Via George Tharenou at UBS:
RBA still expected to extend QE, but what if they taper?
The materially better-than-expected Australian domestic data flow (amid ~zero local COVID-19 cases) has raised speculation that the RBA will not extend its $100bn QE program beyond the scheduled end in Apr-2021, and may even also remove its 3-year YCC target early in 2021. However, such a ‘hawkish’ shift is still not the UBS base case. Instead, we continue to expect that the RBA will both flag an extension on QE in its first few meetings of 2021 (and perhaps signal this as early as February), with an additional up to $100bn of QE through to the end of 2021; as well as keep the YCC 3-year target throughout 2021. However, if we are wrong, how could the RBA taper?
Under a RBA taper scenario, QE would end first as global growth recovers
Fiscal policy in Australia is doing the heavy lifting to support the economy through the pandemic, and boost the subsequent recovery. The Commonwealth and the State Governments have unprecedented deficits totalling ~16% of GDP in 20/21, & will likely remain very large around 10% of GDP in 21/22. Some Semis credit ratings were recently downgraded. Given this, QE can play an important supporting role by absorbing a significant share of the increase in bond issuance. However, it is reasonable to expect that once the global economy recovers further, and global central banks taper their respective QE programs, the RBA will also stop buying bonds under its ‘proper QE’ framework (assuming of course the domestic economy also continues to recover). Critically, another one of the key reasons the RBA started QE was to limit upward pressure on the AUD. Thus, it is reasonable to assume QE will likely be tapered when such upside pressure on the AUD fades, i.e. when global central banks will taper. However, we think global central banks won’t stop QE before the end of 2021.
3-year YCC target can then be tapered if domestic growth remains strong
Yield Curve Control is an instrument of forward guidance. It is explicitly a strong commitment to keep the cash rate unchanged at 10bps for 3 years (i.e. until at least Apr-24); and after that allows for the possibility of rate hikes (if conditions warrant). If the RBA decides to remove the 3-year YCC target, we think they are more likely to do so (at least initially) by keeping the target on the 3-year maturity from the day of the announcement; but every day that target maturity gets shorter (i.e. decays). We think that the RBA is likely to keep YCC at 3 years until, at least, international borders actually re-open in Australia (i.e. not just on the prospect of a vaccine); and hence they become reasonably certain that the economy is on track for a sustainable rebound. This means that we expect the RBA to extend their target to the Nov-24 line sometime in early 2021 (and likely in May-21).
What about cash rate hikes?
In order for the RBA to turn materially hawkish, and actually raise the cash rate, the conditions that would need to exist are: 1) unemployment would need to fall towards NAIRU (~4½%, vs 7% now) and wage growth rise to 3% y/y; and 2) actual inflation would need to be sustainably in the target band of 2-3%. Even with a more positive outlook, this is still clearly a long way away. Either way, the RBA reiterated consistently that the 3-year bond yield target will likely be removed before they hike rates. Hence, we think rate hikes will only occur after the RBA terminate the YCC and QE program. This current framework suggests the first rate hike will likely be 2024 at the earliest.
Forget it. There is no way we will meeting the conditions for sustained inflation though I am at least hopeful that could see some wage growth without the permanent immigration shock.
Given the AUD pressures, the first port of call for tightening will be macroprudential anyway and I don’t even expect that next year, possibly 2022 if immigration is rebooted and lifts southern eastern property.
Bill Evans is right:
As we gaze into 2021 and 2022 we are aware that one significant issue stands out from a policy perspective.
That is how the RBA will address its QE program after the committed $100 billion of purchases is completed in June 2021.
We expect that the Bank will decide to extend the program for a further six months with another $100 billion in committed purchases. Those purchases are likely to be made up of $70 billion in AGS and $30 billion in semi – government securities.
In 2022 we expect the RBA will reduce the QE program to $50 billion per six months (two tranches) and gradually raise the rate for the three year bond target through the year, reaching 0.3% by year’s end.
The driving force behind QE
It is important to recall the Governor’s most recent comments to the Parliamentary Committee, “As other central banks have bought government bonds under quantitative easing programs they pushed down the yields on those bonds. In turn, this put downward pressure on the value of their currencies. As a result, here in Australia, we found ourselves in the position of relatively higher long term bond yields compared with other countries, despite the short term rate being similar across countries. These relatively high bond yields were putting upward pressure on the value of our own currency”.
Westpac is forecasting that the AUD will be rising to USD0.80 over the course of 2021 and there is a risk that the RBA will assess USD0.80 as being overvalued.
The RBA will also be making its decision on the extension of the program in the context that other central banks are continuing to expand their balance sheets. We expect that by June next year, despite a much more positive growth and risk environment, central banks will still assess that they have major challenges in reaching their inflation targets and will be continuing to expand their balance sheets given they have no flexibility on short term interest rates.
The RBA will also be mindful of the direct cost to Australian governments of rising bond rates. We expect bond rates will be rising steadily next year and RBA will be concerned to influence the margin between AGS/Semi government bond rates and those of other countries.
