RBA increases QE3 stimulus by 40 per cent

Christopher Joye

Coolabah Capital

In the AFR I write that after months of debate about whether the Reserve Bank of Australia would increase or decrease its stimulus in recognition of the COVID-induced recession, Martin Place delivered on its promise to maintain a “flexible” and open-ended approach to its government bond purchases (aka quantitative easing).

To make matters more interesting, the Australian Prudential Regulation Authority shocked the banking system on Friday by announcing that the $140 billion Committed Liquidity Facility must be replaced by purchases of government bonds as is standard across the rest of the world. As we previously speculated, closing the CLF perfectly dovetails with the RBA's bond buying.

Back in July the RBA announced a “taper” of its bond purchases from $5 billion to $4 billion per week, commencing in September with a quarterly review. Media cited this as emulating the Bank of Canada’s approach to QE even though core inflation in Canada is running at 3 per cent (well above its 2 per cent target) whereas inflation in Australia is materially below the RBA’s target.

Following the RBA’s July decision, the market assumed it would drop bond purchases by $1 billion per week each quarter. This implied total purchases for the RBA’s third, open-ended QE program (aka QE3) of about $105 billion, which was within the ball-park of economist expectations.

Precisely what the market was pricing in for QE3 was a different matter. Investors were punting on a harder taper summing to only $50 billion to $75 billion in size, which was at the lower-end of the more hawkish economist forecasts, such as CBA ($50 billion), UBS (up to $75 billion), and NAB ($75 billion).

Governor Phil Lowe clearly stated that the RBA was prepared to increase or decrease his bond purchases in accordance with economic circumstances, and that is precisely what the adroit monetary policy mandarin delivered.

With the revised commitment in September to keep the RBA’s bond purchase pace at $4 billion per week all the way through to February 2021, Martin Place has increased the size of QE3 from $105 billion to $147 billion.

This reflects the difference between the original proposal to cut the $4 billion per week bond purchases by $1 billion each quarter, which is known as a 4/3/2/1 schedule, and the new plan of keeping the bond purchases constant at $4 billion per week until February following which they can be tapered according to a 4/4/3/2/1 schedule.

Note also that the $147 billion estimate for QE3 is now substantially larger than the $100 billion worth of purchases executed under the preceding QE1 and QE2 programs that began in November 2020 and April 2021, respectively.

Notwithstanding the differences in Australia and Canada’s inflation outlook, the RBA’s beefed-up QE3 program does emulate what its North American peer has done. The Bank of Canada first tapered in October 2020 down from $5 billion to $4 billion per week, a pace it held until April 2021 when it tapered again to $3 billion per week. Three months later it further decelerated to $2 billion per week, with the consensus predicting a final quarter worth of $1 billion per week of purchases beginning in October.

After this is complete, the Bank of Canada has committed to reinvest maturing bonds to ensure that it does not shrink its balance-sheet. As the RBA has explained, it is the total size of the central bank’s bond purchases rather than the weekly flow of investments that signals the magnitude of the stimulus bequeathed.

In Australia, QE has been much more successful than anyone, including the RBA, ever imagined, crushing long-term interest rates and the Aussie dollar down to way below their estimated fair market value, and by doing so bolstering economic growth.

It also helps solve an important financial stability puzzle for the RBA that has plagued it for decades: how to avoid blowing house price bubbles, such as those that emerged in 2003 and between 2012 and 2017, when relying exclusively on its overnight cash rate in an economy with an unusually large proportion of variable-rate home loan borrowers.

In contrast to economies dominated by fixed-rate debt, most Australian borrowers immediately benefit when the RBA slashes its cash rate via increases in their purchasing power, which gets quickly capitalised into house prices.

In future shocks, the RBA can put downward pressure on both short- and long-term interest rates, and the Aussie dollar, using both its cash rate and QE, which will provide for a more balanced policy platform.

It might mean that the cash rate may not fall as far as it has in the past given the RBA would be augmenting this stimulus with the extra support provided by putting downward pressure on the Aussie dollar through bond purchases that lower long-term rates.

The RBA’s very dovish taper in September is not, therefore, a reduction in monetary support: Governor Lowe materially lifted the total quantum of bond purchases that the market was pricing for QE3 by about 40 per cent (or $40 billion). And that assumes away any future adversity that elongates QE3 beyond the current central case of a Canadian-style 4/4/3/2/1 schedule.

This gradual glide path reflects what central banks have learned is rule No. 2 of any QE program: there is little upside, and considerable downside, when you start tapering bond purchases. Put differently, you can trigger tantrums if you taper too quickly.

Rule No. 1 is to always surprise on the upside with the size of your QE, as the RBA has consistently done—puny programs can be counterproductive, as we saw during the global financial crisis and when the first overseas efforts were announced in the great virus crisis in March 2020.

One speculated motive for the RBA’s taper has been that it was concerned about owning an excessively large share of the government bond market, and crowding out banks. Yet new data from the Australian Prudential Regulation Authority shows that Aussie banks are holding the lowest quantity of Commonwealth government bonds since December 2018, and almost $100 billion less than what they held in mid 2020. This is despite the Commonwealth bond market growing by $250 billion since 2018.

That means that the banks’ share of the Commonwealth bond market has plummeted from 23 per cent last year to just 10 per cent today according to Signal Macro’s chief economist Matt Johnson. Even after controlling for the banks selling bonds to the RBA, their market share has still dropped 6 percentage points.

Johnson highlights that contrary to many banks’ claims that the RBA’s bond purchases would hurt liquidity, annual turnover of bonds in the Commonwealth bond market has increased from 260 per cent prior to 2020 to 300 per cent today.

In huge related news on Friday morning, Australia’s best regulator, Wayne Byres, announced that APRA had boldly, and entirely appropriately, decided to eliminate the taxpayer subsidies enabled via the $139 billion Committed Liquidity Facility.

The innovative CLF was created by the RBA and APRA at a time when there were not enough government bonds for banks to hold as emergency liquid assets. Under the CLF, banks could instead buy other banks’ (higher yielding) bonds, and use their own uber-lucrative loans, as a substitute for lower-yield, yet riskless, government bonds.

APRA has given the banks just under four months to phase-out the first chunk of CLF assets, which must be completely eliminated by 31 December 2022. Since this will eventually compel banks to buy vast quantities of government bonds for emergency liquidity purposes, APRA should revisit the rule that requires them to unnecessarily hold extra capital to protect against losses on these assets.

There is a regulatory contradiction that must be resolved where on the one hand the RBA guarantees the liquidity of government bonds, and APRA says that they have zero risk of credit default loss, and yet on the other hand banks have to hold additional capital against these riskless securities to insure against rare, unrealised "mark-to-market" losses on them.

This is even more weird considering government bonds are held by banks as a hold-to-maturity asset that would only ever be sold to the RBA in an emergency. We should reasonably encourage, rather than discourage, banks from holding these assets in preference to competing deposits issued by the RBA that pay zero interest.

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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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