Frank Uhlenbruch, Investment Strategist in the Janus Henderson Australian Fixed Interest team, provides his Australian economic analysis and market outlook.
Market Review
Both the US Federal Reserve (Fed) and the Reserve Bank of Australia (RBA) continued with aggressive front-end loaded monetary tightening against the backdrop of stubbornly high inflation readings. Risk appetite improved as markets saw signs of moderating growth as limiting the amount of prospective monetary tightening. While volatile, both equity and credit markets ended stronger, while yields fell across the curve. These moves boosted Australian bond market returns, with the Bloomberg AusBond Composite 0+ Yr Index, gaining 3.36% over the month.
Our base case view is for the cash rate to lift by 50bps to 1.85% at the August meeting and for the cash rate to lift to 2.60% by the end of the year and peak at 2.85% in H1 2023.
The RBA lifted the cash rate by a consecutive 0.5% increment in early July to 1.35%. In contrast to recent months, yields fell across the curve despite mixed economic data readings. At the shorter end, the three-year government bond yield fell 46 basis points (bps) to end the month at 2.66%. Further out along the curve, 10- and 30-year government bond yields ended 60bps and 42bps lower at 3.06% and 3.43%.
On the data front, there was evidence of the resilience that the RBA had noted. The labour market tightened further in June with a stronger than expected 88,400 increase in jobs driving the unemployment rate down to 3.5%. Forward-looking labour demand indicators point to ongoing near-term strength and upward pressure on wages.
While resilient, there were growing signs that the highwater mark in the pace of growth may have been reached. Cost of living pressures have depressed consumer sentiment and driven down purchasing power, with monthly retail trade growth slowing significantly over the June quarter. Business conditions remain buoyant by historical standards but looked to have peaked in April.
Broad based price rises pushed headline inflation up by 1.8% over the June quarter for a 6.1% yearly rate. Core inflation, as measured by the trimmed mean, rose 1.5% for a 4.9% yearly rate and price pressures were most acute in the goods sector.
Short-term money market yields continued to rise as markets discounted further near-term tightening. The three-month bank bill yield ended the month 31.5bps higher at 2.12%, while six-month bank bills ended 11bps higher at 2.78%. In terms of the tightening cycle, markets are still looking for a 3.0% cash rate by year end, but have revised down the mid-2023 cash rate pricing from 3.75% to 3.17%.
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Credit markets gyrated as investors grappled with the growth versus inflation debate on the one hand, and geopolitics and energy market volatility on the other. Second quarter earnings began in the northern hemisphere and whilst early days, a picture of demand-side weakness, cost pressure and margin compression emerged, along with heightened concerns that an overly aggressive Fed could push the US economy into recession.
Despite intra-month volatility, credit markets closed on a stronger footing. This is in part due to investors reacting favourably to Fed Chair Jerome Powell’s comments around rates having reached neutral levels in his estimation, and also possibly due to overly bearish technical positioning entering the month. The Australian iTraxx Index closed 19bps tighter at 111bps, while the Australian fixed and floating credit indices returned 2.40% and 0.24% respectively.
Market outlook
Global central banks, as well as the RBA, are front-end loading tightening cycles. The aim being to slow demand enough to allow the supply side to catchup without triggering a recession. In the US, where the cash rate is now at neutral levels, the Fed sees the need for ‘moderately restrictive’ conditions ahead.
Along with the fallout from Russia’s Ukraine invasion, more aggressive monetary policy and hawkish central bank rhetoric are also starting to bite. The OECD leading indicator has begun to turn down and the IMF and Treasury have downgraded their growth forecasts, but lifted their inflation forecasts.
Monetary policy is a blunt instrument with long and variable lags. With the Fed signalling that inflation has a greater cost than recession, the risks of central banks over tightening is material and has been reflected in the rally in bond yields from their mid-June highs. Market pricing has shifted from the Fed being behind to ahead of the tightening curve and falling breakeven inflation rates suggest that central banks have restored some policy credibility.
The RBA has well and truly joined the central bank front-end loaded tightening club, with 125bps of tightening since May, lifting the cash rate to 1.35% in July. Markets are still grappling with the speed and quantum of tightening needed this cycle.
At one stage in mid-June markets were discounting a 3.6% cash rate by December, lifting to 4.2% by mid-2023 and averaging at around that level over the next decade. This seemed implausible to us as it assumed one of the biggest and fastest tightening cycles in the current inflation targeting era resulting in a 4.2% neutral or terminal cash rate. The RBA’s estimate is 2.5% and ours is not that dissimilar. In our view, a cash rate of 4.2% would represent a cyclical peak and enough to cause a slowdown significant enough to trigger the next easing cycle.
Since then, markets have wound back the amount of tightening priced in, but are still discounting a terminal cash rate of around 3.40%, close to 100bps higher than our estimate of the neutral cash rate.
Our base case view is for the cash rate to lift by 50bps to 1.85% at the August meeting and for the cash rate to lift to 2.60% by the end of the year and peak at 2.85% in H1 2023. Such a level is on the tight side of neutral and we look for the RBA to hold that level until mid-2024, before modestly easing as the extended period of tighter policy sees growth slow and inflation head back into the target band.
Against such a backdrop we look for inflation to peak around 7.5% by year end and then gradually moderate from 2023 back towards the top of the RBA target band by H1 2024. After growing by 3.5% this year, we look for economic growth to slow to 2.4% over 2023 and 2.0% the year after as tighter policy grips.
While the recent rally has released much of the value we saw, we still see some value at the shorter to mid part of the yield curve as market pricing does not see the Australian economy responding to an extended period of tighter monetary policy. The recent rally in longer-dated yields has released some of the value we saw building up. Nevertheless, we remain mindful of the term compensation on offer and the scope for further capital gain if central banks overdo tightening and trigger a recession
Uncertainty about the durability of the current expansion and cyclical cost pressures are likely to contribute to ongoing volatility in credit markets. These periods can provide opportunities when spread widening is more than fundamentals. We remain active and selective, favouring relative value within sub-sectors, whilst being judicious on overall credit beta. Recent spread widening has allowed us to access high quality names at attractive levels.
Views at 1 August, 2022
