Strategy commentary cont'd:

June was a mixed month for equities and bonds. Whereas US stocks finished strongly (S&P500 up 5.0% while the Nasdaq was up 6.3%), European and UK equities declined (Eurostoxx 50 down 1.18% followed by the FTSE100, which fell 0.13%). Bourses in Australia (ASX200 up 1.4%) and New Zealand (NZX50 up 1.5%) fared better.

Strategy commentary cont'd: This price action echoed the mixed moves in global interest rate markets. Helped by benign inflation outcomes, 10-year government bond yields dropped in the US (-17bps), UK (-16bps), Australia (-9bps) and New Zealand (-4bps). By way of contrast, 10-year government bond yields rose in France (+13bps) and Germany (+11bps). One dynamic that helps explain this disparity is the recent shift by European governments to commit a much larger share of their budgets to defence spending after Trump convinced NATO countries to lift their investment to 5% of GDP. This has fuelled concerns about the quantum of public debt that will need to be issued to provide the funding for this spending.

Coolabah has long argued that investors should expect higher term premia or greater excess returns from long-term bonds over overnight cash instruments as compensation for inflation volatility, fiscal uncertainty, and the growing supply of public debt. In the US, 10-year government bond yields have historically paid a total nominal term premium of about 100 basis points above cash. If one takes the Federal Reserve's estimate of its neutral or normal cash rate of circa 3% at face value, this implies that 10-year government bond yields above 4-4.5% in the US could be attractive entry points for investors hunting for fixed-rate duration exposures.

While investment-grade cash credit spreads were globally tighter in June (US 4bps tighter; Europe 8bps tighter; UK 9bps tighter), this was not true in Australia where corporate (+2bps) and senior-ranking bank (+2bps) spreads drifted wider. One headwind in the Antipodes was the volume of supply with A$24bn of issuance in June, which was powered by financials (A$13bn) and senior-ranking bank bonds specifically (A$11bn). Supply is expected to be more muted as we head into the northern hemisphere's summer. During this time many issuers and investors are on holidays, which creates a seasonal lull in global supply.

Why we may be on the cusp of a more stable global order

Superficially, financial markets are telling us that the Reserve Bank of Australia is certain to continue its process of normalising interest rates next week.

The market is 100% priced for a 25 basis point cut in July, which would reduce the RBA's official target cash rate from 3.85% to 3.60%.

There has been one dissenting journalist, James Glynn, who has repeatedly argued that Martin Place could pause in July. This view attracted attention because Glynn previously predicted that the RBA would deliver a third rate cut in July following the soft May inflation release.

The latter revealed that rolling 12-month core (or trimmed mean) inflation declined from 2.8% in April to 2.4% in May, ostensibly below the RBA's 2.6% expectation and the 2.5% midpoint of the RBA's target band.

We don't trade individual monetary policy decisions because interest rate markets are supremely efficient, embedding a great deal of public and private information about decision-making probabilities.

It is, therefore, hard to make money consistently betting against the policy paths implied by interest rate derivatives, despite the propensity of many traders to try to do so.

On a meeting-by-meeting basis you are also grappling with the vagaries of the difficult-to-anticipate human condition. Among central banks, the RBA is notorious for its supercilious ways and desire to continuously demonstrate that it is the smartest player in the room.

This has not, however, tended to work out well for the monetary mandarins. Yet the RBA's capacity to surprise never ceases to amaze. This column has a very simplistic take on the situation. Inflation is in the RBA's target band and has been extremely well-behaved.

The highest-quality reading on consumer price pressures is rendered by the quarterly (as opposed to monthly) prints.

Strategy commentary cont'd: The next update will be the June quarter data, available on July 30. Following its last rate cut in May, the RBA published a revised estimate of the normal (or neutral) target cash rate that is likely to prevail, on average, over the course of the business cycle.

This was marked down from 3.6% in November last year to 2.7% in May. While there are some who believe that the neutral rate that is neither stimulatory nor contractionary might be a touch higher, there is a case that the policy remains in reasonably restrictive territory.

