Is everything OK with the RBA? (Clue: No)

The recent RBA backflip has eroded confidence in the Australian bond market and left fixed-income managers fuming.

Just to remind everyone, the last week of October gave us an unexpected RBA decision to abandon its yield curve control policy. How unexpected? 

Very.

Only a few weeks earlier, on October 5, the RBA had said it would defend its stated target for the three-year bond yield of 0.10%, a rate which allowed banks to continue to provide cheap mortgages for the next three years and signalled that the cash rate would stay set at 0.10% until April 2024. 

And yet as the yield rose through October, with five-year bond yields in Australia rising about 80 basis points, and 10-year yields rising about 60, and the bond price tumbling, the RBA sat on its hands, or, as Governor Lowe described it, used 'discretion' in terms of it policy setting.

This ‘discretion’ tipped the Australian bond market into the dirt, delivering very severe losses, and ensuring "the RBA suffered a huge loss of credibility"

That "loss of credibility" quote above belongs to Charlie Jamieson, CIO of Jamieson Coote Bonds, who used his monthly investor update to detail some of the implications of the policy backflip.

Let's take a sample:

"It is surely very dangerous ground for a central banker to start to change policy without having a formal announcement to market," he says. "Clearly, it came about because we are seeing slightly more inflation pressure coming through the system. Australia recorded a 2.1% inflation number throughout the month, and that added additional fuel to the fire late in the month for a substantial drawdown."

What Jamieson makes plain to see, however, is that the pain ahead is not just for bonds but for all asset classes:

"In the process of that drawdown, the bond market priced in more than five rate hikes for the Australian economy in 2022. We have been told repeatedly by the Central Bank that they do not expect to hike interest rates until 2024 under their central scenario. However, that is likely going to come forward by virtue of how quickly they've changed policy in and around something like yield curve control."

With those five interest rate hikes priced in for 2022, there are also an additional four rate hikes priced in across 2023-2024. Jamieson goes on:

"Let’s join the dots on that. For example, everybody with a fixed-rate mortgage that will roll off in '23 or '24, will reset into a four or a five per cent rate. We're talking about a contraction in economic terms that would be simply unfathomable for the economy to operate as we know it today.

For more of Jamieson's less-than-flattering verdict on the RBA, and how all asset classes will be affected if it continues on its current path, watch the short video below.

After all, as he says:

This is important stuff. You can't get this stuff wrong as a central banker and they couldn't have got it more wrong in terms of their communication and the telegraphing of their policy intention to then flip around and completely react in a different way as the incoming data has changed. 

Edited transcript

Hi, I'm Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, and this is a review of markets in 2021. 

A huge month for global bond markets over the course of October, particularly for the Australian bond market, which saw very severe losses as a result of the RBA stepping away from its yield curve control policy and having a huge loss of credibility in the moment. 

What started with a movement from the Bank of England suggesting that they would imminently hike interest rates as a result of some energy issues, which certainly Europe is seeing, plus this continued goods inflation which the globe continues to experience, saw a wholesale reassessment of central banking policies and pathways, but ironically, Australia was the largest selloff in those outcomes with five-year bond yields in Australia rising about 80 basis points across the month of October with 10-year yields rising about 60.

To put that into comparison in the US treasury market, the largest global bond market in the world, still obviously exposed to similar themes, five-year bond yields only rose about 19 and 10-year yields rose only three. 

So very, very substantial underperformance from Australian bonds.
And that has come as a result of the RBA using what Governor Lowe described as discretion in terms of setting the yield curve control policy.

As above, this is very dangerous ground for a central banker to start to change policy without having a formal announcement to markets, but it came about clearly as we are seeing slightly more inflation pressure coming through the system. Australia recorded a 2.1% inflation number throughout the month, and that added additional fuel to the fire late in the month for a substantial drawdown.

In the process of that drawdown, we got to a stage where we find it incredibly difficult to join the dots to the actual realisations of those outcomes. 

The bond market priced in more than five rate hikes for the Australian economy in 2022. We have been told repeatedly by the Central Bank that they do not expect to hike interest rates until 2024 under their central scenario. 

I think we can all agree that that is going to come forward by virtue of how quickly they've changed policy in and around something like yield curve control.

With those five interest rate hikes that were priced in for 2022, there are also an additional four rate hikes priced in across 2023, 2024 at the idea that the worst valuations that we saw across the month. 

Just join the dots on that to think about mortgages starting with a four something. Everybody that has a fixed-rate mortgage that will roll off in '23 or '24, resetting into a four or a five something in terms of their own financing costs. 

We're talking about a contraction in economic terms that would be simply unfathomable for the economy to operate as we know it today.

The bond market has rallied quite substantially over the early part of November because clearly those types of valuations are a bridge too far, but I think we can all agree that the next movement in rates clearly now is to have some kind of lift. 

But the evolution of that policy and how quickly that might come and the damage that can occur to other asset classes as that does occur is the source of great debate. And clearly, this incoming inflation data will need to be watched very, very closely.

Now, remember across a lot of 2020 and 2021, the substantial lockdowns have changed the way the economy work quite considerably. 

