RBA ends QE and pushes back on rate hike

Darren Langer

Yarra Capital Management

The RBA announced an end of QE and kept interest rates on hold as they wait to see stronger wage growth. If inflation continues to rise faster than forecast, and the RBA hikes earlier than expected, what could the knock-on effect be on markets? Tune in to hear Chris Rands and me discuss this and more in the first episode of The Rate Debate for 2022.

Transcript

Darren

Hello, and welcome to the first episode of the rate debate for 2022. I'm Darren Langer, co-head of fixed income at Yara Capital. and joining me is my co-portfolio manager, Chris Rands.

It's the first Tuesday of February and I'm back after a few weeks away from the office and the market landscape seems to have already shifted a lot, but as always, we're here to talk about what the RBA is thinking. Certainly, Chris, we saw a few changes today. The RBA did what we expected taking quantitative easing off the table, but a lot of the other speculation around big changes to some of their forecasts also came about, but probably not to the extent the market thought, what did you see?

Chris

I certainly thought that this was the first tightening of the cycle. So they've removed QE, it might be unconventional policy, but it's still policy easing when they bring it in. So I certainly see this as the first tightening. 

I think the market was probably a little bit upset with the messaging that we've seen, because the RBAs telling us that they're still going be patient because they want see inflation sustainably within that two to three band. 

So, as Lowe told us in the past, it's not going be enough to see a one print in the band. We're going to need to see it a couple of times to make sure that it sticks here.

Darren

Yes, it was certainly quite a dovish statement given that they actually tightened what we would call interest rates, obviously the actual rate policy rate didn't change. But as we've talked about before, quantitative easing does have impacts on the overall level of rates and probably the currency as well, but, they were pretty Sanguine about the rest of the things, there's been a lot of cries out there for the RBA to admit that they got it wrong, and to some extent the RBA has changed their forecast. They've certainly lifted their level of inflation from what it had been. And, and they've certainly talking about slightly stronger growth and better wage and employment outcomes, but they certainly were not talking about US style inflation and growth outcomes.

Chris

That's probably kind of as good a point as ever to focus on here for the RBA and the differences in inflation that we're seeing now. So the RBAs got core inflation at 2.6%, and that is square in the two to 3% band that they've been targeting. When you look at the Fed, or at New Zealand, some of those countries have 4% core inflation and closer to 7% headline CPI. So certainly, for us at the moment, we are not sitting in that situation. Maybe it will get there in the future, but from the RBAs perspective, they have said multiple times, as I said before, that they want to see it sustainably there. And so the thing that I've had a little bit of a struggle coming to terms with, compared to the way the market is seeing it, is we're starting to see people say that the RBAs losing their credibility. This is the first time they've been in that two to three band for about six years, and so it seems odd now to be questioning what they're doing when they've had the policy in place to get us back there.

Darren

I think you hit the nail on the head. You know, the RBAs credibility has been questioned quite a lot for missing the band. They now have it smack bang in the middle of the band, at least as far as core inflation goes and suddenly they don't have enough credibility again, because they're not following what the market wants. I think realistically, it's a fair statement to make. 

It doesn't mean that interest rates aren't going to go up later this year or early next year, but the RBA is still saying that they really don't want to be in a situation where they tighten too soon and they kill off any chance of growth in the future, and I think that's why we've been very critical of central banks globally, not just the RBA, that they have tended to go far too quickly.

And, at a time when inflation it's a high by any means relative to what's happening offshore. And certainly, whilst you might be able to argue that the Fed might need to tighten interest rates sooner than later. There's certainly not the case here.

Chris

There's also a few other things that jumped out to me in the inflation figures that I think the RBA picked up today. The first of those is if you look at the breakdown of inflation, goods prices are running at essentially 30 year highs, whereas services are about where you would expect to see them. And so that's really reflecting the supply chain problems that we've seen. That's forcing up goods prices. If you look through the breakdown of domestic versus international inflation, what you'll see is that international inflation is higher in Australia than the local sources. And certainly from the RBAs perspective, I think that this should raise two questions. The first of that is after 30 years of stable, goods prices, do we think we're entering a regime now where they're going to go up continually? Or is this just a spike because of the COVID supply chain issues? And then the second one certainly jumps to mind is if we reduce demand, does that even fix the supply chain issues that we're caught that we're seeing? Or is it just going to cause some other problem? So I think that's why they're being a little bit defensive here and saying, look, we're still being patient because we just haven't seen this before, and we don't know, maybe it'll keep going, but we certainly don't know, and we don't want to kill it early if it’s not.

