Parsimonious pigs will struggle to pass-through

Christopher Joye

Coolabah Capital

Today I explain why ANZ was nuts not to fully cut its lending rates in May; why it will be even harder for all banks to pass along the next RBA cut, which could come in July or August; why the cash-flow impact of rate cuts could actually be negative; and why all roads lead to the RBA thinking about launching QE much more quickly than anyone in the market anticipates (click on that link to read or AFR subscribers can click here). At the end of the day, the RBA wants to lower lending rates, and to assure this it must reduce bank funding costs, because they do not fund at the official RBA cash rate. This is actually very easy for the RBA to achieve. With the flick of a switch they could turn on a term lending program by doing up to 3 year repurchase or "repo" arrangements, which would radically reduce bank funding costs that the RBA could then insist are passed on to borrowers. Perhaps a better solution is to launch a standard QE program to reduce funding costs via asset purchases, which would have to include government bonds, bank senior bonds and possibly RMBS, noting that senior bonds are by far the most important funding tool for banks outside of deposits. Excerpt enclosed:

Every time the RBA cuts, the net interest margins on these deposits get crushed, which fundamentally limits the ability of the majors to pass through said cuts.

It would not, for example, be surprising if the RBA only gets 50 per cent pass through from its next cut, which could come as quickly as July.

Limited pass through means the RBA is going to be inevitably forced to think about a third cut. This is why the central bank will presumably be considering some form of complementary quantitative easing (QE) to maximise pass through, ideally before the next cut.

And it is fascinating to consider what form this QE could take. One option is to just offer all banks very cheap term funding of, say, up to 3 years via extended repurchase, or lending, arrangements.

The RBA already lends short-term money all the time via repo, which is secured or backed by government bonds, senior-ranking bank bonds, and securitised home loans.

It makes no sense at all for the RBA to crush the banks’ net interest margins through rate cuts and then expect them to comfortably lower lending rates.

If, on the other hand, the RBA initiates synergistic QE, it will directly lower bank funding costs, which they can pass on to borrowers in the form of cheaper borrowing rates.

One problem with direct term funding is that the ECB has found it hard to pull the plug from this kind of QE, and has been repeatedly forced to roll-over or renew these loans.

It may be because there is no real market pricing mechanism when a central bank cuts out private investors completely and lends directly to banks.

An arguably more effective alternative is for the RBA buy government and bank bonds alongside the private sector much like the ECB and US Federal Reserve did.

This would both reduce the base risk-free rate the banks borrow against (ie, government bond yields) while also cutting, just as importantly, the credit risk premium they are forced to pay.

Finally, it is plausible the RBA does a combination of these things: that is, extended cheap repo out to say 3 years coupled with some direct bond purchases.

All would have the impact of flooring bank funding costs, allowing competition between the banks to drive much, much lower interest rates.

Complementary QE fused with cash rate reductions would be much more powerful and targeted than the RBA restricting itself to the cash rate only, and likely ensure full pass through.

One benefit of an outright bond purchasing program is that the RBA is working alongside the private sector, which both the Fed and the ECB have demonstrated a central bank can comfortably stop doing over time. Long-dated term funding has been a tap that appears harder to turn off...

Read full column here.

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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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