The RBA has signalled that it wants to move towards a more normal footing, which would, as a minimum, place the cash rate in the 3% to 3.5% vicinity. It could chisel rates lower in July, noting that the second quarter inflation data published at the end of the month will provide valuable insights on how much wood is left for policy to chop.

That is to say, it will retain considerable optionality regarding future decisions in the event that the June quarter data comes in a little too hot. And taking the RBA's empirical research at face value, a 3.6% cash rate is still likely to be exercising a restraining influence on activity.

Here it is worth recalling that before the pandemic in early 2020, the RBA's cash rate was sitting at just 0.75%. Only a few years ago, some of the best economic brains in the business felt that neutral was probably around 2%.

Since the RBA lowered rates in May, the Aussie dollar has appreciated, as has the trade-weighted exchange rate, which at the margin should work to further mitigate inflation pressures.

The risk of a dramatic appreciation in the price of oil has also been ruled out as a result of the sudden cessation of hostilities between Israel and Iran following US President Donald Trump's dramatic intervention. (It must frustrate diplomats and foreign policy experts to see the hyperbolic Celebrity Apprentice host suddenly bringing peace to the Middle East!)

And then there is a case that Australia's robust population growth rate is providing more than enough new labour supply to keep a lid on wage-related inflation drivers. On our own modelling, the June trimmed mean inflation pulse should print at about 0.7% for the quarter.

This is slightly above the RBA's latest 0.6% projection, although below its prior 0.8% forecast. The bottom line is that it should not be view-changing vis-à-vis the RBA's direction of travel, which is a gradual progression towards a more neutral cost of capital.

Martin Place's broader thesis that the trade war could precipitate disinflationary forces in Australia remains well and truly intact. The hard modelling implies that the near-term risk to local consumer prices is to the downside as global exporters pivot their goods away from the increasingly closed US market and dump them on small open economies like Australia.

Having said all of that, anything is possible when it comes to the RBA, which has historically displayed a perverse fixation with trying to prove market pricing wrong.

On the subject of uncertainty, there are signs that there may be changes afoot in China. Historian Niall Ferguson recently pointed to analysis suggesting that President Xi Jinping could be on his way out.

This fall from grace has allegedly been engineered by Xi's predecessor, Hu Jintao, whom Xi sensationally had physically removed from the 20th Party Congress in 2022.

Dozens of People's Liberation Army generals, who were loyal to Xi, have been purged or mysteriously taken their own lives. Former US diplomat Gregory Slayton claims Xi is "likely to retire at the CCP Plenary Session this August or take a purely ceremonial position".

Strategy commentary cont'd: "Zhang Youxia, with whom Xi had a major falling out after helping Xi secure an unprecedented third five-year term, is now the de facto leader of the PLA," Slayton maintains.

Ferguson responds that this is "big if true". Xi's relentless attempts to compete with the US as the globally dominant military superpower and economic hegemon have precipitated Western efforts to strategically decouple from China, which is no longer regarded as a trustworthy counterparty.

Xi's departure could, as a consequence, be a crucial turning point for the world, especially if his successor rejects the idea of the inevitability of conflict between capitalism and socialism with Chinese characteristics.

"Although not yet certain, it appears that Zhang Youxia and CCP elders have chosen Wang Yang, whom Deng Xiaoping lifted out of obscurity and who served as a successful technocrat until his forced retirement in 2023, to be the next CCP chairman," Slayton says.

Importantly, Wang Yang is believed to be a "soft-spoken reformer who supports more free-market policies, more decentralised decision making, and a much less confrontational foreign policy".

The burgeoning strategic tensions between China and the US have shaped the world in recent decades, cleaving it into competing democratic and authoritarian blocs in both trade and military terms. They have also raised the probability of real kinetic conflict between the major powers over the future of Taiwan.

Although it is perhaps a glass half-full take, we could be on the cusp of a more stable regime involving a ceasefire between Russia and Ukraine, peace in the Middle East, and a benign China that wants to once again capitalise on the prosperity that the liberal democratic world has bequeathed through free trade, open markets, and durable property rights.

