Via the excellent Damian Boey at Credit Suisse:
As leaked earlier today in the press, the RBA cut the cash rate by 25bps to 0.25%, the effective lower bound. It provided forward guidance to the effect that it will not raise the cash rate until it sees progress on jobs, and inflation back within the band. It also announced plans to purchase bonds out to the 3-year horizon, with a view towards yield curve control (ie keeping rates out to the 3-year horizon fixed at 0.25%).
Presumably, the goals behind the bond purchase program are to:
- Limit volatility in fixed income markets, after a recent surge due to risk-parity-related selling of bonds and commodities.
- Reinforce forward guidance that rates will not be increasing over the next few years from 0.25%
- Massage down longer-term borrowing costs to the extent that the private sector does borrow at intermediate fixed rate horizons.
However, the problem with announcing yield curve control out to 3 year maturities is that the Bank has implicitly conceded that long-term bond purchases do not work to stimulate anything.
In our view, the RBA has announced measures largely because it said it would do so on Monday morning. There is very little in the announced package that will effectively stimulate activity growth. And nor is it clear that stimulation should be the primary objective, as opposed to ensuring that the system remains liquid and that businesses remain “going concerns” during the COVID-19 shutdown phase.
If stimulation is the goal, we are disappointed that the RBA has not tried to target semi-government bonds to make state government borrowing a risk free exercise, and therefore enable more fiscal spending. We understand that at this juncture, foreign exchange management is an unnecessary objective, given that the currency is undershooting equilibrium by 23% at present. However, it might have been nice to try flooding the system with liquidity anyway, and make things a little more “Chinese”.
In response to the RBA announcement, bond yields out to the 3-year horizon have fallen – but longer-dated bond yields have experienced another sharp leg higher. 10-year government bond yields spiked to nearly 2.5% before receding from their highs – a record sell off. And bond-related equity exposures have not enjoyed the volatility in bond yields either.
We have concerns here about implementation. The RBA said that it will rock up to the market to buy bonds at 11:15am each working day in exactly which segments of the curve it plans to participate in. But the BoJ did the same thing a few years ago, only to discover that bearish bond investors were concentrating their selling around the times the BoJ was not active in the market. As noted in previous updates, it is not entirely clear that the central bank acting as the buyer of last resort really does improve liquidity and reduce volatility in the bond market. Therefore, the key driver of the selling in bonds stopping is simply the improvement of liquidity and volatility due to other factors (eg such as the absence of large scale risk parity selling).
Overall, we feel the RBA would have been better served not doing anything today. That is how effective the stimulus package is likely to be, compared with the cost of lost credibility. And lost credibility is clearly contributing to greater illiquidity and higher volatility, the very things that the RBA should want to avoid.
This is not stimulus, it is basic lender of last resort functioning. The RBA is aiming to stabilise the risk free rate, or the entire system will melt down.
Questions around implimentation are doubtless important but they are secondary to just getting this done. They have the firepower and should use it. The RBA could eat the entire Australian bond market at $600bn without getting indigestion.
Just further to our previous RBA update, in all of the rhetoric around the start of quantitative easing, it is easy to miss the fact that the RBA cut rates, without doing anything special to lower bank “funding” costs (which incidentally have spiked higher). This means that either the banks pass on very little of the 25bps cut, or they pass on a lot, and experience a sizeable margin squeeze.
What officials could have done was to highlight term repo operations to bring down bank bill swap spread to overnight indexed swaps. They might have also considered running a targeted long-term repo operation like the ECB and BoE have in years past.
But at the end of the day, officials did neither of these things. It seems that the purpose in cutting rates all the way to the effective zero bound was to get on with the business of (ineffective) quantitative easing. After all, quantitative easing involves flooding the interbank system with more reserves than it needs, which mechanically drops rates to the zero bound. And considering that the RBA runs an interest rate corridor policy to target the cash rate, the lower bound of zero has now come into view.
There is a school of thought that quantitative easing could be very positive for Australian financials, even if the path to getting there is not very comfortable. We are now going to test out this line of thinking. The reality is that the path to quantitative easing does involve net interest margin pressures on the banks. And we need to remember that desperate measures are put in place because of desperate times. Therefore, investors will face the ongoing temptation to look through stimulus to the underlying bad news driving it.
Where exactly are we along this progression? It is hard to tell. We have only just cut rates effectively to zero. The banks need to respond. We have not yet seen bad debt provisioning rise ahead of businesses shutting down because of COVID-19. And most importantly, credit conditions globally are quite disorderly.
It does not feel like the system is out of the woods yet. If anything we are just walking into them.
I watched the bond market freeze after the RBA announcment. For ten minutes yields barely budged (on my screen anyway). It was a snapshot of monetary failure. We are not out of the woods.
But the RBA has made a good step . The market can’t dump the short end now which should anchor the long to some extent and, if needs be, the bank can shift purchases out the curve. It already said it will buy across durations. Another positive.
The RBA has also anchored bank term funding and the banks won’t be asked to pass any of the cut through variable mortgages. This is about stabilsing the banking system with cheaper funding and expanded margins, not stimulus.
There should be cheaper business lending as well.
This was a good package by the RBA delivered into the most extreme monetary conditions of my lifetime. They are late to the party but have done well now that they are here.