Market loses confidence in RBA and bond investors get torched as a result

Darren Langer

Yarra Capital Management

After days of speculation that saw the RBA hold Australian bond investors to the flame, only to come out with a far less “hawkish” hint rates would likely not rise until 2023, a lack of trust now clouds the market’s view on the central bank.

This is a key point emphasised throughout our recent podcast hosted by Chris Rands and me. Utterances from the RBA hold a lot of weight, even if it's clearly a two-way street.

"The bond market is equally to blame for overreacting, but we've gone from a world where forward guidance was the norm for central banks to radio silence, which is never a good way to run monetary policy, in my opinion,” Chris says.

Weighing in on the “unusual day” that saw the cash rate - as expected - left at 0.1%, the drastic pull-forward of its outlook for lifting rates, which Australian three-year "guvvies," in particular, had priced in, never eventuated.

RBA governor Phil Lowe said rates would likely rise in 2023 - earlier than subsequent suggestions rates would remain cemented at current levels until 2024. But a year can be a very long time in financial markets.

With the RBA seemingly missing in action last week, the market was left to its own devices. Not surprisingly, bond yields spiked as multiple rate hikes were priced as early as mid-2022. Will mortgage rates rise that soon? And can the market still trust the RBA?

In this latest episode of The Rate Debate, Chris and I discuss the RBA’s big announcement, whether the RBA’s scrapping of its yield-curve controls means the “beginning of the end” of stimulus and what it all means for investors.

Note that episode was recorded on Tuesday, 2 November 2021.

Transcript

Darren - Hello and welcome to the 22nd episode of The Rate Debate. I'm Darren Langer and joining me is my co-portfolio manager, Chris Rands.

Chris - Hello everyone.

Darren - Well, it's the first Tuesday of November and yes, it's Melbourne Cup day, but it also means the RBA has just met. Today was quite an unusual day.

One thing we've seen over the last couple of days is markets have been particularly volatile and a lot of that has been because the RBA seems to have gone radio silent on much of its policies. Today they did give us some clarity around what they're thinking.

A lot of that had to do with the changes to the yield curve control policy. What were your thoughts, Chris? There were no changes anywhere else. It was just around that yield curve control policy.

Chris - If we step away from the decision to drop the yield curve control policy last week, and focus purely on what the RBA said on Tuesday, the big change is that they dropped their language - of lifting rates in 2024 - and said they're expecting inflation to be 2.5% around 2023.

That sees them giving the green light to the market to say potentially, we're now thinking about hiking rates in 2023. But apart from that, they also got rid of the yield curve control. So obviously they're feeling a little bit more hawkish today but didn't want to give too much away.

Darren - It's a bit unusual to be radio silent for so long about it. They could have said it a week ago. We did have a slightly stronger inflation print. The market tested the RBA. They initially defended the policy one week and then went absent the next week.

It's a very strange way to run monetary policy, but I guess it goes back to our criticism originally at the start, when they announced YCC. We thought it was a particularly bad policy and we figured it would end badly when it did. 

The market basically took control away from the RBA, particularly given the RBA has always been a little bit half-hearted about the whole way it would defend the policy. 

Certainly, it's very different to what we've seen offshore with the bank of Japan and other central banks when they've had yield curve control, they've defended it at all stages, but the RBA has never really been completely behind the policy.

Chris - Yes, I think as well, the way that they dealt with it raised quite a few questions. If you extend back two weeks, they did decide to defend it. And there was a statement from a speech that Lowe made where he said that we're not in the same position as all the other central banks. 

And so that kind of felt like them saying that, these policies are here for a little bit and then basically five days later, they've completely given up and they haven't said anything. 

So, it's very strange when you look at it because you kind of think, well, who made that decision? When did they make it? Why did they make it on a Thursday the week before they were meant to meet?

There's kind of all these unanswered questions just lingering over the top of it, that caused the bond market to blow up. And now they've put a statement out that just says it's gone.

So, it's very odd behaviour for a central bank that really wants forward guidance to work, to just give up on a policy midweek and then explain it a week later. 

