Risk assets were mixed through July, caught between the positive influences of stronger economic data reports for May and June and massive stimulus measures around the world all but guaranteeing economic recovery at some stage, but also the major negative influence of still rising COVID-19 infection rates and new or renewed restrictions. These mixed forces were evident in Australia in the month including mostly stronger economic readings for May and June when restrictions were mostly being eased; the Government announcing time extension of income support measures plus more growth-boosting measures; but then sharply rising COVID-19 infections in Victoria during the month and a stalling in progress easing restrictions early in the month turning to renewed imposition of restrictions later in the month casting doubt on economic recovery prospects.
Major share markets were widely mixed in July ranging from a gain of 5.5% for the US S&P 500 trading near a record high, notwithstanding the continuing poor US performance containing COVID-19, to a fall of 4.4% for the British FTSE 100. The gains in the US share market were driven mostly by rising tech stocks. Australia’s ASX 200 was showing a possible monthly gain above 2% until a sharp fall on the last trading day of July driven by concern about the restrictions likely to be needed to stem the high COVID-19 infection rate in Victoria and its potential virus spread beyond. The ASX 200 still managed a small 0.5% gain for the month.
Credit markets rallied again in July assisted by the open-ended buying support of the US Federal Reserve (Fed) for virtually all debt securities as part of its QE (quantitative easing) program. The July Fed policy meeting reaffirmed that low interest rates and Fed purchases will feature for possibly years to come. Australian credit spreads continued to narrow in July assisted in part by the US Fed’s increasing purchases of corporate debt and locally signs that banks are well placed to cope with potential problem loans down the track related to the challenging conditions facing the commercial and residential property markets.
Government bond markets rallied in July as rising COVID-19 infection rates clouded the potential strength of economic recovery and added to the requirement for central banks to maintain very easy monetary conditions. The Fed reaffirmed its commitment to low interest rates in July and again indicated it would provide whatever bond buying support needed for government fiscal measures needed to support growth. The US 10-year bond yield fell by 13 basis points (bps) to 0.53% in July while the 30-year Treasury yield fell by 22bps to 1.19%.
In Australia, bond yields also fell in July notwithstanding the Government’s report during the month that the budget deficit topped $A80 billion in 2019-20 and was likely to push above $A180 billion in 2020-21. The large increase in the budget deficit is mostly a function of COVID-19 household income support programs extended beyond their previously legislated September end-date.
Stage-4 shutdown restrictions just imposed in greater-Melbourne and the setbacks opening the rest of the Australian economy will mean weaker growth than Treasury factored in to the latest budget projections and a higher than forecast budget deficit for 2020-21. High prospective government borrowing will be even higher, but the flood of bond issuance is unlikely to place upward pressure on Australian bond yields with demand for Australian government bonds growing as fast as supply.
In July, the Australian 10-year bond yield fell by 10bps to 0.81% while the 3-year bond yield stayed near the RBA cap of 0.25% without the need of additional purchases by the RBA. Demand for Australian government bonds otherwise was strong during the month, especially demand from overseas purchasers attracted to Australia’s positive yields in a world of negligible or negative government bond yields.
Another factor supporting demand for Australian bonds is the absence of inflation and the increasing prospect that inflation will stay low probably until the mid-2020s. In Q2 2020 several factors including temporarily free childcare, sharply lower petrol prices and lower housing costs generated a 1.9% q-o-q fall in the CPI, the biggest quarterly fall in the 72-year history of the CPI, collapsing the annual reading into deflation, -0.3% y-o-y, for the first time in 20 years. The CPI may not stay in deflation, but very low annual inflation at best is in prospect for at least the next year.
Absence of inflation pressure is a measure of the economy operating well below capacity. High unemployment is another indicator of excess capacity. Currently the measured unemployment rate is above 7% and the effective unemployment rate adding in those on income support but not working is above 11%. The RBA reaffirmed in July that it will not even start to think about lifting interest rates until the economic recovery is advanced and starting to stretch capacity. A rough rule of thumb for stretched economic capacity is when annual inflation is motoring upwards through the 2-3% target range and the unemployment rate (measured and effective) is pushing down below 5%. Obviously, we are a long way off.
In the near-term, with the increased restrictions in Victoria and the heightened uncertainty related to COVID-19 elsewhere in Australia, downside economic growth risks are back in focus indicating that the RBA is even further away from starting to consider higher interest rates than it was a month ago. In this environment Australian bond yields may fall further and we now see the cash rate staying at 0.25% throughout the remainder of this year and through 2021 and 2022 and possibly well beyond.