Bill Evans at Westpac with the note:
The RBA Board is likely to decide that there will be no extension of the YCT to the November 2024 bond at the July Board meeting because such action would imply no tightening till 2025.
Westpac disagrees with that interpretation but cannot dispute the resulting decision.
Not extending YCT means that the gradual tightening we have seen through the YCT program in 2021 will not be reversed in July.
The QE program has now matured to allow the Board more flexibility going forward.
We expect the Governor to announce an open ended $5 billion per week purchase program to be reviewed later in 2021 to be introduced following the completion of QE2.
Given the confidence the RBA has in the QE program and Australia’s low relative use of QE we continue to expect that the ultimate level of additional purchases will reach the $150 billion which we have advocated for some time.
The credibility of forecasts
Following the release of the Governor’s Statement on the June RBA Board meeting it now seems clear that the Board has no intention of extending the Yield Curve Target Bond from the April 2024 to the November 2024.
Accordingly, we have dropped our long held view that the RBA would extend the YCT policy to the November bond.
A media article (AFR 2/6) seems credible and clearly points to that conclusion.
Westpac has argued that the credibility of the Bank’s commitment to its forecasts is paramount and, in our view, those forecasts were consistent with an extension.
The Bank’s most recent forecasts in the May Statement on Monetary Policy go out to June 2023.
Those forecasts are that annual wages growth reaches 2.25%; the unemployment rate is 4.5%; and underlying inflation is 2% by June 2023.
We have argued that those forecasts are not consistent with– full employment (lower than 4%); wages growth consistently above 3%; and inflation sustainably in the 2–3% range being attained within 6 months – the first half of 2024.
The biggest difficulty in the forecasts is achieving the sustained 3+% forecast for wages growth (which the Bank believes is necessary to achieve credibility for a sustained 2–3% target on underlying inflation).
To achieve that target on wages growth the labour market would need to have reached full employment and held there for some time.
Our interpretation of any decision not to transition to the November bond hinged on needing to justify that the Bank expected that it would have achieved the conditions necessary to begin tightening by the first half of 2024.
The explanation in the media report of the Bank’s interpretation of its forecasts is that moving to the November 2024 would have been consistent with guidance that the rate hike was not expected until 2025.
A literal interpretation of “unlikely until 2024 at the earliest”, which has been the Governor’s consistent description of the timing of the first rate hike, might be consistent with a 2025 view, but we agree that the forecasts to mid 2023, while sufficient to form a reasonable view on first half of 2024, do not provide sufficient insight into 2025.
So, while we argue that moving the bond target to November 2024 is consistent with not being sufficiently confident that the conditions for a tightening will be reached in the first half of 2024, the Bank’s interpretation of moving to November appears to be that the conditions will not be met until 2025 and that is too far out to be sufficiently confident.
Deputy Governor Debelle recently noted (May 6, Shann Memorial Lecture) “Three years is a reasonable horizon over which the Board has some confidence about the economic outlook.”
If the decision to move to targeting the November bond, in July 2021, which in the Bank’s view implied a forecast for 2025 then such a decision could not be made given that would require a 3 and a half to four year view.
However, the precedent is somewhat at odds with this three year limit to the “line of sight”.
On 20 October 2020 the Board switched its three year target from the April 2023 bond to the April 2024 bond (there is no November 2023 bond).
On the same argument, that decision could only be justified on a view that the tightening was not likely until the second half of 2024 (just as the November 2024 bond implied a view on 2025) – four years from the time of the decision.
Market pricing and financial conditions
There have been other “clues” that the Board did not favour an extension to the November bond.
When discussing the factors that will impact the decisions at the July Board meeting the April minutes referred to “Members would give close attention to the flow of economic data and the outlook for inflation and employment.”
However, surprisingly, the May minutes referred to “the flow of economic data and conditions in financial markets”.
While “conditions in financial markets” is a wide ranging concept the observations in the May Statement on Monetary Policy are pertinent. “Market participants on average do not expect the Bank to extend the yield target to the November 2024 bond.”
