This time via the excellent Damien Boey at Credit Suisse:
It has been widely reported in the press that the RBA and APRA are considering cutting the interest rate applied to debt serviceability tests for mortgages by 50bps. The implication is that perhaps an actual rate cut may be unnecessary, if this measure is effective in loosening lending standards.
From an investment perspective, we have written recently about our new, curve steepening view. If the press reports are correct, and the measures being considered are effective, perhaps there is room for bear steepening of the curve as rate cuts get priced out. That said, we see a number of serious issues with what is being proposed.
In the first place, relaxation of debt servicing criterion would benefit new borrowers – but not existing borrowers. And existing borrowers need a bit of help – especially when we consider the large pipeline of interest only loans resetting to principal plus interest terms. Therefore, actual rate cuts, rather than theoretical rate cuts are needed.
Secondly, we have written about the new regime of central bank (direct) volatility targeting. In the past, central banks would reduce cash rates, bid up bonds and credit, to indirectly lower volatility in financial markets and encourage re-leveraging. But now that we have seen limits to the effectiveness of these measures (notably the deflationary impact on savers from the removal of net interest income from the private sector), central banks are instead going for the jugular, and targeting volatility directly. Anything but rate cuts apparently to deliver easing. Volatility is the new asset class in town, and volatility cuts are the new policy lever. Cue the research on variance risk premia.
In the Fed’s case, there is the implied room to cut rates, and scope to adjust balance sheet, which are supporting lower volatility, even before actual measures have been undertaken. Indeed, the Fed created room to do this by raising rates and reducing balance sheet to begin with, causing the melt down in financial markets at the end of 2018. We suspect that central bankers are concerned about the potentially perverse consequences of these conventional measures, and are therefore avoiding them for as long as possible, even as they extend the hope of adjustments to bring forward lower volatility to the present.
In the RBA’s case, there may be some room to relax lending standards, because they and APRA tightened them to begin with. In this context, the reported changes to debt servicing criterion are interesting. But like the example of the Fed, we cannot help but think that monetary policy makers are willing to explore any and all easing except for actual rate cuts, because they are concerned that these cuts will not work as intended.
Overall, we see a very unstable and fragile equilibrium at work. For as long as the re-struck Fed put is effective, and bought into by investors globally, the RBA can free ride on this put. Value investing can make a comeback. But once investors sense that the put is over, or no longer effective, we could very quickly see a flight to quality resume.
In our case the volatility will be squeezed into the currency, which will rocket, meaning the attempted targeted easing will actually deliver a broader economic shock, as well as:
- encouraging regulatory capture of APRA two months after the Hayne Royal Commision into regulatory capture;
- hiding monetary policy in the shadows;
- delaying the much needed structural shift to non-mining tradables, and
- materially cutting into Budget revenues via a higher than forecast dollar that lowers nominal GDP offsetting the current commodity boom.
Just cut the bull and interest rates.
