Bill Evans on what the RBA should print

See the latest Australian dollar analysis here:

Australian dollar sags as markets plough into pandemic

Via Bill Evans at Westpac:

Our views on the likely decision by the RBA on November 3 have been clear since our note on September 23.

“All the key policy rates – cash rate; three year target bond rate; and rate on Term Funding Facility will be cut from 25 basis points to 10 basis points.

The rate on surplus Exchange Settlement balances will be cut from 10 basis points to 1 basis point.

The Board will announce a change in its bond purchase program from ensuring the smooth functioning of the bond market and ensuring that the 3 year bond rate holds at the target rate to a more general role of purchasing Australian government bonds and semi government bonds, across the curve, including maturities in the 5 – 10 year range”.

We had not envisaged the Board setting a specific quantity target for the purchase program. It is already setting a price target for the 3 year rate. Fixing both price and quantity may lead to unexpected difficulties down the track.

Markets seem to differ, expecting a total purchase program and a weekly “timetable” for the purchases.

We cannot be sure whether such a policy approach will be taken.

My view is that when you are uncertain about a particular nuance of policy then you should forecast what you think would be the best approach.

With markets expecting a specific volume target, the announcement of an open ended commitment might cause market disappointment with a potential lift in market yields and the AUD.

If I was making the decision I would value flexibility over a possible short term overreaction.

Markets will Want to Limit RBA’s Flexibility

Markets will probably only be satisfied if the quantity targets are also clearly compartmentalised across general maturity “buckets”, (at least a fixed commitment to the 5–10 year part of the curve would be required; and markets may also require a fixed commitment to the AGS/semi government mix).

If we are wrong and the Board only cuts the ESA rate to 5 basis points (seems to be market Consensus) then the effective cash rate will fall to around 7–8 basis points providing a very slim funding margin to attract investors into a 3 year bond rate of 10 basis points.

Under such circumstances the Bank may have to expend considerable balance sheet to support the 3 year target.

Other central banks, with the exception of the Bank of Japan, that announce volume targets have not committed to yield targets.

The Size and Growth in the Balance Sheet Matter

The Governor has noted that “our balance sheet has increased considerably since March but larger increases have occurred in other countries”.

The RBA’s balance sheet ($300 billion) is around 15% of GDP; slightly below RBNZ; and well below Bank of Canada at 20%.

These compare with Bank of England and Federal Reserve at around 33% and the ECB at 47%.

Are there any limits to the size of the RBA’s balance sheet? Arguably, no – clearly, yes, but in a world of consistent under performance on inflation targets by central banks we are certainly, in the case of Australia, a fair way away from any upper limit.

To reach the 20% of Bank of Canada it would need to increase its balance sheet by around $100 billion. But remember that there is still $114 billion in undrawn capacity in the Term Funding Facility.

If the TFF rate is cut to 10 basis points, providing banks and other ADI’s with 3 year funding at 10 basis points, the eventual full draw down seems highly likely.

With regard to the additional drawdown of the TFF there are some complications. There is a guaranteed drawdown of $ 57 billion being the additional facility announced on September 1.

In addition there is an “additional funding allowance” linked to growth in credit outstanding to corporates and SME’s (small and medium enterprises) between the three months to January 2020 and the three months to April 2021. That facility had reached $68 billion but by end August had fallen to $57 billion as loan books have recently contracted.

The extent of the facility will depend on business credit growth out to April 2022. In particular the stock of loans to SME’s has a 5x weighting (TFF increases by a factor of 5 for increase in the stock of loans to SME’s) and any growth can therefore quickly increase the TFF, as we saw earlier this year.

The eventual size of the TFF is therefore uncertain but a cautious central bank would, understandably, allow for a potential increase.

For now, if net new lending is completely flat out to April 2021 there will be a $114 billion extra drawdown in the TFF. In their calculations I think it is reasonable for RBA to assume at least an increase in TFF to $ 150 billion by the final drawdown date of 2021 allowing for a modest increase in new lending.

In particular RBA would need to factor in some usage by firms of the accelerated depreciation allowances provided in the Federal Budget and may also want to retain flexibility to further increase the size of the TFF.

Accordingly I expect that RBA would factor in a further increase in the balance sheet to, say, $450 billion as the TFF is fully drawn down by June next year. Note that increasing the balance sheet to $450 billion would represent a 250% increase on the pre COVID level that compares with the Federal Reserve’s current increase of around 90% since COVID.

(The reverse repo facilities have been scaled back recently and these calculations assume a steady level at around the current quantities.)

That equates with a balance sheet of 23% of GDP – higher than Bank of Canada and RBNZ and around $ 200 billion below the ratios of Federal Reserve and Bank of England.

