RBA sets up July to move to open-ended QE, likely exceeding $100 billion
The RBA has provided clear signalling that in July it will move to a new form of open-ended quantitative easing (QE) at the current run-rate of $5 billion of bond purchases each week, which will be periodically reviewed. This will avoid the policy rigidity of static, five monthly QE programs at $100 billion a pop, and allow the RBA to smoothly glide towards a tapering into 2022, as we and most other forecasters expected. If the data is very positive, the RBA can taper in 2022. If it is negative, the RBA can maintain the current bond purchase pace. It will also mean that the extended $5 billion per week of purchases between mid-September and mid-December plus the eventual tapering into 2022 will involve the RBA likely acquiring more than $100 billion of additional bonds. At its July board meeting, we believe the RBA will de facto taper through not extending its 0.1%, 3-year yield curve target from April 2024 to the November 2024 bond, and via the expiry of its $200 billion term funding facility on 30 June.
The RBA likes to condition policy changes via media signals and has done so for decades, which allows for a smoother transmission mechanism. One of the problems with using media proxies is that the messages can get mangled in translation. We see this all the time.
Another issue is that media commentators high on their RBA imprimatur can start mixing in their own lofty opinions alongside the RBA’s messages, which can then make the latter hard to decode. We have also seen that problem repeatedly from high-profile commentators over the years.
The best financial journalist in Australia is arguably John Kehoe, who is now economics editor at The Australian Financial Review. Kehoe is very smart, very precise, and lacks ego, which makes him the perfect conduit for Martin Place to channel complex messages. When he writes on behalf of the RBA, he delivers their signals, nothing more or less. This is crucial for clarity.
A case in point was the RBA’s latest board meeting on Tuesday. The first key question is what the RBA does with its 3-year yield curve target, and whether it rolls this over from the April 2024 government bond to the November 2024 bond.
A second question is what the RBA does with its successful quantitative easing program, which has kept the Aussie dollar trading with a 7-handle and Aussie 10-year interest rates from soaring above US rates.
A final question that had the entire market aflutter was the RBA removing a line from its statement that said: “the Board is prepared to undertake further bond purchases to assist with progress towards the goals of full employment and inflation”. This line came after the RBA’s now-standard comment that “at the July meeting the Board will also consider future bond purchases following the completion of the second $100 billion of purchases under the government bond purchase program in September”.
Irrelevant RBA language adjustment
The line the RBA removed first appeared in March in this form: “and the Bank is prepared to do more if that is necessary”. In April it evolved to: “Beyond this, the Bank is prepared to undertake further bond purchases if doing so would assist with progress towards the goals of full employment and inflation”.
And finally, in May it was truncated to: “The Board is prepared to undertake further bond purchases to assist with progress towards the goals of full employment and inflation”.
Yet since the RBA has clearly signalled more bond purchases are coming since its May meetingb when it first disclosed that it would decide their size in July, this line is no longer necessary. It had become redundant and was removed because QE3 is coming, albeit likely in a more flexible form.
Kehoe explicitly confirmed this, commenting in his column after the June board meeting that, “Yet markets may have over-interpreted the change in language, which was probably not intended to convey a particular direction”.
So we now know, via Kehoe, that the change in language was neither a hawkish nor dovish signal, but rather simply the removal of the redundant QE qualifier that is no longer necessary given the RBA is committed to doing more in July.
It might seem like a trivial clarification, but a lot of people wasted a lot of time thinking about that one change. That brings us to the two key monetary policy decisions in July.
Yield curve target likely not extended
On the question of whether to extend to 3-year yield target to the November 2024 bond, Kehoe explains that doing so “would imply the RBA believes the 0.1 per cent overnight cash rate won’t rise until after 2024 – an arguably dovish tilt from its current guidance that a rate rise is “unlikely to be until 2024 at the earliest’”.’
“For credibility reasons, the RBA would want to be fairly confident that the cash rate was not going to increase until after 2024,” Kehoe continues. “While that’s possible, if the labour market continues to improve, it’s perhaps not a scenario the RBA can stake its credibility on.”
So, barring a big deterioration in the labour market, it would appear that it is unlikely that the RBA will extend to the November contract, which has been Coolabah’s base case for a while (albeit not one we have had a strong view on).
Kehoe sums it up as: “Though finely balanced, extending the yield curve target seems a bit less likely.”
Open-ended, $5 billion a week, QE Clearly Signalled
On the so-called QE3, Kehoe first rules out any removal of the program, which would be a huge shock to financial markets. Specifically, he comments: “Quantitative easing will continue in some shape or form”.