That is, one measure of financial conditions, was not consistent with an extension.
There are also technical difficulties in extending to the November bond.
The three year futures contract basket includes four bonds – two of which – the April 2023 and the April 2024 are pegged by RBA policy at 0.1%. That means that only two of the bonds can move to allow investors and traders to hedge their physical and swap commitments. Some market participants have been advising that this has increased the basis risk; exacerbated volatility and limited liquidity around that part of the curve.
That problem was particularly apparent in late February when the RBA intervened in the market increased repo costs and purchased $7 billion of April 2023 and April 2024 bonds over three auctions.
The new futures basket is set to drop the April 2023 bond but if the November 2024 bond is now pegged the new contract it will continue to have two of the four bonds “pegged” – extending the basis risk / limited liquidity conditions.
Restoring the new contract basket to three market determined bonds out of four would have been promoted to the RBA by the market as supporting smooth functioning of the bond market and the liquidity of the derivative market.
Another way to address the “financial conditions” argument is the market pricing for the cash rate, which has been priced for up to two hikes by the end of 2023.
If the RBA believed that extending the Yield Curve Target to the November 2024 bond implied it did not expect to hike until 2025 its policy signal would have been significantly out of line with market pricing.
2021 should not have been the year for tightening policy
While our main argument hinged around the Board’s need to act in accordance with its forecasts and forward guidance we also believed that 2021 should have been a year when the policy should have avoided any tightening apart from the winding down of the Term Funding Facility (TFF).
We expected that the Term Funding Facility (TFF) would not be extended. That policy was seen as lowering the funding costs of the entire banking system to lower the cost of credit to households and businesses, “it complements the target for the three year government bond and the forward guidance”(Debelle, Shann Lecture).
If the November 2024 bond had been pegged at 0.1% then household and business credit costs would have been restored to those costs which operated at the end of 2020, when a three year and four month bond was priced at 0.1%. As we have moved through 2021 the Bank has been steadily tightening rates as the targeted bond shortened – moving to the November bond would have meant that the gradual policy tightening through 2021 was reversed.
The TFF was also seen as a significant support to our banking system and was introduced to ensure a smooth flow of liquidity for the banking system by largely replacing the need for offshore funding at a time in early 2020 when there were concerns about global liquidity.
Terminating the TFF was always likely once financial conditions normalised in global markets.
But extending to the November bond would have signalled the intention to at least partially offset the impact of the withdrawal of the TFF.
The economy recovered more rapidly than expected
Finally, the argument that the economy recovered more rapidly than was expected has been put forward as the reason for not extending.
That effect could appropriately have been captured in the Bank’s revised forecasts in the May Statement on Monetary Policy.
But, as discussed, those revised forecasts were still not consistent with achieving the “lift off” conditions by the first half of 2024.
The Board has argued that the “flow of data” will impact the decision in July.
That data is unlikely to paint a clear picture.
The next employment report looks likely to be soft, based on the 1.5% fall in payrolls since end April which is capturing the impact of the unwinding of JobKeeper.
The current lockdown in Victoria may impact the confidence measures.
Wednesday’s GDP Report was strong, boosted by a surge in equipment investment, although somewhat disappointing that household spending grew by a modest 1.3%, including a 0.5% fall in goods expenditure and a patch result on services. The consumption number was impacted by sporadic lockdowns and floods while the current extended lock down in Melbourne will affect the June quarter.
But, by the July Board meeting, it is unlikely to revise its forecasts to incorporate a more difficult growth outlook due to new complications with the virus and the slow vaccination rate. Quantitative Easing (QE) – a significant change in policy now seems likely.
But what about the future of QE?
Remember that, despite the decision to extend the gradual tightening with the YCT policy it is still a central bank with a current inflation print of 1.1% (trimmed mean) chasing a “sustained” 2–3% target, which has proved elusive for many years.
