RBA can act “decisively” to mitigate a deteriorating international environment and beware the bond vigilantes!

Stephen Miller

As was largely anticipated, at the conclusion of this week’s Board meeting, the Reserve Bank of Australia (RBA) announced a cut in the policy rate by 25 basis points (bps), taking it to 3.85 per cent.

That reflected a March quarter consumer price index (CPI) report that was good enough, with trimmed-mean inflation at 2.9 per cent, for such a cut.

The Statement noted that RBA staff forecasts now have underlying inflation “expected to be around the midpoint of the 2-3 per cent range throughout much of the forecast period.”

That gives the RBA Board optionality in its consideration of rate adjustments going forward, albeit that optionality in the near-term is between no adjustment and further decline. (The Governor seemed to confirm in her press conference that any near-term notion of hiking is fanciful.)

Importantly, while retaining optionality going forward, the RBA Board Statement highlighted its consideration of a “severe downside scenario”, noting that “monetary policy is well placed to respond decisively to international developments if they were to have material implications for activity and inflation in Australia.”

Such an observation leaves the door open to further policy rate reductions at future meetings, even if any “decisive” response is conditional.

Clearly that scenario reflects some anxiety on the part of the RBA Board that the upending of the global trade system occasioned by the Trump Administration’s tariff agenda will constitute severe headwinds for the global economy in the period ahead. That is the case despite the President walking back some elements of the “Liberation Day” announcements. That walking back only mitigates the damage relative to the baseline of no change. It does not eradicate the damage. In that context, in my assessment, a global recession by year-end remains a reasonable prospect.

The RBA remains implicitly cautious in framing today’s decision as necessarily the continuation of an ongoing sequence of rate cuts at successive RBA meetings but revealed an openness to that occurring.

In somewhat of a counterweight to the potential for a sharp deterioration stemming from international developments, the Statement canvassed some domestic developments that diminished the case for a larger cut or ongoing cuts.

It noted “a range of indicators suggest that labour market conditions remain tight.” The April labour force report revealed a labour market in robust good health with the unemployment rate at 4.1 per cent, amid record high participation rates and surging employment growth.

Wage growth remains reasonable, albeit that continued sluggish productivity growth creates questions around the sustainability of current levels of unit labour cost growth, which in the RBA Board view remains elevated.

It seems clear, however, that the most worrying risk in the near-term is a sharper deterioration in global growth and the consequences of that deterioration for a medium-sized open economy such as Australia’s.

In other words, the RBA may yet institute successive policy rate reductions at future RBA Board meetings, but it is far from a certain outcome and that explains the understandable unwillingness of the Governor to unambiguously pre-commit to such a path.

Nevertheless, Australia’s eschewal of retaliatory tariff measures may give the RBA a less complicated path to attacking the any egregiously adverse consequences of a global trade war. This was perhaps the message around the ability to “respond decisively”.

The absence of retaliatory measures will mean a mitigation domestically of the inflation part of the global “stagflation-lite” scenario, allowing the RBA to cut rates and, if need be, to cut aggressively to forestall a sharp decline in economic growth.

Are risk markets complacent? Beware the bond vigilantes!

I was more than a little surprised to read in my good friend Gerard Minack’s Monday newsletter that global equities, excluding the US, ended last week at an all-time high, breaking a range that has held since 2007 (see chart below). That is, the MSCI All Country ex-US index hit an all-time high, surpassing the prior June 2021 peak.

This puts the index up almost 2 per cent from its October 2007 peak. Not 2 per cent per year; 2 per cent in total. In short, it’s been 18 years of sideways for global equities outside the US while the US market saw stellar gains.

It was not so much the paucity of returns relative to the US in the last 18 years that surprised me. After all, US tech (exemplified and led by the “magnificent 7”) have seen stellar US returns – at least until end-2024. Rather it was that the ex-US index has hit an 18 year high in an environment where a global recession remains a clear and present danger, reflecting the upending of the global trading system occasioned by the Trump tariff agenda.

There are, as Gerard points out, some reasons for this state of affairs. Global equities ex-US had a much larger exposure than the US to the big three booms that drove the pre-GFC cycle: the boom in financials, the boom in emerging markets and commodities, and the economic boom in the European periphery. All three booms then more or less bust. In other words, the 2007 ex-US index base level was inflated.

But I am still perplexed that not only did global equities ex-US hit a record high, but that the US got within striking distance of its February high after bouncing some 17.5 per cent from its post-“Liberation Day” low.

Sure, President Trump has walked back a fair bit of his “Liberation Day” pronouncements. That is an improvement relative to a bad starting point. But the reality is that relative to the pre-Trump 2.0 baseline, the measures currently in the pipeline augur a substantial disruption to global trade architecture, with the attendant economic fallout that entails. That is, the post-“Liberation Day” announcements mitigate the damage, does not eradicate it.

This is occurring against a backdrop that in my mind was already problematic and where bond market vigilantes are becoming a little restless. There are reasons for persistent “sticky” bond yields even in the face of recession risks.

Bond investors may look askance at a US budget deficit already around 6.5 per cent of gross domestic product (GDP). That it got to this level at a time when the economy was close to capacity was not the greatest of Joe Biden’s legacies. The unfunded tax cuts currently navigating the legislative process will agitate bond investors further.

Not that it was a surprise, but the Moody’s downgrade of the US just emphasises the problem. It comes at a time when the market is increasingly uneasy about the amount of bond issuance needed to fund the budget deficit, and when Chinese central bank demand (and other central bank demand) and private foreign investment in US Treasuries (particularly from Japan) is waning.

There is the notion that there are enhanced structural headwinds to inflation, even before the Trump tariff agenda.

Price pressures have been reinforced by the retreat of globalisation of goods markets as governments everywhere (including successive US Administrations) introduce protectionist measures (tariffs) under the often-specious guise of “industrial policy” and “national champions” or “national security”. Immigration restrictions and the exit of baby-boomers from the workforce will also add to inflation pressures via higher wage growth, absent any offsetting productivity improvements.

In the past quiescent inflation has allowed the Fed to respond swiftly to downdrafts in growth. In the current environment, however, “sticky” inflation has robbed the Fed of the flexibility to quickly cut rates, a flexibility that it enjoyed in the two decades or more leading up to the pandemic.

A possible curtailment of the Fed’s independence may also create some issues. While the President has stepped back from his (unhelpful and, in my view, misguided) “fire Powell” rhetoric, there is some prospect of a more “political” Fed when the President chooses Powell’s successor next year. Markets may see a “political” Fed as inevitably resulting in higher inflation, expectations thereof, and as a consequence higher medium and long-term bond yields.

The forgoing has led to some questioning of the long-term durability of the US “exorbitant privilege”, most recently in an European Central Bank (ECB) financial stability report released overnight.

All this is a way of questioning whether risk markets have got too complacent. Global equities ex-US got to record highs, and the US got within striking distance of a record high, even while inflation remains elevated (and might reasonably be expected to remain so) and when “sticky” (or higher) bond yields may constitute under-estimated headwinds to equity performance.

Beware the bond vigilantes.