ABEWeekly – 23/06/2021

Market Update  

 

“Every problem is a gift-without problems we would not grow” Anthony Robbins 

 

The May Australian employment report which showed a surprise fall in the unemployment rate from 5.5% to 5.1% will be a major influence on the path of future economic policy. It underscores the strength of momentum in the economy and endorses the range of other measures pointing to a very strong labour market. The recovery is now clearly into a self-sustaining upswing and the need for emergency stimulus policies has eased significantly. 

On the back of the May employment number Westpac have lowered their Jun 2022 unemployment rate forecast to 4% and 3.8% by Dec 2022. One could say this essentially reflects a scenario of full employment. We have said before that the strength of the labour market coupled with inflation will dictate central bank policy decision making. At the same time inflation appears to be very much under control with most forecasting a very modest increase in inflation to 2.25% by Dec 2022 and, wages to grow by approx. 2-3%. 

On the back of this, we are certainly moving towards a point where the official cash rate is likely to edge slightly higher. By this we mean a very modest 15bps. Westpac anticipate that the RBA may look to implement this change Q1 2023 with additional token increases each quarter thereafter. 

We are somewhat at a loss to understand how central banks can just keep their foot on the accelerator, redlining the engine, without any apparent consequences thus far. The US Government has created an additional $7 trillion through the Fed Reserve. In addition, Biden’s government has pumped another $3.8 trillion into the economy and is talking about adding more with an infrastructure bill. At the same time the COVID issue seems to be losing importance as vaccine rollouts gather momentum. All in all, it seems the US economy, and the world with it, is about to experience an almighty recovery. 

This week we take a more detailed look at the relationship between interest rates and bond prices. When rates go up, the market value of bonds goes down; but then conversely when rates drop, bond values go back up. However, not all bonds are created equally, and a bond’s sensitivity to rate fluctuations will be influenced by its maturity and whether it has a fixed or a floating rate. Longer-maturing fixed rate bonds will be the most sensitive to interest rate rises but like any security can fluctuate daily based on the market forces of supply and demand. The bottom line is that unlike equities, and other risky assets, bonds have a pre-defined income stream and final value making them a perfect foundation investment in any diversified portfolio. 

The charts below illustrate the enormity of bond markets globally. The first chart illustrates the size of the global corporate bond market with China and the US the largest issuers. Whilst the market in Australia is nowhere near as big, it is still a major and important source of financing for corporates in Australia but remains underutilised and insignificant relative to the size of the Australian economy.