Darren - It's also rather weird when financial stability is one of their goals and basically, they torched the bond market through their actions.

I guess it takes two to tango in that respect and the bond market is equally to blame for overreacting, but we've gone from a world where forward guidance was the norm for central banks, to radio silence, which is never a good way to run monetary policy in my opinion.

I guess the only good thing that comes out of it from my perspective and it's something we've always felt that whilst 2024 was the language that we're using, they've stipulated it was down to the data looking better.

We need to see wages improving, we need to see unemployment decreasing, and we ultimately need to see some sort of growth. And now we're going to probably see the market focus on those things a little bit more and less on worrying about whether the three-year bond or whether the target bond is 10 basis points or 12 basis points.

Chris - Yes, I think as well, when you look at the way that they've described that, I was certainly nervous last week on the idea that they were going to be much more hawkish than they were in today's statement, simply because you had seen a little bit of noise, particularly with Debelle when he said that a little bit more inflation's welcome, but not a lot more.

So it felt like potentially they were overreacting and the radio silence is the thing that really magnified that. 

But if you look and say, okay, well, if we're forecasting 2023 is when inflation comes back, that's when more hike rates, an 18 month forward forecast inflation is not that accurate to begin with, so it then leaves the market to the guessing game of when's inflation coming back, how long will it be, and that's when we're going to move the rates. 

So you can move away from these front end rates that had just been artificially held at zero to something a little bit more free and moving around with where those estimates for inflation now come from.

Darren - Yes, it's certainly the first step to starting to push central banks back into the corner again and letting the market take over again, reacting to things the way it should. But we've also seen a significant hit to market confidence in the last few days given the way the RBA has done this, and it sort of makes you wonder, have they done some serious damage to their credibility?

I mean, are we going to be able to trust them on any of these other policies . I think that's probably the biggest amount of damage that they've done, regardless, we eventually got the right answer that they felt that it really wasn't doing very much, so they decided to step away. I think the RBA should have announced that up front, not waited a week to do that. 

It begs the question: We've got this quantitative easing policy out there, which the RBA has said it will review in February, but can we rely on that anymore? I think it's really opened up a lot of questions about how the RBA is going to interact with the market going forward.

Chris - Yeah, certainly one of the questions that kind of follows on from what they've done to me, is this the precursor to them dumping QE come February.

Now the market is probably already speculating a little bit that that's what's going to happen, but how they're going to announce that hopefully it's not just turning the button off and not buying anything one day and then telling us a week later, hopefully it's kind of well telegraphed, but you know for people like us who are relying on these policies, I guess not relying is the right word for, for what we're doing, but it's dictating what happens in the bond market. 

If you're holding a position that they've said they're going to support, and then suddenly they go radio silent, it can kind of cause a lot of damage to the confidence that you hold in them following through with their policies in the future. 

So certainly, from my perspective, if you know inflation misses in 12 months time and they say, we need to do yield curve control again, I certainly won't be relying on that.

Darren - Yes, I think I said in one of the other podcasts, with ultra-low rates where they are, without some kind of central bank support, it makes it very unlikely that too many people are going to want to own bonds.

Part of the reason people are happy to own bonds at low rates is that they have a reasonable amount of certainty that they're not going to get destroyed in a rate sell-off. And last month was particularly horrible for bond investors, a three percent decline or three and a half percent decline in the value of the main benchmark is not a normal occurrence in bond markets.

And I think whilst governments budgets are probably in better shape than anyone would have expected this time last year, they're still not in great shape. They still have to come to market. They still need to borrow a lot of money. 

It makes you wonder again, are offshore investors going to have much confidence in the Australian market to keep funding us. 

And I think one of the other things it's probably done is it'll make Australian bonds, relatively cheap to other markets. We had been pretty much flat in spread to the US, now we're likely to see that foreign investors will want a premium for Australian bonds over the rest of the market.

And I think that's ultimately going to cost taxpayers and it's going to hurt the AOFM's ability to continue to fund their budget deficit at a reasonable rate.