Here another commentator, Karen Maley, claimed the market did not react to the RBA’s statement on Tuesday because it expects a taper. First, the market did react, with the Aussie dollar falling noticeably because market participants were hoping the RBA would be more hawkish. Overall, the statement was considered to be fairly dovish vis-à-vis expectations.
While the market is expecting soft tapering in the form of (1) the end of the RBA’s term funding facility and (2) the likelihood that the RBA will not extend its 3-year yield curve target to November 2024, this is not true in the case of QE.
All the big forecasters like ANZ, Westpac, Citi, Goldman Sachs, HSBC, TD and others expect the RBA to do a third round of QE that is $100 billion in size (RBC and UBS think it could be up to $100 billion). Only a minority of forecasters, like CBA, project a serious taper down to $50 billion in size.
We know that every taper ever attempted by a central bank in the past has had a market impact, and this time is likely to be no different. The Canadians have tapered twice - in October 2020 and April 2021 - and their currency has soared 10% above both the US dollar and the Australian dollar.
So Kehoe begins by telling us that “the easiest option will be to add another $100 billion at the existing pace”, which would be consistent with the consensus view.
His most interesting remark, however, is a new program, which he flagged after the RBA’s May meeting, which is to stick with the $5 billion a week of purchases (ie, the run-rate of the first two $100 billion programs), but “to introduce some flexibility” without stating exactly what that flexibility means.
Significantly, Kehoe adds, “the RBA has historically liked to have flexibility on monetary policy”.
Kehoe first canvassed this open-ended QE program at $5 billion per week following the RBA’s May meeting. Here he was more precise, stating: “A third more flexible option is to continue QE over an unspecified timeframe, and to review the bond-buying program periodically, such as each month or so, as the Bank of Canada has committed to”.
Finally, on a proper QE taper down to say $75 billion or $50 billion, Kehoe noted it is a final option, but cautioned this week that while the Canadian and New Zealand central banks have tapered, “Canada is already around its 2 per cent inflation target and New Zealand unemployment is a low 4.7 per cent”.
In contrast, Kehoe retorts that, “in Australia, the weakness in prices and wages is much more entrenched”, leaving him to conclude that, “hence, Lowe will want to do more, it’s just a matter of how much”.
We know that core inflation in Australia is running at 1.1% annually, miles below the mid-point of the RBA’s 2-3% range in contrast to central banks in the US and Canada, wages growth is very weak at 1.5% year-on-year, near an all-time low, and the jobless rate at 5.5% is still potentially years of stimulus away from the real natural rate of unemployment, which is potentially in the 3s.
So what can we take from all of this? In summary, Coolabah’s view is as follows.
First, the RBA will likely not extend the 3-year yield curve target from April to the November contract. Second, the RBA will likely commit to a new form of more flexible and open-ended QE at the current run-rate of $5 billion a week with a periodic review. Importantly, this could ultimately mean longer and more sizeable QE than a one-off, $100 billion program for just six months.
Total Open-Ended QE Should Comfortably Exceed $100 billion
If you think about the current QE2 program’s expiry in mid-September, it would make sense to review the new open-ended QE3 run-rate every few months, as Kehoe has suggested, with perhaps the December board meeting prior to the January break an optimal juncture to evaluate the size of the monthly purchases.
That would imply $75 billion of bond purchases between mid-September and December. If all the central banks have started tapering by then (Australia will emphatically not want to get ahead of the US Federal Reserve), the RBA might at that stage keep the $5 billion weekly run-rate or reduce it to say $4 billion or $3 billion in December with another review in three months.
Assume the jobless rate is at 5%, everyone is tapering, and the RBA reduces to $3 billion a week for another 3 months. That would be an extra $45 billion of bond purchases.
If the economic data continued hitting it out of the park, and there was no bad news, one could imagine an orderly tapering down to $1 billion a week for a further three months. That scenario would suggest the RBA has $125 billion to $130 billion of QE left to do, subject to the data playing out perfectly.
Obviously, if there are any setbacks, downside surprises, lockdowns etc, the RBA could simply maintain its weekly bond purchases at a given pace, which means its balance sheet would expand more than the circa $125 billion of extra purchases implied by the aforementioned optimistic scenario.
Here it is critical to remember that as a share of GDP, the RBA’s QE-driven balance-sheet growth has massively lagged its central bank peers overseas. At the same time, it has, as Kehoe highlighted, a structural problem generating core inflation in line with its 2% to 3% target, which surveys data suggests may be dragging down inflation expectations.
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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...