From Westpac chief economist, Bill Evans:
I was surprised to note in the RBA Governor’s Statement following the September Board Meeting that “The Board will maintain highly accommodative settings as long as is required and continues to consider how further monetary measures could support recovery”.
This is the first time since the major policy changes in March that the Board has noted the possibility of “further monetary measures”.
That could mean even more easing of the current policy stance or a new approach to policy easing.
Current policies are exerting strong downward pressure around the three year part of the curve.
Both the Term Funding Facility (three year funding to ADI’s at 0.25%) and the targeting of the three year bond rate at 0.25% have put downward pressure on that part of the curve.
By targeting the three year rate and “jaw boning” that the Bank does not expect to be raising the cash rate any time before the end of 2023 it has guaranteed a flat curve.
With matched funding available from the TFF ADI’s can lock in an attractive three year margin given, for example, that the three year fixed mortgage is still around 2.35%.
Surprisingly, to date, ADI’s have been reluctant to use the TFF.
At September 1 when the RBA increased the facility by $57 billion ADI’s had only drawn down $52 billion of the available $152 billion.
That included an initial allowance of $84 billion and plus $68 billion from the Additional Allowance.
The Additional Allowance is linked to lending from 31 January 2020 to 30 April 2021. After seven months of this fifteen month arrangement ADI’s have qualified for that $68 billion.
Arguably that balance could build by a further $80 billion if ADI’s continue at the current pace of net lending.
Consequently the RBA could be providing three year funding to the ADI’s of up $300 billion by 30 June 2021.
Westpac forecasts that the 2020/21 Commonwealth Budget deficit will reach $230 billion (following a deficit of $85.8 billion in 2019/20); to be followed by a further $150 billion in 2021/22.
Markets are now speculating that this sharp increase in the bond supply will accommodate a winding down of the Committed Liquidity Facility that the Reserve Bank has provided to ADI’s to meet their regulated Liquidity Coverage Ratio (LCR).
Until this surge in actual and prospective bond issuance the Reserve Bank allowed ADI’s an estimated (by December 2020) $226 billion in CLF to complement $243 billion in holdings of (AGS and semis) to reach the necessary holdings of $469 billion in LCR.
It is now almost certain that the RBA will gradually wind back the CLF as more AGS and semis will be available for the ADI’s to reach their LCR requirements. Prudent policy emphasises the need to be gradual since ADI’s will be required to implement considerable adjustments to their portfolio mixes particularly at the margin as new deposit growth which will result from the government’s increased deficits and the RBA’s ongoing QE program (offsetting the liquidity effect of new bond issuance) will need to be disproportionately allocated to AGS and semi’s.
ADI’s purchasing more AGS will certainly assist the RBA in achieving its three year bond target and may, in time, embolden them to extend the rate targeting further out along the curve.
We know that the Governor rationalises the three year target at 0.25% because he does not expect the cash rate to rise over the next three years.
I expect he would be reluctant to send a comparable message about the five year bond rate but may choose to “flatten the curve” by targeting a five year rate that is above the cash rate but significantly below the current five year rate.
That is possible but bear in mind the original motivations for the RBA to buy bonds in the first place.
1. To target a rate that would be important for private borrowing rates.
2. To stabilise the bond market in the aftermath of the Covid shock.
The five year part of the curve may qualify under (1) although longer maturities would not be seen as relevant to private borrowing rates.
Enticing the ADI’s into the longer end of the curve as CLF is wound down would also be an unlikely outcome.
But the availability of up to $300 billion in the three year TFF would also pressure the three year part of the curve.
The strategy to lower the three year rates is working.
The three year fixed mortgage rate has fallen from 3.5% to 2.3% since November whereas the cash rate has only fallen by fifty basis points.
In recent months there has been a surge in the mortgage market to switching from floating rate to fixed rate.
The 44% increase in refinancing of housing loans in June was largely due to this switching.
For now, the housing market appears to be recovering (with Victoria being the obvious exception). Housing finance (new lending) for July is now only 3% below its pre COVID levels.
The share of fixed rate loans in ADI’s portfolios has moved towards 25% from the previously accepted 20% level.
In previous economic recoveries following recessions or significant slowdowns aggressive rate cuts have been a hallmark of RBA policy.
With the cash rate at 0.75% coming into the COVID recession the RBA had limited scope to cut rates given its avowed resistance to negative rates.
