We think the likelihood of quantitative easing (QE) in Australia is tied closely to the risk of global recession. If you believe a global recession is near (we view the risks of global recession at around 50%), then the likelihood of the Reserve Bank of Australia (RBA) being forced to take on non-conventional monetary policy becomes significantly higher.
In this special report for Livewire, we look at what QE could look like in the context of the Australian market, and its potential flow-on effects. These include a steeper yield curve and a push into riskier assets such as equities and lower-rated debt.
We also look at the scale and duration of gains in residential property prices that have been seen in other markets that have experienced QE.
How likely is a US recession?
We believe a global recession is likely to be led by the US and our main warning signs are coming from the shape of the yield curve and weakness in manufacturing. Having said that, it wouldn’t take a lot to tip some of the other indicators into the warning zone.
Table 1: Recession monitor
Source: Bloomberg, Nikko AM
Table 2: Recession monitor
Source: Bloomberg, Nikko AM
How might QE look in Australia?
The most likely guide to how QE may be used in practice in Australia is to read what the RBA has said in recent speeches and the Q&A sessions that follow.
RBA deputy governor, Guy Debelle suggested in his speech 'Lessons and Questions from the GFC' that the short end of the curve has more influence on borrowing rates in Australia (given our reliance on floating rate mortgage debt) than the longer end of the curve (as would be the case in the US, which relies more on fixed-rate mortgages).
This might suggest that a more traditional style of QE enacted by purchasing government bonds may not be the first or most effective method of QE implementation in Australia, and other measures affecting short-maturity interest rates may be more appropriate (similar to what we saw the ECB do initially as it implemented its non-standard monetary programs). In Australia, it’s quite possible that some form of direct funding to banks or the use of longer-term security repurchase (REPO) programs may be the starting point for the RBA.
Phil Lowe, RBA governor, has since suggested that the purchasing of government bonds may well be appropriate although it’s more likely that a combination of measures could be more successful.
We would interpret this to include measures such as forward guidance (similar to the US Federal Reserve’s (Fed) lower for longer guidance) and direct bank liquidity measures (such as repo facilities) as a first step and then, if necessary, to use the RBA’s balance sheet to purchase government bonds.
It is also possible that they could directly purchase mortgage-backed securities (RMBS) as this was done during the financial crisis, from late 2008 to 2013, in order to stabilise the domestic RMBS market and support the mortgage market more broadly (although this was done by Australian Office of Financial Management (AOFM) rather than the RBA).
The size and timing would very much depend on the circumstances leading to QE being implemented, but offshore experience would dictate that it needs to be substantial relative to the size of the market and once started it’s not an easy policy to unwind as markets become dependent on the central bank as a buyer of last resort.
Some likely impacts on markets
The impact on fixed income markets is perhaps more direct and timely than other markets and we can look at offshore markets for guidance. The most immediate effect would be to lower the implied cash rate to zero or below and to lower the entire rate structure across the government curve.
Contrary to popular opinion, which suggests a flatter government yield curve from QE, evidence points towards steeper yield curves during periods of QE. This idea can be seen in the Chart 1 for the US, where the green shaded areas show periods when QE was in operation with the curve steepening and in the blue shaded areas when QE was taken off and the curve flattened.
Chart 1 US 3m/10Y curve and QE timing
Overall borrowing costs for non-government issuers should be lower and credit easier to obtain. This should move investors away from low or negative-yielding assets into more risky and/or less liquid assets such as equities and lower-rated debt.
One of the main aims of stimulatory monetary policy is to lift consumer spending and reduce savings. This has been less obvious in most economies using QE, however, consumer spending may well be better than might have otherwise been the case without QE.
Interestingly, one of the observed effects for consumers has been the effect on real asset prices such as housing as the start of QE programs has often coincided with higher house prices, which is reflected in German and US house prices (Chart 2) increasing from 2011 onwards.
Chart 2 House price index
Given the sensitivity of Australian housing to lower rates, we would expect house prices to also increase from QE.
Bear in mind QE would have recession as a backdrop
Given that we believe QE in Australia is only likely in the context of a global recession, things may be different for investment markets than during the US and European experience of QE.
In a recession, you would generally expect interest rates to fall across the curve, yield curves to steepen and risk assets to perform poorly, whereas generally we have seen risk assets including equities and credit do relatively well during periods of QE — driven partly by lower discount rates and partly by better market liquidity.
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Written for Livewire by Darren Langer and Chris Rands
What about a domestic recession? It's been a long time since Australia has had one but that doesn't mean we are forever immune. If we enter a recession in the next couple of years and we are already near the zero bound for interest rates QE is sure to follow.
Our view at the moment is that a domestic recession is likely driven by offshore factors rather than onshore. To end up in a domestic recession we would need to see housing decline, but the recent interest rate cuts seem to have (at least for now) reversed that trend. Employment growth and participation is still quite strong despite the small uptick in unemployement and that is a sign that the domestic economy still has positive momentum.
I don't see QE helping the domestic market at all. We already have high levels of debt in the housing market and lower interest rates will aggravate the problem. Where is the evidence that QE actually works reducing debt because ultimately it will have to be paid back?
QE is no different to other forms of monetary easing, it makes debt more affordable, lifts asset prices and improves liquidity. It definitely is not designed to reduce debt. Our research show the any unwinding of QE takes a long time and generally comes from GDP growth expanding an economy, not from a direct reduction in central bank balance sheets. We still believe it works; most economies that have tried it have had positive growth and avoided recession, growth just hasn't been as strong as we have experienced in the past from monetary policy easing. There are structural changes happening in western economies that may mean we are unable to grow at a pace experienced in the past 20-30 years (for more information read my colleague, Chris Rands’ article https://www.livewiremarkets.com/wires/rating-the-challenge ). Things may have been far worse without QE in those economies. We are not advocating that it’s the best policy (and I agree it’s going to be difficult to repay all of the debt that’s out there and the process will be a painful adjustment), we are just trying to see what it might look like if policy makers do go down that path.