe than earlier forecast.
The Australian share market rallied despite increasing trade tension between Australia and its biggest trading partner, China. Any negative impact from rising China trade tension on large Australian resource shares was countered in the month by problems in another of China’s big resource suppliers, Brazil, the latest hot spot for rising COVID-19 infection and mortality rates during the month. Iron ore prices in particular were boosted by restricted supply from Brazil during May, benefiting Australian producers.
The strong rise in share markets during the month extended to credit markets. Australian credit spreads narrowed in May, albeit on thin trading at times. Credit markets drew some support from various RBA statements during the month including the quarterly Monetary Policy Statement and testimony from senior officials reaffirming the RBA’s commitment to providing low interest rates (maintaining the cash rate at 0.25% and commitment to keeping short-term government bond yields no higher than 0.25%) and liquidity for the financial system.
Credit also benefited as a potential area of stress for Australia’s banks, rising problem housing loans seemed less of a potential problem amid encouraging signs of buying support returning to parts of the Australian housing market amid the early return of open auctions.
Government bond markets mostly gave up a little ground in May with investors allocating more for risk assets. The US 10-year bond yield rose by 1 basis point (bp) to 0.65% while the 30-year Treasury yield rose by 13bps to 1.41%. Shorter-term US bond yields are likely to be anchored by the Fed maintaining the funds rate in a 0-0.25% range for the foreseeable future. The Fed is resisting pressure to push the funds rate below zero recognising that negative interest rates tend to be counter-productive weakening rather than strengthening banks’ ability to lend.
There is also no pressure on the Fed for a considerable time to consider lifting the funds rate. The US economy is currently in deep recession/depression suffering insufficient demand and weak price pressure. Before the Fed is under pressure to lift interest rates the US economy needs to shift to the polar opposite of what is occurring currently – return to full employment; demand rising beyond productive capacity; prices and inflation rising.
The policy shift of recent months in the US towards massive monetary and fiscal stimulus and multi-trillion dollar lift in government borrowing will eventually return the US economy to full-employment. It is unlikely, however, that the US bond market will wait the years that may take before starting to push up longer-term US bond yields. Most likely, longer term US bond yields will start pushing higher relatively soon even as shorter-term yields are held down by the steady and low Fed funds rate.
In Australia, the RBA is in a similar position to the US Fed in the sense that the cash rate has been reduced to its lowest functional level, 0.25% and is likely to be held at that level for a considerable period. Like the Fed the RBA sees pushing interest rates into negative territory as being counter-productive. Short-term bond yields held close to 0.25% in May while the 10-year bond yield edged down by 1bps to 0.87%.
The near-term economic outlook in Australia is more promising than a month ago. The three-stage plan for reducing covid-19 restrictions developed by the Federal Government in conjunction with National Cabinet in early May is being implemented faster than expected. Australia’s success flattening the covid-19 infection curve has continued in May and permitted faster easing of restrictions. Australia’s worst economic readings are likely to be for the months of April and May with noticeable improvement in June and beyond. A potential renewed fall in output as Government support programs wind down in September is well recognised and may be averted with Federal and State Governments planning on-going support spending necessary to support vulnerable businesses beyond September.
Improved prospects of recovery in the Australian economy beyond the covid-19 restrictions and the extended fiscal stimulus needed to deliver it are likely to place more upward pressure on longer-term Australian bond yields over the next few months. Shorter-term bond yields, however, are likely to be anchored by the 0.25% cash rate (likely to be in place the remainder of this year and much of 2021 as well) and periodic RBA buying of short-term bonds keeping their yield below 0.25%.
Financial market focus on a more positive medium-term economic outlook during May while warranted could also be disrupted again if progress containing covid-19 and easing of restrictions promotes a second wave of infection. It is worth keeping in mind, however, that almost everywhere around the world, including in Australia, a return to widespread economic shut-down seems unlikely with better infection tracking allowing localized and far less disruptive shut downs.