Darren

And I guess that's also one of the things we need to look at is inflation running at 4% per annum has to keep going at 4% per annum if it's going to stay there. If we just hit 4% and then suddenly see inflation tail back to one or 2%, we’d just be back in the same boat that we've been in the other few times over the last 10 years where we have seen a couple of big inflation prints, generally off the back of higher energy prices and oil being the main culprit, and then we've seen it come back off again. So I think that will be in the back of the RBAs mind at the moment saying, well, we've seen this happen before, everyone told us we should be tightening. The last couple of times we thought about it and got pretty close, this time we're just going to wait and see.

Chris

There's one last thing that sits in my head and this probably doesn't really kind of relate too much to what the RBAs probably thinking at the moment. But certainly, it's something that I come back to is before the COVID supply chain issues. 

They had been overestimating their inflation forecast for essentially 10 years. 

And so certainly it seems that in the back of their minds, they're thinking, well, when we go back to that environment, maybe we're still going to be overforecasting. That doesn't mean that for the next 12 months there isn't the chance that it's going to pick up, but I think from their perspective, they're saying we really want to see it before we go.

Darren

I must admit, there's one thing that makes me a little uncomfortable about being on the same side as the RBA in terms of our views is that they haven't been right very often. It’s not always a good feeling but I think we've got enough evidence in our own work that we can sort of see where the inflation's coming from and to have it sustainable, as you say, we've got to see either a really big pickup in services inflation, higher than what it has been, or goods inflation continue to keep going, and we're increasing goods prices at rates never seen before and we're in the middle of a pandemic. 

It's hard to say that if the pandemic goes away, goods price inflation will continue at the same pace. So for us, we want to see some evidence of post pandemic numbers, rather than worrying about what's happening in the pandemic itself.

Chris, the RBA has decided to end QE. What that means is after the 10th of February this month, they won't be buying any more bonds. They still haven't actually told us though whether they will continue to reinvest maturities and things like that, or whether they will actually start the process of quantitative tightening. How do you think it's likely to play out over the next couple of months and what do you think that ending of QE actually does to the overall level of liquidity in the system and the ultimate level of interest rates?

Chris

This is what I was hoping to see from them. So when you look at what you're seeing from the federal reserve at the moment, what they're saying is that they could remove QE and then tighten rates basically at the same time. I'm generally a little bit cautious when they start talking like that because the quantitative easing that they've done was easing. I know it's unconventional, I know you can't see the effect on the cash rate, but a lot of the estimates that I've seen in the research tells us that it does take the kind of effective cash rate lower. So, to put that into perspective, we talked about this in mid-2020, when we were hoping that the RBA would start the program, that 10% of GDP purchases is equivalent of about a 1% rate cut. The RBA through its bond buying purchases has bought about 300 billion. So that's about 15% of GDP. That would mean that the rate effect is in the range of one and a half to 2%. So the reason that I say I would like to see them stop this program and pause, is we need to see what effect that's going to have on the economy. You can kind of already start to see bits and pieces of that turning up. We've got higher swap rates that's flowing into higher fixed rate mortgages. You're starting to see bank spreads. You're starting to see semi-government spreads start to push out a little bit, that pushes up the cost of funding. And so the ultra-low rates come out of the economy. 

When you look across different countries, when the fed ended QE in 2014, it took them about two years before they could move rates. And when the ECB tried to end their QE program in 2018, they basically had to stop straight away. 

So it's been very hard to quantify what the effect is going to be. But I think when you're looking at it prudently, that the best approach is probably in the program. And then let's reassess in three to six months’ time if we've caused any problems, because we know rates are probably going to back up a little bit, especially in spreads and that's going to cause high borrowing costs.

