The RBA needs Operation Twist

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Macro Afternoon

Via Bloomie:

While bets on steepening yield curves are growing in popularity, money can also be made in countries that already have one and that’s drawing investors Down Under.

Thanks to Australia’s yield-curve control policy, its bonds have the steepest curve among major sovereign markets, according to two- and 10-year note data compiled by Bloomberg. Investors can exploit that difference by borrowing at lower shorter-term rates and investing higher up the curve.

For example, a trader could employ a “carry-and-roll” strategy, borrowing over a short time period at relatively cheaper rates and putting the proceeds into longer-term higher-yielding bonds. Players then earn “carry” from the bond’s coupon and “roll” from its capital appreciation as the note slides down the curve toward maturity. The steeper the yield curve the greater the opportunity.

“What I have learned from Australia is that a yield curve control policy targeting short-term yields can steepen the curve from time to time and make the debt attractive,” said Akira Takei, a Tokyo-based global fixed-income money manager at Asset Management One. “Investing in a bond market where the curve is steep like Australia generally turns out to be a winning bet.”

The RBA needs to deploy a new Operation Twist:

The name “Operation Twist” was given by the mainstream media due to the visual effect that the monetary policy action was expected to have on the shape of the yield curve. If you visualize a linear upward sloping yield curve, this monetary action effectively “twists” the ends of the yield curve, hence, the name Operation Twist. To put another way, the yield curve twists when short-term yields go up and long-term interest rates drop at the same time.

Operation Twist first came about in 1961 when the Federal Open Market Committee (FOMC) sought to strengthen the U.S. dollar and stimulate inflows of cash into the economy. At this time, the country was still recovering from a recession following the end of the Korean War. In order to promote spending in the economy, the yield curve was flattened by selling short-term debt in the markets and using the proceeds from the sale to purchase long-term government debt.

The RBA’s yield curve control can remain in place while it explicitly flips some asset purchases to the long end of the curve. This will flatten it and cut off the motivation for the carry trade that is lifting the currency.

One might argue that in doing so the bank will be sending a negative growth signal but that’s paralysed thinking. Growth is buggered whatever they do. This is about mitigating that as best they can.

To do so the bank should seek to crush the curve further out which will help lower the currency. The usual objection to this is that it will hit bank profits. In the US this is true given mortgage rate are set by the 30 year mortgage.

But in Australia they are set at the short end by the cash rate with some input from funding costs at the long. So, if the RBA were to conduct an Operation Twist then bank funding cots would actually fall and profitability lift. Some of this may even be passed on to mortgages though I doubt it given other huge headwinds for bank earnings.

That’s a by-the-by anyway. The main purpose of Operation Twist is to pressure the currency without doing harm to credit markets.

David Llewellyn-Smith
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