Chris - And certainly something that I look at is just where rates ended up in New Zealand. They've hiked first and the market has been very aggressive with where they've taken their rates. Their two-year swap rates are over 2% now.

So, they're going to be in for a quick repricing in the mortgage market and kind of what that does to the economy in slowing it down potentially before it's really had its chance to take off is something that they're going to need to think about too.

But you know, with what they've said today, I think they've tried to call it back a little bit. You just hope they don't have another misstep with how they announce these policies in the future.

Darren - I think one of the other things that sticks in the back of my mind and we've mentioned it a few times, is that central banks have become, I won't say comfortable with inflation, but they've almost encouraged it globally. In the past central banks have seen inflation and they've tended to kill it off real quick by tightening rates fairly fast, often killing their economies along with it, but they promised us this time that they would take it a little bit easy and they might just let it run a little bit here and there because they've undershot their targets for so many years.

We certainly haven't seen that offshore, admittedly the US does have very high inflation and above its target, so does New Zealand and we're probably seeing something similar in Canada. Those central banks have been very, very hawkish, and haven't really let things run like they perhaps suggested they would.

The RBA is still a long way from what we would say, being consistent in its band. We've just ticked into it for the first time in five years, and the market reacts as if we're going to suddenly see large amounts of tightenings.

Can we trust the RBA to not turn into the Fed and basically we get two or three prints close to the middle of the band and suddenly they're talking about tightening's earlier than even we're expecting.

Chris - Certainly I guess the way that I look at it from someone who joined the market in 2010 and has never seen these so-called inflation forecast eventuate, I feel like a lot of the central bankers are fighting, an inflation battle from the 1970s and f always tightened too fast.

The hope for me had been that they were going to let inflation run this time and slow it down once it was actually in the top end or well through the band.

But from what that statement from Debelle says is they're still in that older way of thinking where we can have a little bit inflation. But the risk is that it runs away. The reason I'm less concerned about it running away is you can see what the bond market is ready to price.

As you said, we see 2.1% inflation the first time we're back in the band and the bond market's ready to price six hikes over the next 18 months. So in terms of fighting inflation running away, I don't think there's going to be any problem with that. 

I think the bigger problem is still going to be generating inflation over the kind of the next five years. So, I hope that they're going to let these policies run a little bit longer, but we're already seeing the signs that they're getting ready to take it away. 

So, you know, there's the hope there that they would let it run, but their actions are kind of again, pointing the other direction.

Darren - I guess that's something too, as we saw the RBA did change its forecast for inflation out in the back end to around two and a half percent, which is the middle of their band, but that assumes no changes in current policy.

You would imagine that they do tighten sooner than that, that starts to put that particular forecast at risk. And I guess that's one of the hard parts for a central bank is that if you do change policy it then probably doesn't invalidate them, but it does change the conditions around what some of your forecasts are.

And, and as we talked about it, it's particularly hard to forecast, you know, six months forward, let alone 18 months forward. So, any sort of changes to monetary policy is likely to have a fairly significant impact on some of those forecasts.

Chris - This is something we've talked about in the past and looked at as well in that if you look at where the inflation's coming from at the moment, a big chunk of it is coming from the oil market, and another large percentage of it is coming from housing.

So, when you look at those two things, I would argue that the RBA has got little over control over the oil market. So they probably don't want to overreact to, you know, what was, I think about 40% of the figure, but they do have a little bit of control over that the housing market, if they wanted to slow it down.

And, you know, if they want to kind of see inflation consistently in the band over the next two years, then they don't want to step on housing too much.

So, you can see we've got the macroprudential slowdown coming, we've got a reduction in the TFF, that's going to push up fixed rates, So, whether or not you want to go quickly, to lean on housing when it's going to be the thing that drives inflation is kind of questionable. 

Which to me says maybe they can get away with a little bit of tightening, but they're going to need to be careful that they don't weigh too much on the housing market, because that's a large percentage of what is inflationary at the moment.

Darren - Yes, one of the reasons we'd been perhaps a little bit more critical of some of the forecasts for higher interest rates is not that we don't think that policy needs to be tightened if we see inflation, but it's just the magnitude of it.

