Frydenberg’s miracle, saving AAA rating

Christopher Joye

Coolabah Capital

In the AFR this weekend, I write that make no mistake, Treasurer Josh Frydenberg has pulled off a minor miracle saving Australia’s prized AAA credit rating, which has helped borrowers avoid the equivalent of half an interest rate hike. Excerpt enclosed:

In May 2020, weeks after Standard & Poor’s impulsively downgraded Australia’s rating to a “negative outlook”, this column argued that “if we can normalise activity much more quickly, Frydenberg can prudently pare back this stimulus, which would (once again) save Australia’s AAA rating, sparing borrowers unnecessary interest rate increases”. “Morrison did this in 2017 and 2018 by bringing the budget back to balance years ahead of schedule, and I reckon his successor will do it again.”

Notwithstanding that the federal budget has massively outperformed Treasury’s absurdly negative projections in October 2020 (as we repeatedly claimed would happen), Frydenberg’s May budget revealed much bigger future deficits than analysts had anticipated, and many, like CBA, quite reasonably argued that the AAA rating was a goner. Certainly nobody, including myself, thought S&P would be so quick to do an about-face by June 2021.

Frydenberg has somehow managed to convince S&P’s lead sovereign analyst, Anthony Walker, that he will significantly under-promise and over-deliver on the fiscal front, perhaps aided by the fact that Treasury has persisted with pessimistic parameters. By upgrading Australia’s rating to a “stable” outlook, Walker has allowed the major banks to dodge an automatic downgrade from AA- to A+ that follows from the sovereign rating falling. This could have easily increased their cost of debt by 10 to 15 basis points, which would have been passed on to borrowers via rate hikes.

In December last year this column reiterated that “our central case [is] that Australia will retain its AAA rating” because there were “real problems with S&P’s logic”. “First, we are projecting large upside surprises to the federal and state budgets, which will significantly outperform [S&P’s] extremely conservative assumptions. These positive revenue shocks reflect an ebullient housing market, robust employment growth and booming commodity prices. This will drive better-than-expected stamp duty and payroll tax revenues, royalties, GST payments and Commonwealth tax receipts.”

“Second, S&P has failed to acknowledge that its forecast 10 per cent drop in national house prices has failed to materialise, and that the bounce-back since September is miles better than it anticipated. It has also underestimated the economic benefits of eradicating COVID-19 in Australia, which is enabling the states to open up aggressively and liberate latent growth.”

Nevertheless pity Australia’s most resilient state, NSW, which has arguably managed the COVID-19 crisis better than any other government, and yet lost its AAA rating after S&P imprudently downgraded it to AA+ in December on the basis of budget forecasts that were, like their Federal counterparts, completely fictional. Treasurer Dominic Perrottet would certainly benefit from harnessing Frydenberg’s powers of persuasion.

At the time we alleged that S&P “had confused the temporary blowout in the NSW deficits, which it should be looking through, with structural problems”. “On the balance of probabilities, NSW will return to surplus much earlier than its own projections and those of S&P.” Seasonally-adjusting the monthly budget data, we estimate that NSW’s deficit for this financial year will end up being 30 to 40 per cent lower than what Perrottet announced in November 2020.

As public finances normalise, and the more parsimonious states focus on budget repair, fiscal policy will begin to detract from growth. We are seeing this with tax hikes in Victoria and big budget surpluses in Western Australia running way ahead of their official numbers. (We think Victoria’s 2021 deficit will be around $25 to 26 billion, or up to $14 billion lower than the $39 billion deficit that was originally expected.)

And yet Australia remains a long way from securing wages and inflation outcomes consistent with full employment. The AFR’s Economics Editor, John Kehoe, has explained that this is why Martin Place will maintain ongoing monetary stimulus at its next board meeting in July. In particular, Kehoe has signalled that markets should expect a third, open-ended round of RBA bond purchases (aka “quantitative easing”) running through 2022 to ensure that Australia’s long-term interest rates, and even more importantly, our exchange rate, remain competitive with the rest of the world.

Judged by these standards, the RBA’s existing QE program has been highly effective, preventing Australian interest rates soaring above their US equivalents, and anchoring the Aussie dollar in the mid-to-high US70 cent range, 5 per cent lower than where commodity prices imply it should be.

On Friday NAB’s Skye Masters commented that “for now, RBA QE purchases are keeping the spread [between Australian and US interest rates] tighter than otherwise would be the case”. The RBA believes that 10 year interest rates are about 30 basis points lower than in the counter-factual of no QE. This has protected exporters and import-competing businesses while they face a one-sided trade war with China and the spectre of global central banks doing everything possible to debase their own currencies.

Based on Kehoe’s analysis, the market is preparing for a new open-ended, $5 billion a week QE3 program, reviewed once a quarter, starting in September once the current fixed, $100 billion QE2 initiative expires. While many traders and strategists have been hoping that central banks, and the RBA in particular, would aggressively taper QE, they are likely to be disappointed as policymakers keep stimulus in place until they observe sustainable wages and inflation congruent with full employment. In fact, on Thursday the European Central Bank announced it will be accelerating its bond purchases.

Central bankers need their economies to overheat somewhat to be assured they will not disappoint as has been the case since the global financial crisis. Those that have jumped the gun, such as the Bank of Canada and the Reserve Bank of New Zealand, have suffered the cost of currency appreciation. Kehoe suggests that the RBA sees no upside in getting ahead of its peers, and will be cautious if and when it decides to dampen its stimulus, with any tapering of QE likely to occur in 2022. This has prompted economists and the market to adjust their expectations. Westpac’s Bill Evans has retained his forecast for $150 billion of total purchases after QE2, but has embraced Kehoe’s proposal.

“Committing to an open ended, $5 billion per week program would not imply a tapering (given it is the same purchase pace as QE1 and QE2) and the RBA’s July press conference could be used to make that point very clear,” Evans says. He highlights that the RBA has considerable untapped QE capacity given that “as a proportion of GDP, the RBA’s stock of bonds is projected to reach [only] 10 per cent of GDP at the end of QE2, which compares with 20 to 25 per cent for the US, Canada, and New Zealand, and 30 to 35 per cent for Europe and the UK”.

ANZ’s David Plank hypothesises that the RBA could buy $5 billion per week through to December 2021 and, if and only if the data continues to surprise on the upside, gradually temper this to $4 billion per week in the March quarter followed by $3 billion per week in the June quarter and finally $2 billion a week in the September quarter. This would result in total purchases north of $150 billion.

Bank of America’s Tony Morriss says a new “flexible” QE regime would mean that “bond purchases could just as easily be increased as much as scaled back”, outlining two possible scenarios. The first involves the RBA maintaining purchases at $5 billion per week for six months following the end of QE2, sizing QE3 at $120 billion. The second captures a staggered taper, starting at $5 billion in the first quarter, and then moving to $4 billion a week and $3 billion a week over the next two quarters, for total purchases of $130 billion by the end of May.

Kehoe hints that any complete exit from QE might be tied to Australia clearly obtaining full employment, which would require a couple of quarters of year-on-year wages growth exceeding 3 per cent. Most don’t think that will materialise until the jobless rate is in the low 4 per cent to high 3 per cent territory. In the meantime, Martin Place has the economy’s back.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 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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