Bond market tries to bully RBA

Christopher Joye

Coolabah Capital

In the AFR I write that two big dramas playing out this week are the bond market trying to bully Martin Place into tightening monetary policy and allegations that NSW premier Dominic Perrottet’s otherwise remarkable debt retirement fund, which saved taxpayers from a fiscal crisis, has funneled $450 million to dictatorships and tax havens. Let’s examine each in turn.

We know the Aussie economy was absolutely ripping coming into the most recent lockdowns, which informed the Reserve Bank of Australia’s confidence that it should substantially upgrade its growth outlook, only to be kiboshed by the Delta-variant of COVID-19.

One interesting 'tell' regarding the upside economic surprise in 2021 has been the difference between what the State governments had been forecasting for their budget deficits and what transpired. (We had consistently argued that these deficits would be a fraction of what the States and sell-side analysts expected.)

In November 2020, Victoria forecast a gargantuan $38 billion deficit for the 2021 financial year. In May, they slashed this to $29 billion. And in the final June 2021 budget outcome, this was reduced by another $4 billion to $25 billion ($13 billion less than they first predicted).

A similar pattern has been observed across other States. Queensland originally projected an $8.6 billion net operating deficit for 2021. This was crushed to $3.8 billion in June this year. You would think with the financial year behind them, Queensland would know how big the deficit was. But it turned out much better than expected, coming in at just $0.9 billion. Queensland is likely in surplus right now.

As we come out of lockdown, there is every reason to think the NSW and Victorian economies will start roaring again. The rest of the country was already on fire. And the transition from the pandemic-induced lockdowns to the more normal notion of living with COVID-19 will inevitably drive bond markets to price in long-term interest rates that are likewise more normal.

Around the world, 10-year interest rates have been trending higher. In Australia, the 10-year government bond yield has climbed from 1.08 per cent in August to 1.83 per cent today. It is still incredibly low: the average 10-year rate since 2000 has been 4.2 per cent. One trigger for higher rates has been underlying, or core, inflation climbing to be at or above the pace central banks target. This is true in Canada, the UK, the US, and New Zealand, which is compelling their central banks to slowly withdraw the COVID-19 stimulus and consider hiking rates, which the Kiwis recently did.

And yet this is where Australia, and hence the RBA, buck the hawkish global reflationary trend. In Australia, wages growth and inflation are running at levels well-below what the RBA requires to meet its legislated targets. This miss is exacerbated by the fact that core inflation has not reached the mid-point of the RBA’s target band since 2014. Some experts, such as Signal Macro’s Matthew Johnson, worry that this may be depressing inflation expectations, making the RBA’s mission even harder.

Johnson highlights that financial markets seem to be mispricing the incongruities between Australia’s situation and the rest of the world. Whereas markets are predicting chunky interest rate increases in Australia (two hikes are pencilled in for 2022)---comparable to expectations in the US, Canada, and the UK---Australia is the only one of these nations with core inflation running materially below the central bank’s target. So, either the inflation data is wrong or the markets are.

The battle between bond bandits and the RBA has played-out around the RBA’s yield curve target, which commits to keeping the interest rate on the April 2024 government bond at 0.10 per cent. In recent days this has jumped to 0.18 per cent as investors bet that the RBA will drop its forward guidance that it will not lift rates until 2024. Yet the RBA’s guidance was always state- rather than time-dependent, which means that it will be determined by actual wages and inflation outcomes rather than any specific interval. If core inflation rises more rapidly than the RBA assumes, it will not hesitate to change its view.

The sharp increase in longer-term interest rates is putting upward pressure on both the exchange rate and mortgage rates. The Aussie dollar has jumped from US71 cents in August to around US75 cents today. Concurrently, banks are hiking their fixed-rate mortgage costs, which price off the interest rates on 3-year and 5-year government bonds. If you then overlay regulatory constraints on housing and our projection for a surge in skilled migration, the task of generating decent wages growth and inflation is only getting harder.

Bond markets look to have been emboldened by speculation the RBA will aggressively taper its bond purchase program in February. The RBA is currently buying $4 billion of bonds each week. Several commentators feel confident this will drop to $2 billion per week in February rather than the slower $3 billion weekly rate followed by the likes of the Bank of Canada at the same point in time.

While there is no material economic difference between the two trajectories, the signal they send varies markedly. The normal taper path implies the RBA remains data-dependent and will relax downward pressure on interest rates and the Aussie dollar as the economy converges to full employment and the RBA’s inflation target. Pundits promoting a more aggressive taper posit that the RBA wants to withdraw stimulus as quickly as it can, lending credence to the hawks’ view of the world.

The second drama of interest is The Guardian’s report that NSW’s $26 billion Debt Retirement Fund, which is managed by NSW’s investment arm, TCorp, has been providing debt and equity finance to dictatorships and tax havens, including Russia ($75 million), Saudi Arabia ($45 million), China ($225 million), UAE ($15 million), Cayman Islands ($30 million) and Angola ($15 million).

Premier Dominic Perrottet had the commendable foresight to create this unique fiscal shock absorber in 2018 to accumulate reserves to repay debt whenever the budget lurched into deep deficit. And he has taken the unprecedented step to draw-down on it to pre-emptively repay $11 billion of NSW debt to alleviate COVID-19 induced budget pressures. Markets applauded this decision by rewarding taxpayers with lower interest rate spreads on NSW debt.

In managing the Debt Retirement Fund, TCorp appears to have deployed a standard emerging market debt strategy, albeit one that could improve its Environmental, Social and Governance (ESG) protections regarding the types of political systems NSW supports. In our portfolios, we require all investments to be domiciled in democratic, rather than authoritarian, states where there are minimum safeguards regarding the rule of law, property rights, freedom of individual and religious expression, human rights, and so on. Without this democratic criterion, it is easy to end-up lending money to the likes of Vladimir Putin and the Saudi royal family.

Michael West Media further reports that a number of the asset managers selected by TCorp have exposures to China Evergrande bonds, which have infamously missed their interest repayments. It is unclear, however, whether the Debt Retirement Fund allocates to vehicles that own Evergrande securities.

In response, incoming NSW Treasurer, Matt Kean, who is an enthusiastic ESG advocate, has announced a review of the Debt Retirement Fund. Beyond the need to avoid underwriting authoritarian regimes, there remain two key questions. The first is whether NSW continues to automatically divert scarce taxpayer revenues to the Debt Retirement Fund, which must be replaced with additional taxpayer debt given the budget is in deficit. Rediverting these revenues back to the budget would save NSW as much as $20 billion in debt over the next few years, and ensure the Debt Retirement Fund is not being paradoxically debt-funded.

There is also the question of what to do with the $15 billion left in the fund after Perrottet repays the $11 billion of debt. Rather than gambling this on global stocks and junk bonds, it would be preferable to use the $15 billion to pay for the $108.5 billion in infrastructure spending that Perrottet has signed-up for. After all, the $7 billion from the sale of the first-half of WestConnex that seeded the fund in 2018 was meant to pay for new infrastructure spending.

The fund could then be replenished when the budget returns to surplus via future reserves and asset sales. Selling equities at all-time highs while interest rates are near record lows would not be a bad idea either. As a lender to all State governments, including NSW, these are responsible decisions that we would support. 

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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