This probably represents the largest “task” of any central bank in the developed world.
It will already have forsaken the opportunity to reverse a tightening that has been gradually building through 2021 by not extending YCT and has curtailed the TFF program.
Expect a significant change to QE to be announced at the press conference
Governor Lowe has committed to a Press Conference following the July meeting.
That is unlikely to be needed to announce and explain the YCT decision or QE3 at $100 billion or $50 billion.
At the February Board meeting when he announced the extension of another QE program of $100 billion but there was no Press Conference.
The last Press Conference followed the November 2020 Board meeting when QE was introduced and the cash rate was cut to 0.1%.
Our current view that the RBA would maintain the pace of stimulus by adopting a third $100 billion QE program looks unlikely to justify a Press Conference.
Recall that in the Governor’s statement following the June Board meeting he moderated the language around QE. That decision would be consistent with a QE reset.
As the same AFR article (AFR 2/ 6) pointed out one option might be to introduce some flexibility to the QE program.
Why not go to the model used by the US FEDERAL Reserve of adopting an “open ended” commitment, which in the case of the FED is a USD 120 billion monthly purchase program.
My view is that the original program of $100 billion was introduced as a fixed amount rather than an open ended approach to put a specific limit on a new program until the market became accustomed to the process.
The flexibility of the FED style program would be attractive to any central bank.
Committing to an open ended $5 billion per week program would not imply a tapering (same pace as QE2) and the Press Conference could be used to make that point very clear.
That model would provide flexibility; allow the RBA to more closely monitor the actions of the FED; but certainly not appear to be “tapering” given how much scope still exists for QE in Australia (see below).
We pointed out some weeks ago that a third $100 billion at a $5 billion weekly pace would be completed in mid-January necessitating guidance at the December Board meeting.
We concluded that a preferred approach would be to scale back to $4 billion per week, completing the program in mid-March and allowing new guidance at the February Board meeting.
Markets will assess the ultimate size of the program
An open ended $5 billion program would avoid the implication of a tapering (with the fall to $4 billion per week) but allow the full flexibility to review later in the year.
For example, the Board could commit to the $5 billion pace until, say, the December Board when around $60 billion would have been issued but with a clear commitment, at the Press Conference, that there was “more to come”.
The markets would not see that as tapering since the weekly pace was going to be continued while providing flexibility to move the pace both “up” and “down”.
Remember that the RBA believes the program has been a success- lowering the AUD by up to 5% and reducing the long bond rate by around 30 basis points.
The stock of bonds matter more than the flow
In the Shann Memorial speech Deputy Governor Debelle noted that, “it is the stock of central bank purchases that matters rather than the flow.”
He also pointed out that the RBA was well behind other central banks on that “stock“ measure.
As a proportion of GDP the RBA’s stock of bonds is projected reach 10% of GDP at the end of QE2.
That compares with 20-25% for the US; Canada; and New Zealand and 30–35% for Europe and the UK. oportion of bonds on issue the RBA is projected to reach 30% for QE2 compared to (projected) 45% –50% for Europe; Canada; New Zealand and the UK and around 35% for the US.
Debelle argues that “both metrics are relevant in assessing the degree of stimulus.”
He also does not appear to be concerned about the “sticker shock” of only announcing a weekly program.
He points out that “the market will form some expectation of the total size of the program.” In that regard, no doubt, the Governor’s press conference will leave the market in no doubt that the RBA is not planning a premature tapering which would see total new purchases in the vicinity of the $50 billion as suggested by some commentators.
Westpac, which had been forecasting two more programs QE3 ($100 billion) and QE4 ($50 billion) expects that eventually the RBA’s new purchases after QE2 will amount to around that total figure of $150 billion.
The process will almost certainly involve some gradual scaling back of the initial $5 billion weekly pace with the timing depending mainly on the actions of other central banks and the progress of the economy.
That would push the RBA’s holdings of bonds to around 36% of bonds on issue and around 18% of GDP – still well below the ratios of other countries.