The end of the COVID-era migration boom

In terms of the overhang from the pandemic, population growth boomed across nearly every advanced economy in the wake of COVID, but that boom is over.

That is, most countries saw their populations broadly stall at the height of COVID and some saw their populations shrink a little.

As borders re-opened, pent-up demand saw massive migration flows boost populations across nearly every advanced economy (Japan was unusual, in that its population briefly fell at a slower rate, while the flows into the euro area were boosted by Ukrainian refugees).

Now, populations are growing back in line with pre-COVID averages and sometimes below.

US population growth – which seems likely to fall further as the new administration deports illegal immigrants and refugees – has eased to an annualised rate of about 0.5%, matching the immediate pre-pandemic experience, which was the lowest growth in the history of the republic.

Japan's population is contracting at an annual rate of about 0.5%, while the euro area's population is back to barely growing, increasing at an annualised rate of about 0.25%.

The UK's current population growth is hard to judge, though, as recent annual estimates are ONS forecasts.

Canada's population, which experienced a massive post-COVID surge, is back growing at an annualised rate of about 1%.

Australia's population growth has also slowed to an annualised rate of about 1.5%, also in line with pre-COVID readings, but still at the high end of advanced economy experience.

Strategy commentary cont'd: Across the Tasman, the adjustment has been more abrupt, with annualised growth slumping to about 1%, which is at the low end of the range of the past few decades.

Why does the end of the migration boom matter? The return to slow population growth – where Australia is still an outlier – points to slower growth in potential output.

Other things being equal, slower growth in potential output should resume placing downward pressure on central bank neutral policy rates.

However, other things are not equal, and an increase in defence/AI-led investment, as well as spillovers from investment to productivity growth, should counteract this demographic drag.

The RBA marks down the neutral cash rate again

In figures released from the May Statement on Monetary Policy, the RBA has revised down its average estimate of the nominal neutral cash rate from 2.9% in February to 2.7% in May, where the neutral rate is what the RBA will steer the cash rate towards if it can successfully return inflation back to the 2.5% target.

The May revision followed an unprecedently large downward revision from 3.6% in November to 2.9% in February, where the RBA made similarly large downward revisions to its historical estimates of the neutral rate as far back as the early 2010s (past post-COVID vintages of RBA staff estimates averaged around 3.5% through successive revisions).

At the same time, uncertainty around the estimated neutral rate – as approximated by the difference between the highest and lowest estimates of the neutral rate – has ballooned from 2.7pp to 3.2pp, which is a much higher sustained level of uncertainty than for any past RBA calculations of the neutral rate.

The RBA estimates of the neutral rate, which are currently derived from seven different approaches, contrast with surveyed economist estimates of the neutral rate, which the RBA now adds to its chart of staff calculations.

That is, as at May, the median economist estimate of the neutral rate was unchanged at 3.5%, having held around that level for more than a year now.

The low average staff estimate of the neutral rate also contrasts with Deputy Governor Hauser's remark late last year that the neutral rate was probably around 3.5-3.75%.

Strategy commentary cont'd: More interestingly, the low average rate does not seem to gel with the RBA's May updated economic outlook, which forecasts that underlying inflation will settle at 2.6% for the next couple of years based on assumed market pricing that has the cash rate falling to 3.2%.

This outlook seems inconsistent with the neutral rate calculations, in that if the neutral rate is actually 2.7%, then the higher assumed cash rate over the entire forecast horizon implies persistently tight monetary policy that would presumably see underlying inflation edge below the 2.5% midpoint (although the RBA's MARTIN macroeconometric model estimates that the cash rate has a gradual impact on inflation, the RBA's separate DINGO – yes, you read that right – DSGE model incorporates a more immediate effect).

All this raises the possibility that RBA policy-makers are not taking the downwardly-revised staff estimate of the neutral rate at face value, which means that it may have less influence on how far the RBA cuts rates, assuming that inflation continues to slow over the next year and that the fallout from the US-led trade war is manageable.

Strategy commentary cont'd: