Markets are suddenly not so sure about the interest rate outlook from here.
I noted in yesterday’s post that markets are in a tizzy given the changing interest rate outlook in the US.
That’s been swamped by the impact of the Iranian attacks on Israel over the weekend, but in the medium term, this is the key trend to watch.
As I said yesterday, basically inflation came in hotter than expected – and we’ve now had four up-side surprises in a row.
And it’s increasingly looking like the US Fed (and the RBA and every other central bank) might not actually have inflation under control.
As a result, bond markets are ratcheting back their expectations for rate cuts this year. In January, the bond market was pricing in 175 basis points of rate cuts – that’s seven regular sized rate cuts in a twelve month year.
Now, they’re pricing in 42 basis points – that is, one, maybe two rate cuts.
And not until September at the earliest.
The always-excellent Christopher Joye at Coolabah capital notes that the key thing here is the changing outlook for services inflation:
Equity and fixed-income investors were shocked during the week by the release of the official US inflation data, which confirmed a massive re-acceleration in services (rather than goods) inflation in March, with the annualised trend now running at an incredible 6.5 per cent (or 7.7 per cent if we exclude housing).
Despite ongoing deflation in core goods prices in March, which declined by 1.1 per cent on an annualised trend basis, overall core inflation in the US was reported to have re-accelerated to 4.5 per cent from a trough around 3 per cent late last year.
When the US Federal Reserve was hitting its 2 per cent inflation target before the pandemic, core services inflation was expanding at an annual rate of just 3 per cent. That is, less than half its current pulse.
The surge in services inflation is being driven by an excessively tight US labour market, which is pushing up wages that represent the primary cost of service-orientated businesses (ie people). The US unemployment rate of 3.8 per cent is notably below its long-term average and the Fed’s estimate of full employment.
Australia faces precisely the same plight.
Every country does. And it’s a worry.
Services inflation in Australia ticked up a little last month, but if it follows the US trajectory, which it normally does, then we might have a problem on our hands.
I still think the case for rate cuts is there, particularly in Australia where consumption has crumbled (it’s holding up reasonably well in America).
But as Joye notes, there are a number of inflationary spectres haunting the outlook:
With the spectre of intensifying conflict between Israel and Iran forcing oil prices higher and an ascendant Trump campaigning to slash migration, which would boost US labour costs, coupled with the inflationary idea of slapping tariffs on Chinese imports, the downside risks for asset prices are becoming increasingly acute.
The outlook isn’t entirely clear just yet. But another upside surprise to the inflation data next month, and markets could really freak out.
JG.
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