Markets continued to take an optimistic view of the situation in the Middle East despite conflicting headlines over a US-Iran agreement. WTI crude oil futures fell by almost 8% over the week, supporting broad equity gains. FX and rates pricing was more mixed. A hawkish shift from the Fed saw the US rates curve lift at the front end, though the USD was largely flat this week. Locally, a weak update on the labour market has thrown doubt on further RBA hikes, a headwind to the AUD.
A near-term pause in the RBA's tightening cycle is strongly backed by markets after a very weak labour force report for April. Australia's unemployment rate rose to 4.5% - its highest since late 2021 - from 4.3% in March, driven by an 18.6k fall in employment (see here). Both outcomes were significant downside surprises, with markets looking for the unemployment rate to hold at 4.3% on the back of a 15k rise in employment.
Market pricing for a 4th consecutive RBA rate hike in June was cut to a 5% chance from around 15% prior to the release, though one further 25bps hike to the cash rate (currently 4.35%) is still expected by year-end. That broadly reflects the RBA's narrative around capacity pressures and inflation risks, reiterated again this week in a speech by Deputy Governor Hunter and in the May meeting minutes. However, in my view a more interesting observation in the minutes was the Board's acknowledgment that risks to the full employment side of its dual mandate had increased due to its hiking cycle, a view seemingly validated by the April labour force report.
In the US, a hawkish shift now has markets pricing in a 25bps hike as the next move by the Fed, previously expected to hold the fed funds rate steady in the 3.5-3.75% range through year-end. That reflected commentary from the Fed moving away from the question of when to cut rates to considering when it may need to hike. This is the discussion that Kevin Warsh, the incoming Fed Chairman sworn in by President Trump on Friday, will now lead. The April meeting minutes communicated the shift noting that 'a majority of participants' would likely support a hike if inflation remained above target, while 'many' members were in favour of removing the long-standing easing bias from the decision statement. A speech from Fed Governor Waller titled Policy Risks Have Changed was another key development. Waller said that the longer the energy price shock persists, the greater the risk that this translates to a broader spillover into inflation.
The policy outlook in the UK and euro area is showing signs of divergence. Markets price a moderate risk of a BoE hike this year whereas 2-3 hikes are priced in for the ECB, starting in June. This week, UK labour market and inflation data surprised to the downside, casting significant doubt over BoE tightening prospects. UK unemployment rose from 4.9% to 5% in March, while earnings growth softened from a 3.6% to 3.4% annual pace. In April, annual inflation slowed from 3.3% to 2.8% in headline terms and from 3.1% to 2.5% on a core basis, both undershooting expectations for 3% and 2.6% respectively. Additionally, the April reset of many prices saw services inflation - the key part of the basket being monitored by the BoE - fall from 4.5% to 3.2%, below the 3.5% pace expected.
