Westpac Market Outlook May 2022
Our latest thinking on Australia, markets and the global economy
Central banks have again taken centre stage. In our April Market Outlook, we highlighted that “central bankers changed their tune, asserting their determination to respond to the inflation challenge”. This new found determination was on full display over recent weeks. An RBA tightening cycle is now underway, with the RBA lifting rates by 25bps to 0.35% at the May meeting, the first rate increase since late 2010. The decision was accompanied by a significant upward revision to the RBA’s core inflation forecast profile, to 4.75% for this year, up from 2.75% in February. This challenging inflation outlook points to a front-loading of rate hikes by the RBA. We anticipate a 40bps move to 0.75% in June, with the cash rate rising to 1.75% by year end and then a peak of 2.25% in mid-2023.
As foreshadowed by US Fed Chair Jerome Powell, the FOMC delivered a 50bps rate hike in May, taking fed funds to 0.875% up from 0.125% at the start of the year. Long dated bond yields both in the US and Australia soared over the past couple of months as the scale of the inflation challenge has become clearer. Australian 10 year government bonds have jumped to around 3.5%, about 45bps above US 10 years, and sharply up from 1.7% a year ago. We expect Australian 10 year bond yields to consolidate above the 3% mark moving into the second half of the year, before moderating to 2.35% by end 2023.
The Australian dollar has taken on a softer tone and is likely to remain so near-term against the backdrop of an earlier tightening cycle by the US FOMC. Over the second half of 2022 and through 2023, the AUD will likely find its feet, advancing to US80¢ by end 2023, supported by elevated commodity prices and the RBA tightening until mid-2023, whereas the FOMC goes on hold from end 2022.
Australia: While a strong expansion of the Australian economy is still in prospect for 2022, led by the consumer, we have moderated the profile for output growth. Higher inflation and an earlier and more compressed RBA tightening cycle will begin to impact in 2022, squeezing household incomes. Growth will cool appreciably in 2023 and 2024, with household balance sheets to come under some pressure as interest rates rise. We now expect output growth of 4.5% this year, which will see the unemployment rate decline to an historically low level of 3.2%, with growth slowing to 2.5% in 2023 and then slipping to a below trend pace in 2024, at 2.0%.
Commodities: Most commodities softened in April, except for coal which had a robust rally. Central banks are normalising rates and commencing quantitative tightening, providing a boost to the US dollar and weakening commodity prices, particularly precious and base metals. Following the Russian invasion, supply disruptions, as well as increased demand by the EU to replace Russian gas, drove a 36% surge in thermal coal prices while tight supply is supportive of iron ore prices.
Global FX markets: Developments in Ukraine and the consequences for Europe have provided a strong bid for the US dollar this month, so too US rate expectations at fever pitch. Both factors are likely to at least partly reverse through the remainder of 2022 and 2023 as downside risks for global growth abate. Despite the threat of COVID-zero, China holds the greatest promise for upside surprises.
New Zealand: Inflation has hit its highest level in more than three decades in New Zealand. This and the related risks for inflation expectations have got alarm bells ringing at the Reserve Bank of New Zealand. The Monetary Policy Committee hiked the Official Cash Rate by 50bps in April and we expect that will be followed by a series of further hikes over the coming months.
United States: Having delivered a 50bp hike at the May meeting, the FOMC then made clear that additional 50bp rate hikes are likely at its June and July meetings. While a dramatic change, the May communications made clear these decisions are not being made in fear but rather in recognition of the distance to neutral and the uncertainty at play. Into year end, risks to growth and inflation will balance, allowing the FOMC to go on hold at 2.625% in December, a rate we view as consistent with contractionary policy.
China: GDP surprised the market in Q1 and, come Q2, trade and investment are again set to provide resilience against the negative consequences of the Chinese authorities’ tough stance against COVID-19. In the second half of 2022 and beyond, momentum will increasingly come to depend on the consumer, with pent-up demand, sentiment and income gains to provide support.
Europe: Russia’s invasion of Ukraine has resulted in a material slowing of activity growth in Europe. Ongoing supply-side issues have weighed heavily on business confidence and investment, and broadening price pressures are threatening real incomes and consumer demand. The tight balance between inflation and growth risks warrants a highly conditional policy normalisation process for the ECB. The BoE, in delivering a 25bp rate hike to 1.0% in May, surprised with a materially weaker growth outlook and an expectation for higher and longer-lasting inflation, highlighting an incredible policy challenge to manage longer-term inflationary expectations.