The RBA has adequate scope to continue expanding its balance sheet
The RBA has been “late” to the QE table. Consequently, in terms of risking a “bloated” balance sheet relative to other central banks RBA is in good shape.
In the November Statement on Monetary Policy (SOMP) the RBA provided comparisons with other central banks. Figure 1 (Graph 2.2 in the Statement) compares purchases of Government Debt since March 2020 and projected purchases (based on purchase targets and recent rate of purchase).
Since the Statement,the ECB has further increased its targets while the US Federal Reserve is expected to lift its purchase program following the next FOMC meeting on December 15–16.
We have adjusted the Australian program in the slide to include the further purchases of $100 billion around 5% of GDP) and it can be seen that even with this additional activity the RBA is well behind other major central banks.
In the SOMP the RBA also notes that since March most major central banks have purchased the equivalent of more than 50% of net government debt issuance whereas RBA purchases in the secondary market have been around 25% of net issuance.
The RBA has also been increasing its balance sheet through the provision of the Term Loan Facility. The RBA balance sheet is currently 16% of GDP but could lift to near 30% with future QE and TLF drawdowns.
That compares with other central banks such as US (36%); Canada (24%); UK (not published since Q2 2019 when it was 28%) and ECB (60%), at present, before we allow for future programs.
The relentless move towards negative market rates
When the RBA buys bonds in the market its assets expand and the matching liability will be Exchange Settlement balances with the banks.
The RBA is currently paying zero on ESA balances so when a bank is offered a wholesale deposit and its only option is to lodge the funds in the ESA account at zero there may be occasions when those deposit rates go negative.
With an increase in the ESA balances as the QE program expands the potential volume of negative wholesale deposit rates increases.
The growth outlook and a need for more stimulus.
Last week we raised our forecast for growth in the Australian economy in 2020 from –3% to –2%; and from 2.8% to 4% in 2021.
One key implication of these revisions is that the unemployment rate will reach 6% by end 2021 and 5.2% by end 2022 (revised down from 7% and 6.3% respectively).
We now expect that economic activity will return to the end 2019 levels by the June quarter next year rather than the December quarter, as was our earlier forecast.
If correct, might this brighter outlook deter the RBA from extending its QE program?
There are a couple of key nuances to this argument. In particular the 6% unemployment rate is not acceptable to the RBA. To achieve their inflation target the RBA expects to need to see a “tight” labour market with wages growth at around 3–4% . The Governor recalls 2019 when the unemployment rate hovered around 5% and wages growth was stuck at around 2–2.5% – there will be no comfort for the RBA that policy support can be withdrawn if “only” a 6% unemployment rate is in sight.
A common theme from RBA speakers through 2020 has been the risk of withdrawing stimulus “too early”.
That risk will be prominent in discussions between the RBA and the Government as the Government considers policies to support the economy once JobKeeper has been withdrawn. Such discussions will be especially relevant in the lead up to the May Budget.
The RBA would find it difficult to argue for the Government maintaining stimulus and – one month after the May Budget – withdrawing its own support by eliminating or even reducing its QE program.
What would be the allocation of purchases?
The RBA is currently allocating $80 billion of QE purchases to Australian Government Securities (AGS) and $20 billion to semi government purchases.
At present there are $804.6 billion in AGS on issue and $317.9 billion in semi government debt, (Semi’s represent around 28% of total issuance).
Based on recent Budget announcements we expect combined deficits of government borrowers over the four years from 2020/21 to total $480 billion for the Commonwealth and $263 billion for the States.( of which $325 billion and $171 billion cover deficits in the 2020/21 and 2021/22 years). Over those forward years the states will represent around 35% of future deficits establishing a “reasonable” argument to lift the share of semi purchases in the new program .
There may be differences on how governments fund deficits but moving from 80/20 to 70/30 in the next round seems a sensible approach.
The outlook for 2022
For 2021 our expectation is that the RBA will maintain its yield curve control approach to target the three year bond rate at the cash rate supplemented by two rounds of QE, each at $100 billion , with a slight increase in the proportion of semi government bonds in the “mix”.
Looking further out recall that our forecast is for the unemployment rate to fall to 5.2% by end 2022.
We also expect bond yields to be rising (AU 10 year bond rates up to 1.25% by end 2021 to 1.7% by end 2022).
That will also be in the context of AUD rising to USD0.82 in 2022 (with upside risks).
Under those circumstances we expect the RBA will be unable to credibly support forward guidance that the cash rate will remain on hold for three years – out to mid 2025.
However, yield curve control at the short end of the curve will still be seen as appropriate policy given the importance of the three year part of the yield curve for Australian borrowers (both mortgages and SME’s).
Lifting the three year target rate to be more in line with market expectations would be a prudent policy – to around 0.3% by end 2022, in gradual steps through 2022, (from the 0.1% base at the beginning of the year).
QE will still have a role to play in 2022 – by providing some cover against other central banks with more difficult paths to recovery in a world of upward pressure on bond rates and risk currencies.
For the RBA, which would be moving toward a normalisation of rates, cutting back the QE program to $50 billion (per six months) would be a consistent approach to complement the policy of increasing the rate for yield curve targeting.