Share markets fell sharply again over the last week in response to another round of hawkish rate hikes pushing up bond yields and adding to recession fears. A threatened intensification of the war in Ukraine has added to the worries.

Reflecting the poor global lead Australian shares fell about 2.7% with falls led by interest-sensitive IT, property, utility and retail shares. Oil, metal and iron ore prices fell on the back of ongoing recession fears. The AUD fell as the USD rose.

Hawkish central banks remain the key driver of the downside in shares. While inflation is showing signs of peaking in the US, it's not enough for the Fed which hiked by another 0.75% and remains very hawkish. High inflation also drove rate hikes from numerous central banks over the last week – with another 0.5% hike from the Bank of England which also remains hawkish, a 1% hike from the Swedish central bank and a 0.75% hike from the Swiss central bank (although these were both catchups) and rate hikes in South Africa, Norway, the Philippines, Indonesia and Taiwan.

While the Fed’s 0.75% hike to 3-3.25% was expected, its post-meeting statement and comments were very hawkish. The so-called dot plot of Fed officials' interest rate expectations was revised up by 1% for this year to 4.25-4.5%, its inflation forecasts were revised up, its growth forecasts were revised down and its unemployment forecasts were revised up to 4.4% next year. While the Fed is not yet forecasting a recession, its forecast rise in unemployment would normally be consistent with one and it appears willing to tolerate one as its “overarching focus” is to bring inflation down to 2%.

Channelling Paul Volcker, Fed Chair Powell said “we will keep at it until the job is done.” To slow the pace of tightening Powell wants to see a slowing labour market and more evidence inflation is slowing. Another 0.75% hike looks likely in November.

The commitment of central banks to getting inflation down is good news as a sustained return to 1970s-style high inflation would be very bad for economies, living standards, jobs and investment markets. 

The danger though is that the Fed and other central banks have become locked into supersized hikes based on backward-looking inflation and jobs data and a loss of confidence in their ability to forecast inflation at a time when they should be giving more attention to monetary policy lags. This increases the risk of overtightening driving a deep recession. (Just as in hindsight they were too slow to start hiking.)

Fed tightening and hawkishness has seen the US 10-year-2-year yield curve further invert strengthening its recession warning, with the more reliable 10-year-Fed Funds rate curve yet to invert but getting close.

The bottom line is that while short-term inflation remains high, these considerations are consistent with the US having reached peak inflation and point to sharply lower inflation ahead which should enable central banks to slow down the pace of hiking by year-end hopefully in time to avoid a severe recession (except perhaps in Europe). If this applies in the US, then Australia should follow as its lagging the US by about six months with respect to inflation. For this reason, while shares are likely to fall further in the short term, we remain optimistic about shares on a 12-month horizon.

Five reasons why the RBA should be less hawkish than the Fed

The increased hawkishness coming from the Fed has led many to conclude that the RBA will have to get more hawkish too and so match extra Fed rate hikes. However, there are five reasons why the RBA should be less hawkish than the Fed and other central banks:

1. Household debt to income ratios in Australia is almost double US levels – at 187% in Australia v 102% in the US.
2. Household debt interest costs in Australia are far more responsive to rising interest rates – as most borrowers are on variable rates tied to the RBA’s cash rate and the rest are on relatively short-dated fixed terms many of which mature next year in contrast to the US where most mortgages are 30 years fixed so only new borrowers are impacted by rising rates. Combined with the first point this means that a given sized rate hike in Australia will be more potent in slowing consumer demand than in the US.
3. Inflation is lower in Australia, at least for now.
4. Wages growth – the biggest single driver of business costs - is running around half what it is in the US.
5. The Fed risks overtightening and causing a serious recession in the US and there is no logical reason why the RBA should do the same. But taking the cash rate to 4.15% by mid-next year as the money market is assuming would knock home prices down by 30% and put the economy into a recession we don’t have to have.

In short, the combination of Australian households being far more vulnerable and hence responsive to rising rates than US households, lower inflation pressures in Australia and a desire to avoid overtightening means that the RBA should not raise rates as aggressively as the Fed.

The main argument for following the Fed is that if the RBA doesn’t the AUD might crash but the whole point of floating the dollar was to get an independent monetary policy. And we have seen that in recent times with RBA hikes in 2009-10 (but no move by the Fed) and Fed hikes in 2015-18 (but the RBA still cutting rates).

Of course, if the AUD crashes to say $US0.50 and brings Australian inflation up to US levels then it may be harder for the RBA – but it's also worth noting that strong commodity prices are providing a bit of an offset to the negative AUD impact of the Fed hiking more than the RBA. If the AUD does crash though it will probably be in a period of immense global stress and plunging commodity prices where it would make more sense for the RBA to let it go as it did in the GFC and early in the pandemic when it fell to $US0.60 or below.

Overall, we think the RBA should scale back to 0.25% at its October meeting, but it’s starting to feel like another 0.5% is on the way. A 0.4% hike might be a nice compromise!

ABS Monthly CPI Indicator to show a further rise in Australian inflation

The ABS has decided to bring forward the release of its monthly CPI Indicator to 29 September with data for July and August. As at June, it had already increased to 6.8%yoy.

Based partly on the already released Melbourne Institute’s Inflation Gauge showing a sharp rise in July and some fall back in August we expect it to show that monthly inflation rose to 7.8%yoy in July and fell back to about 7.1%yoy in August. Note that this volatility is partly due to the base effect of a strong rise in August last year.

Caution should be applied in interpreting it at least initially as; it only updates about two-thirds of CPI items and will be subject to revisions; it will be very volatile month to month; and there will be no trimmed mean or median, initially making it hard to assess underlying pressures.

The RBA has indicated that it could take time for reliable trends to be discerned and reflecting this, Deputy Governor Bullock has noted that it's “unlikely” to have much impact on the October rates decision. But a big move either way may be hard to ignore and could impact market volatility.

Economic activity trackers

Our Australian, US and European Economic Activity Trackers were little changed in the last week. Overall, they continue to suggest that while some momentum has been lost after the recovery from the pandemic, economic activity is holding up reasonably well so far – but this likely reflects the usual lags from monetary tightening.