More on the RBA’s new forward guidance

From Phil Lowe yesterday:

“It is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the 2-3 per cent target range,” Mr Lowe said. “It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range.”

And The Australian today:

Mr Lowe later downplayed the comments, saying they were just an act of policy transparency, something he is always keen to do.

“I wouldn’t describe this as a shift in approach to a kind of explicit forward guidance. It’s just consistent with this view that I’ve long had that we need to be as transparent as we can,” he said.

But economists and markets are reading more into it. “This looks like explicit conditional forward guidance to us … regardless of how it is termed, we see it as a device aimed at flattening the yield curve,” said David Plank, head of Australian economics at ANZ.

Looks like it to me too. More via the excellent Damien Boey at Credit Suisse:

Yesterday, we saw both the RBA and ECB deliver dovish forward guidance:

  1. The RBA committed to its inflation target, with Governor Lowe suggesting that rates will not be rising for quite some time, and that the Bank has optionality to cut further if needed.
  2. The ECB paved the way for rate cuts, rate cut tiering and potential expansion of asset purchases in September, with President Draghi noting that growth and inflation are persistently undershooting, and that the Bank is serious about returning to target.

In response to the RBA’s forward guidance, bond yields fell. In response to the ECB’s forward guidance, bond yields fell, but later spiked higher. Three different reactions to two examples of forward guidance.

First on the RBA. It is quite unusual to see forward guidance employed the way the Bank has. In the past, the RBA has tended to give guidance on the rates outlook in so far as it has a particular easing or tightening bias. But we have not seen the Bank commit to lower for longer rates like it did yesterday. Perhaps the RBA is channelling former Fed Chair Bernanke’s “price level targeting” – where persistent inflation undershoots need to be matched by persistent inflation overshoots in order to maintain credibility. Certainly, the Bank does have a credibility problem because it has persistently overestimated growth and inflation over the past decade. And right now, bond markets are suggesting that the Bank does not even have the medium-term credibility to hit its 2-3% through-the-cycle inflation target, because 5-year, 5-year forward inflation expectations (ie expectations after abstracting from near-term cyclical factors) are sitting only at 1.5%. Yet if it was the Bank’s intention to jawbone longer term inflation expectations higher, clearly the attempt did not work (at least, immediately). And we also note that in Australia, because no-one borrows at the long-end of the curve, lower bond yields cannot be considered stimulus. The best the Bank can hope for is to give households greater confidence with which to gear up on low rates and easy credit, and to keep the currency lower than it otherwise would be.

Second on the ECB. There are several possible interpretations of the “schizophrenic” market response:

  1. The optimists will argue that investors eventually came around to the view that easing measures will work, consistent with reflation, curve steepening and higher bond yields.
  2. The contrarians will argue that the ECB put will compress peripheral European spreads to bunds, “making European peripheral bonds great again”. The flipside is that this causes bonds elsewhere to look relatively less great. In other words, if there has been pricing dislocation in US Treasuries, bunds, Japanese government bonds and Australian Commonwealth Government securities of late, because investment grade managers have decided not to buy peripheral European bonds for fear of low quality, then these dislocations should be unwinding.
  3. The pessimists will argue that low liquidity is starting to manifest in bond markets, and that “black swan” events will happen. After all, if the central bank is the only one on the bid, then what happens when that bid fades or disappears?

Equity market investors did not know what to do with the rise in bond yields post-ECB. One would have thought that curve steepening and higher bond yields would have been marginal negatives for defensive momentum trades. But alas, the trade has reared its head again. Apparently, equities cannot handle higher bond yields, and so low-beta stocks outperform even as bond yields rise, because they weaken less than a falling market.

A famous asset allocator once said that there are only three factors that matter: trend (momentum), carry (value) and liquidity. Most investors are well aware of trend and carry. But few focus on liquidity. And it is the overlooked risk factor which could end up being highly problematic. If low liquidity in bonds is a problem, and we do see more increases in yields simply because they have no-where else to go, the risk is that value starts to outperform quality and bond proxies. The complication is that low liquidity could undermine the performance of all factors to a degree. But in these sorts of times, it pays to have more diversification in one’s portfolio, because low liquidity should increase our investment and turnover horizons. We cannot all rush for the exits at the same time!

We think that on an intermediate horizon, the best ways to uncorrelated portfolios right now are to:

  1. Seek out commodities as a second-best defensive asset class to bonds with optionality to capture reflation
  2. Take a more constructive look at factors that have not worked recently, like value.

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