RBA delivers $100 billion of QE 2.0, as we forecast last week...
As we predicted last week with our detailed QE 2.0 paper (see here), the RBA today surprised the market by announcing another $100 billion of Commonwealth and State government bond purchases on top of the $100 billion it is currently spending as part of its QE 1.0 program, which is due to end in April.
This is in line with Coolabah’s forecasts for another $100 billion of bond purchases as part of what we have coined "QE 2.0". The RBA has not yet revealed whether it will increase its purchases of State government bonds from the current 20% allotted as part of the program (we were forecasting that this could rise to 25-30%).
The surprise for the market was two-fold. First, investors did not expect the RBA to reveal its hand on QE 2.0 for a while yet (perhaps at the March meeting). Second, the market was very conflicted as to whether they might taper or even eliminate the program. Capital Economics forecast that the RBA would do no more QE at all. NAB thought they would taper it to just $50 billion, as did JP Morgan. DB were also in the tapering camp (assuming a reduced $75 billion commitment).
So the RBA surprised with its pre-emptive timing, and probably shocked about one-third to one-half of the market in terms of the hefty size of its investment. Here it is important to note that this might not be the end: the RBA's QE program could be easily extended again in the future given how much stimulus the economy needs to restore full-employment. And with this in mind, the RBA has flagged that it does not expect to increase its cash rate until 2024 at the earliest. Last week we wrote:
Lowe will be mindful that Australia still confronts many important challenges: the global economy is experiencing a fresh setback from COVID-19, with lockdowns in Europe, the UK and US, amongst others; a serious, albeit one-sided, trade war has erupted with China; much of the federal government’s massive fiscal stimulus is unwound this year; and the international border likely won’t open until 2022/2023 given Australia’s tough and highly successful approach to managing the pandemic.
With annual wages growth running at a record-low of 1.4%, core inflation less than half the RBA's official 2-3% target at 1.2% year-on-year, and the 6.6% jobless rate miles above the RBA's estimate of the circa 4.5% NAIRU, Martin Place has a lot more heavy-lifting to do to get labour earnings growth back to the 3.5-4.0% range required to normalise inflation back into its target band (which we have not seen since before the GFC).
This will mean effectively trying to get the Aussie economy to overheat, and pushing the jobless rate through the NAIRU, perhaps below 4.0%, as Janet Yellen had previously done in the US, in turn successfully normalising wages growth.
The key challenge for the RBA is the rising Aussie dollar, which has appreciated by 6% on a trade-weighted basis since the end of 2019. The best way to alleviate demand-side pressure on the Aussie dollar is by reducing the attractiveness of the world-beating AAA and AA rated interest rates on Commonwealth and State government bonds, which are much higher than any other comparable country in the developed world.
This is the essential goal of the RBA’s QE program, which is currently focused on purchasing 5-year to 10-year Commonwealth and State government bonds. And there is no doubt that the program has been immensely important in slowing the ascent of our exchange rate.
Based on the historical nexus between commodity prices and the Aussie dollar, one would have expected its appreciation to be about twice as much as what we have actually experienced since the RBA launched QE in November 2020. That is to say, the RBA’s QE has saved local exporters and import-competing businesses from much harsher commercial conditions.
The RBA buying 5-year to 10-year government bonds also has virtually no impact on housing market dynamics given most Aussie home loan borrowers use variable or short-term fixed-rate products. It does not, therefore, raise the financial stability concerns associated with other, more conventional tools.
Furthermore, housing credit growth remains weak while there has been no net aggregate house price growth since 2017. In fact, home values in Sydney and Melbourne are actually 3.88% and 1.76% lower today than they were three years ago.
In our detailed paper last week, we wrote:
Full employment is crucial to lifting wages above 4% to return core inflation to the RBA’s target 2% to 3% band. The last time Australia experienced full employment was prior to the global financial crisis (GFC), which explains why the RBA has consistently undershot its inflation target in the years leading up to the pandemic. Lowe will also be mindful that Australia still confronts many important challenges: the global economy is experiencing a fresh setback from COVID-19, with lockdowns in Europe, the UK and US, amongst others; a serious, albeit one-sided, trade war has erupted with China; much of the federal government’s massive fiscal stimulus is unwound this year, and the international border likely won’t open until 2022/2023 given Australia’s tough and highly successful approach to managing the pandemic.
With the RBA a long way from its economic objectives, the Taylor rule from the RBA’s MARTIN macroeconomic model points to the need for a strongly negative cash rate: as much as -3¾% in 2021. Since Lowe has all but ruled out negative rates, the RBA will have little choice but to furnish additional unconventional monetary stimulus in 2021 and, to a lesser extent, in 2022. Quantifying how much extra support is required is difficult, but CCI expects that the RBA will extend its existing quantitative easing (QE) program, which is due to expire in April, for another six months with a similar, c.$100bn commitment to relieving upward pressure on Australia’s high long-term bond yields and the trade-weighted exchange rate.
Although we don’t have high conviction on the size of QE 2.0 (there are credible arguments in favour of a significantly bigger commitment), we agree with Deputy Governor Debelle when he remarked last year, “I think in the situation we’re in at the moment, I would certainly think the right decision is to err on too much support rather than too little support”.
If anything, market participants may be underestimating the possibility of a larger program given that the key learning from QE 1.0 is that the RBA has not done enough to achieve its macro aims, as reflected in a higher Australian dollar. This is reinforced by the fact that both the cash rate and the 3-year government bond yield are at their effective lower bound (the 3-year rate is being managed under the RBA’s yield curve control policy). A final consideration is that banks have not materially drawn on the RBA’s c. $180 billion term funding facility (TFF) since October 2020 because they are awash with excess liquidity in a world where balance-sheet growth remains very weak. The last remaining policy tool with substantial untapped potential is QE targeting long-dated bonds, which also has the very attractive benefit of having little impact on housing market dynamics given most Australian home loan borrowers use variable or short-term fixed-rate products. It does not, therefore, trigger the financial stability concerns associated with other more conventional monetary policy tools.
There is also a case for the RBA to take this opportunity to fine-tune the mix of its purchases of Commonwealth and state government bonds to 70%/30%, more in line with the relative weights in the stock of outstanding debt. The RBA had previously underweighted its purchases of state bonds (or “semis”) over concerns about liquidity in the market, which proved unfounded even following the announcement of much larger state budget deficits and the rating downgrades of NSW and Victoria. In fact, all the evidence suggests that the RBA has uncovered enormous offer-side liquidity in the semis market, buying most of its bonds very cheaply at or wide of the mid-credit spread (i.e. not at the offer as would normally be the case).
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Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 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...