In the past, all we had was interest rate policy, so it was pretty easy to say, ok inflation goes to the top part of the band or through the top part of the band, you tightened two or 300 basis points of interest rates and that slows inflation.

But now we've got the situation where it's not only monetary policy with low interest rates, but we've got, well we had up until today, YCC. We had prior to that the bank TFF, which was where the central bank was funding the banks for three years, we also have quantitative easing.

And then if we take all of those things off, our estimate is that the non-traditional style of monetary policy probably was an easing of somewhere between 200 and 300 basis points equivalent to rates. I mean, that's a best guess, but that's kind of what we think it is. 

So if you take all of those policies away, then you also tighten rates and other two or 300 basis points, which is what the market seems to want to try and predict over a long period of time that that's a tightening cycle that is far more aggressive than 94, which is, you know, the other time where we really did have runaway inflation, not expected inflation, but actual runaway inflation, and we had tightening's from, you know, cash rate from four and a half percent up to seven and a half percent. 

So that was only 300 basis points of overall tightening. We think for that to happen all at once, would be very unusual and highly damaging to the economy and obviously to housing. We've already seen housing rates, probably fixed rates up somewhere around 70 basis points.

Chris - Yes. I think kind of 50, 70 basis points is about right. And, when you talk about those estimates that you described saying, here's what comes from QE and here's what comes from the TFF, the TFF which was the RBA lending to the banks is, is a great way to view how these changes work. The RBA was lending to the banks at 0%, for three years.

And because of that, the fixed rate mortgage was able to drop considerably below the variable rate. And if you look at the lending stats at the moment about 40% of home lending is coming by fixed rates.

So, while the cash rate didn't fall, as far as perhaps it needed to, they are actually able to pull these fixed rate loans down further than the variable rate. And that kind of juiced the economy a little bit as well. As you let that TFF come off.

That's when you've seen the first 50 to 70 points. If you start unwinding QE, that should be when you start to see the next hit as well. 

So when I think about the RBA and what they're doing, I kind of think the most likely outcome when they do start hiking is it's going to be slow and steady. 

If you look at the market's pricing at the moment, they've pulled it all forward there. They're saying you get five hikes in 12 months and then we'll be done with it. It kind of feels like the market's thinking is a little bit opposite to the way that they will actually try to get us out of this.

Darren - Yes. The other thing that isn't factored into a lot of this is the fact that we've had a fair amount of fiscal stimulus as well, which the Morrison government and most of the state governments and are busily trying to take back, so it's hard to gauge the impact of that in terms of interest rates, because it's not the same effect, but it's also another thing that will be taken out of people's pockets that they would have had previously. 

So to me, if we do that all at once, it is such a big shock to the economy that, we've joked about negative interest rates before, but we could end up having to do that if that sort of shock was added to the economy. 

In the end, it'll probably be much lower than the market's anticipating and maybe a little bit slower as you mentioned, but to do it all at once as the market priced in the last couple of days, is just not possible.

Chris - Yes. And generally when I look at this, I try to find examples that we can look back at through time. And I think the federal reserve in 2014 is a great example.

They took QE off and the market at that time expected that the hiking cycle would come straight after it. But what we actually saw was that it took about two years for that hiking cycle to really start. So generally when you look at these non-conventional policies like QE, like the term funding facility, yield curve control, while you can't see the cash rate move, they are policy easing.

So, when you're thinking about taking them off, you need to also think about what effect they're going to have. And I don't think you just go, okay, we turn QE off and then we lump 200 points of hikes on top of that, because that's not just 200 points that works out to be more like three or 400 points.

And so, I think when you look at how they're going to deal with these policies, it is interesting to go back to whether it's Europe, whether it's Japan, whether it's the US and say, when they have tried to stop QE, what does it actually do? And usually it slows the economy down.

Darren - It's one of the things it's hard to see the impacts because you will see a lot of commentators will say quantitative easing, nothing improved, didn't do anything.

