RBA delivers stealthy QE increase

Christopher Joye

Coolabah Capital

In the AFR I write that one of the most interesting developments in local financial markets this week has been ANZ breaking the drought of senior bank bond supply with a surprising $1.2 billion issue of a 12 month bond just one day prior to the end of the quarter. Excerpt enclosed:

At exactly the same time ANZ was hoovering up this cash, I was at the The Australian Financial Review Banking Summit asking two of the top treasury stars—Westpac's Treasurer Jo Dawson and CBA’s head of funding Kylie Robb—when they expected to see the first senior bond deal from one of the big banks. The best I could get was the second half of this year.

So why did ANZ gazump this prediction when it is ostensibly carrying significant excess funding given a huge surge in deposits since the COVID-19 crisis? Without getting too wonky, it would appear that the major banks’ liquidity coverage ratios (LCRs) are starting to decline as a result of several influences.

LCRs simply measure the size of a bank’s stock of high quality liquid assets (HQLA) relative to the banks’ net cash outflows (NCOs) in a 30 day liquidity stress-test. These NCOs try to capture the risk of a bank-run if deposits rush out the door.

When LCRs fall below a target threshold of around 125 per cent, banks have to buy more HQLA to boost them back up. And the only investments that are sufficiently liquid to count as HQLA are Commonwealth and State government bonds.

To fund these purchases, banks have to raise money. One might therefore speculate that ANZ’s sudden, $1.2 billion senior deal was executed to boost a declining LCR. It was, interestingly, followed immediately by Macquarie Bank announcing a 5-year senior bond offer in pound sterling overnight.

The question of course is what is pressuring LCRs. One driver could be a shift from term deposits to at-call deposits given their relative interest rates are converging, where at-call accounts are hit with more punitive run-off, or NCO, assumptions.

Another might be a move from retail to business deposits, which also carry a higher run-off rate (retail deposits are assumed to be stickier).

A third driver would be APRA’s prudent decision to reduce the size of the Committed Liquidity Facility (CLF) from $223 billion late last year to $139 billion today as the quantum of available HQLA (ie, government bonds) has soared care of big budget deficits. The CLF was originally established when Australia had, rather uniquely, almost no government bonds on issue. That’s no longer a problem with about $1.2 trillion outstanding.

Instead of holding liquid government bonds, the CLF allowed banks to substitute in higher-yielding and yet much more illiquid home loans, senior bank bonds, and AAA rated residential-mortgage-backed securities. As APRA sensibly shrinks the CLF, banks have to replace these illiquid assets with HQLA to bring them back into line with best-practice around the world.

There are other subtle and not-so-subtle sources of HQLA demand, which have the important by-product of keeping the interest rates on these bonds lower than they might otherwise be. For example, APRA has forced Westpac to increase its NCO assumption by 10 per cent as punishment for fudging its liquidity calculations.

During the Summit, Dawson and Robb also stated that they expect their balance-sheet growth to start normalising over the next year, which will require them to bid for more HQLA again.

A final buyer of HQLA is naturally the Reserve Bank of Australia via its bond-purchasing, or quantitative easing (QE), program, which seeks to slow the ascent of 5-year to 10-year Australian interest rates as the local recovers. A former RBA director, John Edwards, commented during the week that Martin Place “has to stay in the bond-buying business for quite a while” because “it’ll be awkward for us if [the Aussie dollar] goes much over US80 cents”. It’s safe to say that this reflects most elite thinking on the subject.

After some early problems when the market questioned the credibility of the RBA’s commitment to QE, the policy has increasingly become a striking success. Before the RBA launched QE, Aussie 10-year interest rates were more than 30 basis points above US 10-year rates. At one point, that excess jumped to around 45 basis points. And yet today the difference has fallen back into the single digit range.

This has helped keep the Aussie/US dollar cross, which is currently trading below US76 cents, and Australia’s trade-weighted exchange rate, about 5 per cent lower than they would otherwise be, which is helping exporters struggling with China’s trade war and local businesses competing with imports that have been artificially cheapened by foreign central banks’ comparatively more aggressive QE policies.

We’ve long asserted that a third round of QE is all but certain in October this year with the high-probability case that the RBA maintains the current run-rate of buying $100 billion of bonds every six months. Any diminution of the RBA’s commitment to QE is likely to force the Aussie dollar much higher and unnecessarily hamper our economy vis-à-vis the rest of the world.

Westpac’s chief economist, Bill Evans, has been one of the most consistent advocates of the need for QE, and recently upgraded his forecast for the size of the RBA’s third round of QE, commencing in the final quarter of 2020, from $50 billion to $100 billion. “Were the RBA to taper [QE] it will expose the [Aussie dollar] and signal to the market that it has begun tightening, which could expose the recovery to unnecessary pressure,” Evans said.

Evans added that the RBA “has a reasonable case to argue that QE has lowered Australian long bond rates by around 30 basis points”, which supports Martin Place’s argument that it has kept the exchange rate 5 per cent lower than it would otherwise be in the absence of QE.

While there have been calls for the RBA to increase the size of its bond purchases, the fact that it is maintaining them as Commonwealth and State budget deficits are coming in much lower than the market expected means that QE is indeed much more impactful. That is, we are indeed getting a de facto QE increase.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

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...

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