A better week for risk sentiment as equities broadly reversed last week's declines. This was supported by strong US data that indicated recession fears have been overdone and gives the Fed the green light to hike by 75bps later this month.
RBA hikes rates by a further 50bps
The RBA met expectations by hiking its key interest rates by 50bps this week, taking the cash rate target to 1.35% and the Exchange Settlement rate to 1.25%. A detailed review of the July meeting is available here, but the key points in Governor Philip Lowe's statement related to keeping inflation expectations anchored between the 2-3% target with the strength of domestic demand putting pressure on the supply side of the economy. This focus looks consistent with another 50bps hike in August post the next CPI report, with that data likely to prompt the RBA to again raise its forecast for peak inflation later in the year (currently at 7%).
While markets are priced for the RBA to keep hiking at every meeting through to the end of the year to bring the cash rate to around 3%, my estimate sits just above 2% which factors in the RBA pausing in September ahead of hiking at a slower pace later in the year. Recent comments from Governor Lowe have highlighted that the RBA's arrangement of monthly meetings allows for a graduated response to countering the risks to the inflation outlook, particularly noting the flexibility built into the inflation target, defined as a medium-term average of between 2-3%. Three successive 50bps hikes could be seen by the Board as finding the right balance between moving ahead of a rising inflation outlook without overdoing the scale of tightening in the near term. The Board noted it will be attentive to the outlook for inflation and in the labour market and also to developments in the global economy where prospects are increasingly uncertain.
Record trade surplus headlined Australian data in May
A surge in the trade surplus to a record high of $16bn was the standout data point this week (see here). The nation's trade surplus was already at elevated levels at the beginning of the year but has subsequently doubled on the back of the escalation in commodity prices following the Ukraine war. Housing data defied expectations for weak outcomes as new finance commitments lifted by 1.7%m/m (see here) and dwelling approvals posted a 9.9%m/m rise (see here). Meanwhile, ongoing strength in retail sales, up 0.9%m/m, underscored the resilience of spending to weak sentiment (see here).
No let-up from the Fed...
The minutes from the Fed's meeting in mid-June made clear no let-up was in sight, putting a hike of "50 or 75 basis points" on the table for its meeting later this month as the FOMC signalled its intent to drive rates up into restrictive territory for economic activity. Markets are priced for a 75bps hike in July and comments from Governor Waller and St. Louis Fed President Bullard this week supported that assessment. The FOMC was also clear that the intent behind tighter monetary policy was to slow demand to be in closer alignment with a constrained supply side of the economy, an imbalance currently contributing to the high rate of inflation.
... as the US labour market remains strong
Markets took a strong labour market report for June as a green light for the Fed to hike by 75bps. Despite growth concerns in the US, the labour market continues to perform as nonfarm payrolls posted a 372k rise in the month, printing well above the consensus forecast of 268k. Employment increased by 1.1m over Q2, down from 1.6m in Q1 but still a very solid outcome. The unemployment rate held at 3.6% for the 4th month in succession, though the broader underemployment measure came in from 7.1% to 6.7%, a record low. The disappointment remains on the supply side with the participation rate ticking down from 62.3% to 62.2%, which is around 1ppt down on pre-pandemic levels. The constraint of lower participation as employment has recovered from the pandemic is reflected in the step-up in average hourly earnings growth to above 5%Y/Y compared to its pre-Covid pace that struggled to rise much higher than 3%Y/Y.
BoE's Financial Stability Report highlighted risks from high inflation
Although politics dominated the headlines in the UK, it was also a busy week at the Bank of England. The Bank's latest Financial Stability Report noted that a persistence of high inflation risked economic growth prospects, tighter financial conditions and increased volatility in markets. The key risks are around the war in Ukraine and in China from both its Covid response and in the deleveraging in the property sector. Noting that the economic outlook had "deteriorated materially", the Financial Policy Committee (FPC) judged that the banking sector was well placed to act as a support to UK households and businesses rather than amplify the shock in the event of a downturn. However, to enhance resilience, the FPC confirmed the rate for banks' countercyclical capital requirements would rise from 1% to 2%, effective from July next year.
Also of note from the BoE this week was a speech by Chief Economist Huw Pill. In the speech, Pill said the Monetary Policy Committee's reaction function centred on preventing an upward rise in inflation expectations. There is concern that imported inflation could become more entrenched domestically if UK corporates try to offset the squeeze on profit margins through persistent price increases, a situation that would encourage workers to push for higher wages to compensate for the increased cost of living. Pill outlined that the MPC's policy guidance has been calibrated to give it a high degree of flexibility to either speed up or back off from tightening in light of the very uncertain outlook, characterised by crosscurrents from high inflation in the near term against the potential for disinflationary impulses to emerge further out.
ECB weighs up 25bps and 50bps
The key message taken from the account of the ECB's meeting in early June was that there had been support from some Governing Council members to commence hiking rates by more than the 25bps increase currently guided. Faced with a negative terms of trade shock caused by surging energy prices following the war in Ukraine and also being exposed to the spillover impacts from China's lockdowns, the rapidly deteriorating growth outlook has led to the view that the ECB's window to hike and move away from negative rates is closing.
It is possible the ECB could up its first hike to 50bps later this month, but the question is whether enough members have seen something since June to shift the consensus. June's account revealed that the consensus for a 25bps hike was made on the basis of wanting to start with a modest increase and with longer-term inflation expectations still anchored at the 2% target. The further weakening in the euro to 20-year lows against the US dollar may constitute a material change that prompts a reassessment but for now, 25bps looks the way forward.