Darren

The other thing too is that we're probably going to see a few other central banks doing the same thing. We've had a lot of liquidity sloshing around in the system. It's created artificial problems in the bond market in particular, but it flows through into other markets. So when we suddenly see it's not just what the RBA does, but what the fed does and what the ECB does, all at the same time in international markets, suddenly you're going to have the main buyer of bonds in particular, disappear. Whether that helps liquidity in the long run, whether it frees markets up to do what they should do it, it's hard to know because we haven't had many years in the last 10 or 15 where we haven't had some sort of quantitative easing somewhere in the world. So it'll be an interesting experiment from that point of view.

I don't think we really know the effects. We did see in the US when they tried to remove quantitative easing once before, it started to create other issues for the fed in particular around liquidity and Repo markets and things like that. So there's a lot of moving parts to this that people don't really understand. And we think it's not something you want to take off and then suddenly jam interest rates higher at the same time, because it could exacerbate other problems that they haven't even tried to think about yet.

Chris

This probably comes back to the opportunity cost of what they're doing. The RBA said that they're expecting core inflation to rise to a bit over 3% and then drop down again in 2023. If that's your forecast and you've had core inflation running under the band for the past six years, then being a little bit slow to hike the rate after you end QE, I don't think going to be a huge problem. But if you remove the accommodation too quickly and you cause problems, then you might see that inflation figure drop down far faster and so I come back to the idea of, I don't know what it's going to do, it's very hard to quantify the effect, but the past has told us, you need to be a little bit careful with this. They’re only forecasting inflation just above the band, so I don't think it's too much for them to kind of sweat over it at the moment.

Darren

So that brings us to the thing many people want to know about which is how is it going to affect the housing market or will it affect the housing market? You know, we've already seen rates, at least fixed rates starting to rise in some cases as much as 150 basis points, that's even without the cash rate moving. Prices are still rising, in December at least, what do you think will be the outcome for housing over the next six to 12 months?

Chris

I think when you look at the lead indicators, it's clearly going to be a tougher market for prices to rise this year than it has for the past 18 months. We're already starting to see a bit of softening in the clearance rates for auctions and building approvals have started to drop off. Certainly, the mortgage finance figures look like they're probably peak at the moment. So typically, those things would point to probably close to the top maybe kind of six months away. But when you put on top of that the fact that 50% of the mortgage market was going through fixed rates and they've backed up 1%. It probably means we're a little bit closer than we expect. If the RBA is as patient as they claim they're going to be, then I probably wouldn't see too many problems for the housing market. If they start hiking rates aggressively in the second half of this year, that's probably when I'd become more concerned.

Darren

So, Chris, it seems a bit ludicrous, I guess to me to think that quantitative easing coming off, you know, we've said that it was quite a large percentage of GDP. A lot of that has flowed into housing, not just from the level of interest rates, but just the availability of cash that people have. Are we being a little bit cute in saying that house prices will stay flat to unchanged, unless we get a rate hike or do we really think they should be coming off a little more, even without a rate hike,

Chris

When I calculate the cost of finance on a house with interest rates where they are, I still think housing is relatively affordable. So if rates stay down and the fixed rates are able to stabilize, maybe the Sydney and Melbourne property markets that have the most forth in the them come under a bit of pressure, but places like Brisbane, Adelaide, Hobart, whether it's not quite as expensive, will probably hang in there quite well. 

Once you start pushing rates up above kind of 1%, that's when the metrics that I use start to come under pressure. 

And, house prices have risen 30% from a one and a half percent fall in the cash rate. So I think it does stand to reason once we start moving them higher, we start to see that pain, but certainly with where interest rates are at the moment, it still seems affordable in terms of debt to income ratios and those types of things.

Darren

I guess the other thing to take into account is that if we do start to see some pickup in wages, people's capacity to borrow probably isn't going to change automatically, unless rates do go up. So it's something to keep an eye on. Obviously, rates affect the ability to pay interest, but they also affect the amount banks will lend to people. 

The level of housing prices are a function of available finance. So it's probably unlikely QE will have a huge impact on that ability to borrow and ultimately house prices. 