While any announcement of a specific purchase volume would be over an extended period, say to June 2021, I doubt whether RBA would be prepared to rush its balance to FED and B of E proportions so quickly.

A commitment to $100 billion, which seems to be a “market favourite” would see an implied commitment to boost the balance sheet to $550 billion or 28.5% of GDP – well clear of current ratios of BOC and RBNZ.

That balance sheet would see a 300% increase since pre COVID – certainly a strong signal but, in my view, such growth is already expected by the market.

That “market favourite” may be acceptable to the RBA.

Personally, given that it is already committed to a yield target, I would opt for a more open commitment but can certainly see that a $100 billion target would be manageable without forcing RBA to abruptly lift the balance sheet to FED and B of E proportions.

The Policy Announcement and the AUD

In the lead up to the speech by the Deputy Governor on September 22 and Westpac’s forecast that the RBA was expected to announce a raft of policy changes the AUD had fallen from around USD 0.73 to USD 0.71.

While the move from USD0.74 to USD0.73 in early September was due to external factors, particularly a recovery in the USD, the fall from USD 0.73 to USD0.71 seems to have been largely related to the speculation around the Reserve Bank.

The expected policy moves were effectively confirmed in the Minutes of the October Board meeting.

I believe that the only uncertainties around the policy mix are, as discussed above, firstly whether the Bank announces a reduction in the ESA rate to 5 basis points or 1 basis point and secondly whether there is a fixed quantity target for bond purchases.

The decision to cut the ESA rate to 1 basis point (our expected option) might, at times of high liquidity, lead to markets printing negative rates at the very short end of the yield curve.

If banks are faced with a 1 basis point rate on the ESA account then they might be reluctant to accept deposits from large corporates and institutions at the short end of the curve at a positive rate.

Arguably, issues around relationships, in particular, are likely to impact these decisions.

What is certain is that markets should not interpret some slight negative deposit rates in the institutional space as a change in the Bank’s strong resistance to negative policy rates, along the lines of the ECB and other European central banks which have adopted negative rates.

We understand that a negative rate policy would put significant downward pressure on the AUD but do not believe that the decision to cut the ESA rate to 1 basis point should be seen as some early commitment to negative rates.

The announcements from the RBNZ; B of E; and BOC indicate that these central banks are much further down the track towards negative rates than the RBA.

We have also noted above that there might be a short term “disappointment” in markets if the RBA does not announce a specific quantity target for its bond purchases but expect that sentiment disappointment will be short lived.

Despite the fall back in the AUD from USD0.74 to USD0.71 since early September we maintain our constructive view towards the AUD with targets of USD 0.75 by end 2020 and USD0.80 by end 2021.

We believe that the key fundamental issues: current fair value around USD0.78; a sustained structural weakening of USD; the continued out performance of the Chinese economy and the RMB; a return to “risk on” psychology in markets following the US election and further progress with vaccines; world growth lifting to 5% in 2021; and the historical evidence of long cycles in the AUD will make it very difficult for RBA, with its limited policy options, to contain the rise in the AUD.

It is ironical that the RBA is likely to announce a suite of policies that will, in part, be directed at the AUD.

Currency markets are notoriously pre-emptive. Arguably, the impact on the AUD from these RBA policy changes is already behind us. Going forward the other fundamental forces discussed above are likely to replace RBA policy as the key drivers of the currency.

David Llewellyn-Smith

Comments

  1. Amazed Bill’s not suggesting the TFF rate should be negative and that banks should get a clip of the ticket at both ends to do god’s work.

  2. Print – wait and see
    Print some more – wait and see
    Print even more – wait and see
    …. and so on … until ….

    CPI 10%!

    Then what?

    • Jumping jack flash

      It wouldn’t happen all at once, but I see your point.

      To get to 10% they first have to get to 3%.
      And to get to 3% they need to get above 0.3%. (which is a bit of a joke really)

      And there is huge headwind to get anywhere close to 3% due to all the deflationary forces.

      And then if they print, I guarantee that the vast majority of it would find its way into obtaining nonproductive debt unless they made some radical changes, because right at this moment obtaining mountains of nonproductive debt is as necessary as breathing in the New Economy, and since nonproductive debt is inherently deflationary (wrt CPI) we’d be back to where we started very quickly, and very likely even deeper in the poo due to all the additional debt that was magicked up as a result of the printing.
      CPI at 0.1%?

      So nothing really all that different than the effect of all stimulus over the past couple of decades…

  3. So much for the interest rate lower bound being 0.5 or 0.7. CAD – what CAD? Free money for everyone!!!