In Australia, our economy is 70% plus services-orientated, but there have been very few services to acquire whilst you've been locked at home as we've certainly been for a lot of the year in Melbourne and Sydney sadly. 

Now that we're released out and about to play again, what has been very focused on goods purchase, thinking home gyms or Wi-Fi equipment to work from home or tech equipment or whatever that might be, is now changing.

And certainly if we look at search trends, [00:04:30] the search histories of those types of things, accommodation, flights, restaurants, is going through the roof unsurprisingly.

Across that timeframe also, we had just-in-time manufacturing meet global lockdowns, and it's been a disaster for the supply chain. But we do believe that that will clear. 

And so central bankers are still saying, look, it's transitory, but as we've spoken about previously, there is no definition as to what length of time transitory actually is. So we've been told it will be transitory. 

We saw inflation rise and fall by virtue of the base effect, which we wrote about extensively earlier in the year. We're seeing it rise a little bit again as these goods demand is insatiable, meaning there's supply blockage, but there are reasons to believe that the supply blockages are easing. 

If we look at a lot of commodity markets, they're now falling. Oil, which is probably the most important commodity of all. If we look at freight rates, things like Baltic Dry they are falling quite substantially. 

There's a lot of talk about supply problems around Christmas, but if we manage to stay out of lockdown as we transition into 2022, we do absolutely expect that we'll get to a more normalised economy.

Now, that doesn't mean that we're not going to continue to have incredibly bouncy economic data as a result of all of this, but it is important to join the dots through as to how that might affect things, particularly if what's happened in the bond market and predominantly in the short part of the bond market where we could see some global rate rises. 

If that turns out to be true, then it has vast implications for all asset prices into what we know will be likely slower growth into 2022 by virtual of reduced fiscal spending.

Two possible pathways forward for bonds 

Either we've had a vast over-reaction and there's a substantial recovery, and that probably won't derail asset markets too much, but if bond markets have sniffed something out here and there is a policy tightening cycle, hiking cycle coming from global central bankers as we come into 2022, we think that has really substantial and profound implications for asset valuations.

I guess the best example of this, and we come back to this a lot, is the fourth quarter of 2018. 
When we did have a big bond market sell-off in October of that year, credit froze up in November as a result of much higher interest rates. 
Remember corporates have got to refinance all of these low-grade issuers. 

The zombies or the junk bond issuers need to refinance or borrow new capital, and the market loses confidence as those rates move higher. 

And in December, equity markets fell over quite substantially. And that actually turned Federal Reserve policy at that time to be much more supportive. It turned it from being what we call hawkish, more rate hikes, to completely neutral and the Fed was cutting rates seven months later in July of 2019.

So if bond markets continue to sell-off, you should definitely pay attention. We don't believe that's going to be the base case. Central bankers have pushed back on the timing of all of this. 

The Bank of England that started this route, then mysteriously passed on doing anything about it and were actually quite dovish, very supportive in many respects of low rate structures, completely wrong-footing that marketplace causing a huge amount of turmoil in the process.

As we've seen from the RBA, this discretion which nobody knew about [00:08:00] which has been exercised, puts a lot of questions under the commitment to the quantitative easing policy. 

Should Australian bonds trade cheap to their global counterparts as a result of this credibility shock? Yes - they probably should. 

This is important stuff. You can't get this stuff wrong as a central banker and they couldn't have got it more wrong in terms of their communication and the telegraphing of their policy intention to then flip around and completely react in a different way as the incoming data has changed. 

Clearly, the forecasting is pretty ordinary over there. But we are living in unparalleled times. We've not all recovered from a pandemic before and it is going to remain bouncy.

Volatility doesn't stay in one asset class for very long

When we think about the RBA, it's almost certain that the first live meeting, if we are to believe what they're telling us continue to, it cannot be really before May. 

We only get inflation data here quarterly in Australia. We're not due to get inflation data again until January and then April. And we would need to see inflation getting up to that midpoint of the targeted band above 2.5% and sustainably staying there, plus wages growth at 3% or higher in order to satisfy what the RBA have told us is the criteria to hike interest rates.

With the borders reopening and foreign labour allowed to come in, that should take some of the sting out of that wage pressure. 

But clearly, as we're reopening, there is some wage pressure around. We're seeing [00:09:30] that in all economies. 

So watch this space very carefully. I think central bankers for now push back really intently pretty hard. The Bank of England wrong-footed everybody. The Fed and the ECB have calmed things down. 

The RBA tried to push back or shot themselves in the foot in the process, but it should definitely be a fairly spicy end to the year for all asset markets.

We do believe that after moves like this, liquidity in all markets can be affected. Clearly, risk assets have had a fantastic year. Will there be some moving to the sidelines ahead of that year end? 

These are things to think through. But I would encourage you to really watch the bond market because if we stay on this track, it can have vast, vast implications for total portfolios, not just the fixed income piece. 

And as we know, volatility doesn't stay in one asset class for very long. If it is severe enough, it is likely to jump across asset classes. So it really does bode watching those bond rates and how the markets are perceiving the growth path forward and the inflation pathway forward into 2022.

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