But certainly you wouldn't expect to see prices rapidly rising from here, which again, may take some of the froth out of the investor market as well. So, I guess if we put down our crystal ball and we look a little bit further out, some of the reasons that we think the RBA might want to be a little bit cautious, and it's been interesting sitting out for a couple of weeks and only seeing what's going on in the main sort of press, we've seen a few things where people are talking about the possibility of recession in the US, right at the time when they're actually talking about tightening interest rates. We're in a situation where past history isn't that helpful for how we come out of this particular cycle, we're in a situation that we talk about a lot where we have demographics changing very quickly, automation is also a big part of what's going on out there. We've got reasonably high levels of debt across all economies yet we're still talking about what happened in the 1990s and 1970s and this is where we're going to go to. Is it more complicated than that? Do you think it's more complication that?

Chris

It’s a relatively tough kind of question to answer, certainly anyone who's probably listened to the rate debate over the past kind of two years will know that we're very bullish on rates being low for a very long time. The thing that has got me to that view over the past five years is a combination of a few things. I think wages are going to struggle to rise in an aging of economy, which is probably one of the biggest things that we see. A lot of what the RBA, the fed, the ECB and the BOJ have been hoping for over the past 10 to 15 years, is that wages pick up and with that people spending. But what doesn't seem to be too well known is that as an economy ages, wages growth naturally slows because older people don't get the same wage gains that young people do, and we know the economy's aging, and so to expect that we're going to see wages growth similar to the 1990s, take us into this pickup in growth to me, just goes against what we've seen over the past last 10 years. That's what builds into why I'm probably more bullish than others on rates staying low, because I think it's going to be harder to pick them up. And as you said, all we've seen over the past 10 years is just a constant increase in debt. So every time they go to move rates, the person who's borrowed too much money seems to come out and say, please stop doing that. But as you kind of point out before, that's jarring with some of the views of the market at the moment, because clearly the market thinks inflation is here to stay. And I feel like a bit of a stick in the mud saying, well, hang on a minute, you know, it's just goods, it's not services, there's all these things going on. What I would really need to see to be wrong is wages picking up into that four and a half percent bans to really think that we're going into a new regime.

Darren

There is a capacity, particularly market commentary, to oversimplify problems. We think rates can go higher, we've never, ever suggested they can't, but the magnitude of the rate hikes is limited by those factors. And unless something dramatically changes to affect that, it's a trend that is been happening now since the early 2010s and there's no sign of it changing. Even economies that are rapidly growing like China, are aging, and all those things are likely to have an impact on what happens with rate markets over the next, two to 10 years. So it'll be an interesting outcome to see if we're right. We're certainly not in the camp that a lot of people agree with or even want to agree with, but these are the sorts of things that sit in the back of our mind and keep us awake at night.

Chris

And pick up on that, the reason why I’ve been harping on about goods prices so much at the moment is that if you look at the raw index of good prices for inflation, they went nowhere from about 1999 through to 2020. And so you had this 20 year period where good prices went sideways. People said it was demographics, it was automation, it was China joining the world trade organization, it's globalization. And then when COVID hit, suddenly goods prices have risen 15% in 12 months. It's a little bit complicated for me to say, well, this inflation going to be here forever. When the thing that is driving it was in a sticky trend, not going anywhere for reasons that we understood. So again, that's probably not quite a sexy to say inflation's here to stay, but I think that's the big thing that the RBA needs to grapple with here. How real do you think this is? If it's a new regime, then rates are going to go much higher. And if we back off to where we were before, then we could be stuck at zero for longer than the market expects.

Darren

It would be very easy to be flippant and just say the cure to all economic ills is the pandemic. Because that ultimately seems to me what's happened. But I tend to agree, we have to wait til the end of the pandemic to see where things end up settling.

Tune in next time

So, that's it for the month. If you ever want to suggest topics or discuss further anything with Chris or I, we can be contacted at theratedebate@yaracm.com. Tune in next month when we deliver our latest thoughts on the RBAs March rate decision and provide an update on what's been happening in markets. Until then, stay safe.




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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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