But we don't know that for a fact because we don't know what would have happened if they hadn't done it. And that's the part that I think most people forget, that perhaps if we hadn't done quantitative easing, growth would have plummeted even more, unemployment would have been higher. 

It's just very difficult to know that for sure without testing the case and no one in their right mind is going to want to test the situation of seeing whether we'd end up with more people unemployed and a worse outcome by not doing a policy. So I think central banks believe quantitative easing works.

And as you say, it works because it is another form of monetary easing. So, I think we have to then say, if we believe it works, removing it has to have an impact.

And I think that's another thing that needs to be kept in the back of the mind is that if you do take them all away there is going to have an impact. It may not be immediate, and it may not be obvious at first, but it will have an impact.

And that's the sort of thing we'd be looking out for over the next couple of months, because now we've had not only the TFF taken off, but YCC we've taken two out of the four main monetary policy tools that the RBA has, we're seeing a withdrawal of stimulus from the government, and we do ultimately have higher interest rates.

Regardless of what happens with the cash rate, for the average mortgage borrower their interest rates are now higher, for new borrowers and for anybody who's got a fixed rate loan.

Many of those were one or two-years of fixed rates. And, you know, they're going to be coming up for a reset sometime in 2022, maybe 23 for some. So, there is going to be impact over time, which needs to be factored in when sort of working out where interest rates could get to.

Chris - Yeah. And I guess just to finish on one point that I always draw on for these policies, is that the entire time I've been in the market, ending QE has always been 12 months away.

Whether it's Japan, whether it's Europe, the US, it's always well in the next 12 months, these policies are going to be gone. So, I always feel that it can always turn the other direction very quickly, because every time we're told they're going to end, they seem to just get bigger.

I hope that's not the case here, but certainly when you look offshore, it's always been just as you think it's going to, it seems to turn up twice as large.

Darren - Yes. And I guess the one thing we point out as a risk, and it could be that factor that nobody's taking into account, because we certainly didn't see the RBA even mentioned it today from memory, is what's happening in China.

We saw as we came out of the COVID crisis, initially China was very strong. It led the rest of the world out of the initial turmoil. We've slowly seen Western economies catch up to that, but now we're starting to see China weaken, some of that is by design because they're changing policies internally to try and make things more sustainable.

But, if I saw a left-field event happening, a weaker China could well be problematic, and even more so for Australia because one of our key exports. Iron ore has fallen from around $220 a ton down to probably around $95 a ton.

That's going to have a fairly large shock to incomes for the country. So, there are these things happening in the background as well, which aren't really factored into some of these decisions that the RBA and others are building in at the moment.

Chris - Certainly when I look at the trajectory of our economy, I'm much more concerned with what's going on in China than necessarily the west.

China's been about 30% of global growth over the past 10 years. So if you take that out of the equation, it starts to make Australia's outlook kind of much dimmer than you would expect.

And when you look at China, it's not terrible, but some of the lead indicators, whether it's PMI's, new orders, commodity prices, a lot of those have started to fall. You're starting to see some property developers default, and usually you stack those things up and you start to think this doesn't look fantastic. 

We probably shouldn't be too hawkish, but the west is certainly getting ready to jack up rates and how that flows through to China will be important how you think about the economy. Probably not in the next six months, but maybe at the back end of next year.

Darren - And just to sort of summarise, the things I think we're going to be looking at over the next couple of months, really to get a better handle is, do we see wages in Australia pickup, is a lot of this inflation really transitory or is it real, and by real, I mean, is it going to stay in the numbers? Are we going to keep seeing prices go up?

That's still a little bit difficult to tell because of the after-effects of COVID. And I think as we said, we'll be keeping a close eye on what's happening in China because it is being a bit of lead indicator at the moment for the global economy.

And as you just mentioned, it's not looking real flash. So, they're the things you really want to keep an eye on. 

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Darren Langer
Co-Head of Fixed Income
Yarra Capital Management

Darren is highly regarded in the fixed income industry and is regularly featured in the press. He is also co-host of the popular Australian podcast series The Rate Debate. He has more than 30 years’ experience in fixed income markets and 25 years...

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