Will markets attack RBA yield curve control?

Here’s what the RBA said at its last meeting:

The Board remains committed to the 3-year government bond yield target of 10 basis points. Later in the year it will consider whether to retain the April 2024 bond as the target bond or to shift to the next maturity. The initial $100 billion government bond purchase program is almost complete and the second $100 billion program will commence next week. Beyond this, the Bank is prepared to undertake further bond purchases if doing so would assist with progress towards the goals of full employment and inflation.

Bloomie has a few bond bears on deck today taking advantage:

“If inflation expectations do start to un-anchor, then I think the RBA will be one of the first central banks to be tested by bond traders,” said Shaun Roache, an economist at S&P Global Ratings in Singapore. “The RBA is a canary in the coalmine for central banks as it is ahead in its labor market recovery.”

Australia 3-year swap rate has risen even as key bond stays anchored

But keeping the market at bay next time may prove more difficult, as vaccination campaigns gather pace in major economies and the U.S. recovery nears an “inflection point,” emboldening traders.

If yield control fails in Australia, it may fade away as a potential option for other monetary authorities in need of more policy ammunition. Especially because yield control’s record in Japan — the only other country to officially employ it — is patchy.

Pinning the rate of one key bond maturity has helped the Bank of Japan reduce borrowing costs in general and also allowed it to slow the pace of bond purchases. But it has come at a cost. The nation’s debt market is lambasted as dysfunctional and an economic recovery strong enough to revive inflation looks as far away as ever.

Meh. The RBA will welcome rising inflation expectations. Westpac’s Bill Evans recently looked at this question:

Our expectation is that from the August meeting the Board will announce that it is directing its purchase program to the November 2024 bond from the April 2024 bond.

Since the bond market sell off and the stream of better than expected data reports the market and most commentators have expected that the Bank would not switch its buying to the November bond – essentially restricting the three year YCC policy to the April 2024 bond and therefore implying that the Bank expected to have achieved its objectives by the first half of 2024.

Figure 1 tracks recent movements in the yield on the November 2024 bonds; this yield has fluctuated between 0.2% and 0.44% since bond rates started lifting in early February- currently around 0.33%.

The margin over the 0.1% (we expect the RBA would buy those bonds at 0.1% after August) and the current market pricing reflects the steepness in the curve but most importantly market scepticism that the RBA will extend YCC to buying the November bond.

Indeed, if there were no market caution, with funding costs near zero, the bonds should be trading close to the 10 basis points.

Buying a 3.5 year bond at 0.4%; holding it at a funding cost of near zero, and selling to RBA at 0.1% from August is a trade that appears not to have captured the interest of the market.

We have consistently argued that now will be too early for the Bank to scale back its YCC policy.

For us, the key will be the August Board meeting and the Statement on Monetary Policy on August 6 where the Bank will reveal its forecasts up to the end of 2023 (extended from mid2023 for the May SOMP forecasts).

Those forecasts will be very close to the date (first half of 2024) when the Bank would expect to achieve the conditions to justify a rate hike.

Bear in mind that the conditions for raising the cash rate will be: full employment; inflation sustainably between 2 and 3%; and wages growth running at 3% plus.

Current forecasts from the Bank’s February Statement on Monetary Policy go out as far as June 2023.

By then (Feb SOMP) the unemployment rate is forecast to be 5.25%; wages growth 2%; and inflation 1.75%.

The issue is what forecasts for the end of 2023 would be consistent with the Bank achieving its objectives by the first half of 2024.

The sharp fall in the unemployment rate in the February Employment Report from 6.4% to 5.8% has been a constructive start along that road to full employment.

But the winding back of JobKeeper will impact the unemployment rate. Westpac estimates a loss of 100,000 jobs on the basis that there are around 1 million recipients of JobKeeper. Our estimates are based on a subjective assessment of the expected proportional loss in various industries (we
constructed a series for numbers on JobKeeper in each industry).

Another approach where the focus is on the wedge between hours worked and employment in each industry derives larger expected losses.

Our cautious approach forecasts that the unemployment rate, after absorbing the 100,000 job losses in the June quarter, will lift to 6% by mid year falling back to 5.7% by end year.

RBA’s end 2021 forecast is likely to be comparable (revised from 6.0% currently) pushing down their mid 2023 forecast to 5% (from 5.25%).

While an unemployment rate at 5.0% by mid-2023 would represent an improvement on current levels, that is still too high.

The Governor has indicated that full employment is in the 4-4.5% range while the Deputy Governor mused about “high 3’- low 4’s” at a recent Senate hearing.

To lift inflation into the sustainable 2-3% range and boost wages growth to “3% plus” the unemployment rate will need to hold at full employment or lower for a sustained period.

Just “touching” the upper range of full employment (assuming a reduction in the end 2023 unemployment forecast to 4.5% – a large 0.5% drop in 6 months, particularly when the supply of labour will be boosted by a return to normal immigration levels; the housing market will be slowing; and post election fiscal policy is likely to be tightening) does not seem to be sufficient to lift wages growth to above 3% and inflation to 2.5%.

With the Bank’s credibility paramount given previous failures to reach forecast targets it seems appropriate that the best approach will be to stick with YCC for the remainder of 2021 and extend the current bond purchasing program by a further $100bn, albeit at a slightly slower pace.

The Westpac timetable looks like a better base to me, bearing in mind that I expect two shocks to gather speed in 2022:

  • APRA macroprudential is the first material tightening cab off the rank. The RBA will be anticipating that in 2022 some time.
  • Chinese growth is going to slow in H2 and more next year with a material terms of trade shock landing on Australia’s external accounts.

We will also have convulsive lockdowns as the vaccine rollout fails and out-of-cycle bank hikes. It’s likely that Labor will win next year’s election, raising the possibility of it forcing APRA to take house prices into account.

RBA YCC won’t fail. It has all the firepower it needs.

The Bloomie article is rumourtage.

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