The channel through which rate cuts had the most immediate effect was housing so with other policies – yield curve control; TFF targeted at the three year part of the curve the disproportionate fall in the three year fixed rate and the early evidence that the housing market is responding will be of some comfort to the RBA.
But risks are looming.
Firstly, APRA reported today that there are $240 billion in loan deferrals in July (down from $274 billion in June). The value of deferred housing loans fell from $195 billion in June to $167 billion in July but the value of small/medium enterprises remained at around $55 billion.
The RBA may be concerned that the nascent recovery in housing will be severely impacted by a surge in distressed sellers in the housing market in 2021 once lenders insist on a resumption of payments.
The best “defence” against a sharp lift in supply is to stimulate demand.
Another reason why the RBA might be disposed to further stimulus is that it is forecasting that the unemployment rate is set to increase to 10% by December from the current 7.5%.
We estimate that would mean further job losses of nearly 300,000 – a very disturbing outlook.
We expect that is way too bearish with our forecast unemployment rate at 7.8% by December so assume that as time passes the Bank will need to revise down its current forecast.
On a number of occasions the Governor has raised the possibility of cutting the cash rate to 10 basis points from the current 25 basis points.
That rate would match the current BBSW since BBSW is reflecting the ADI’s rate on deposits with the RBA. ADI’s, which are flush with liquidity due to the government fiscal stimulus and early withdrawal of superannuation, are prepared to lend at the ten basis points they currently receive on their deposits with the RBA (ESA).
As discussed the effective rate in the market which is driving BBSW is the rate paid by the RBA on ESA funds.
Were that rate to be reduced to, say, 1 basis point then, theoretically BBSW could fall to 1 basis point.
At a time when the RBA is likely to be purchasing a high volume of bonds to fund the forecast budget deficit of $230 billion.
For example, recall that with a Budget deficit of $85.8 billion in 2019/20 saw RBA purchases of around $50 billion in AGS. RBA purchases of bonds from the market will see an equal lift in ADI’s balances in the ESA.
In dismissing the prospect of a negative cash rate the RBA Governor referred to “stresses in the financial system”– presumably implying the negative impact on bank profits of negative rates. Such a reduction in the ESA rate at a time of extensive QE where ESA balances can be expected to soar would certainly impact bank profitability.
It is also not certain whether BBSW would fall all the way to 1 basis point.
But such a move would allow the RBA to lower its target rate on the 3 year bond rate.
It could use the consistent argument that it did not expect the cash rate to rise for three years. Most forecasters would agree that the lower cash rate would not sufficiently impact inflation and employment to significantly bring forward expectations of the timing of the first rate hike.
Changing the three year target would impact the whole yield curve although there would be a significant steepening of the curve, particularly when the ADI’s would not be active in the long end despite their increased bond targets as the CLF is gradually wound down.
Of course further downward pressure on the three year bond rate would assist in lowering the three year fixed mortgage rate.
That would provide further stimulus to demand particularly in the event of a damaging shock to supply from a surge in distressed dwelling sales.
Furthermore, perhaps the RBA could announce a renewed tranche of TFF at 10 basis points for three years, providing more stimulus through the ADI’s.
Other possible further stimulus through currency intervention; or sharply boosting its balance sheet by accommodating aggressive fiscal stimulus are most unlikely at this juncture.
The Governor believes that the AUD is currently around fundamental value and policies to lower it would not be effective.
Accommodating a build-up in government “IOU’s” on the central bank balance sheet would only be appropriate if governments were unable to finance their expenditure in the capital markets.
Australia’s bond supply, while expanding rapidly has not reached the point where there is “market indigestion” – an MMT style expansion of policy seems very unlikely.
And, of course, the RBA itself would be a buyer – particularly if it needed to defend a 10 basis point yield target.
That rate might also fail to attract key offshore support placing even greater pressure on the RBA’s ability to defend the target. Note that the US 3 year bond rate is around 0.18%.
A “middle ground” of cutting the cash rate but leaving the bond target unchanged would open up a huge arbitrage as markets set to lock in funding costs well below the bond rate although it is unlikely that the bond rate would settle as low as 0.1%.
The move to a 10 basis point cash rate would also have the indirect effect of downward pressure on the AUD but the dominant purpose would be to further lower fixed rate private sector borrowing costs.
We do not see such a move as imminent.
I expect that while the move may continue to be considered, including the policy around the bond target, the Board is in no hurry.
Bill Evans, Chief Economist