RBA taper, non-taper options

Christopher Joye

Coolabah Capital

I don't want to get back into the speculation game of what the RBA does or does not do in September. I've covered this territory before --- with the surprising move away from nowcasting to forecasting, decision-making has become much more unpredictable. But what we can do is sketch out some intelligent solutions. 

The beautiful thing about the open-ended QE3 program is its optionality --- it is theoretically meant to be flexible, able to be recalibrated up and down (as the RBA has repeatedly stressed), although the RBA has thus far not sought to exploit this flexibility. 

One odd argument has been that there is no point because the impact of the stimulus would not be felt for 12 months: yet any change in the RBA's policy posture would be immediately priced into market interest rates and the Aussie dollar, would immediately reduce public sector borrowing costs, and would in turn alter the outlook for the next year, which has undoubtedly soured very materially indeed.

In the RBA's defence, the taper was never meant to begin until September, and so while the market has wanted to see some adjustments from the RBA as the economic data has deteriorated to beyond its downside scenario, it could argue it has had time on its side. Time to collect data, and time to flex its once uber-optimistic base-case to the reality of the world it faces (see more on this below). Although there is increasingly an overwhelming case for the RBA to do something, and the Aussie dollar appears to be pricing in a much bigger QE3 program, you just never know what Martin Place will resolve to do.

What it has done, however, is really emphasise that it does have options and state that it will act if the pandemic forces a material change in its forecasts. So what are some of the options? 

1. Business-as-usual, 4-4 taper

Here the RBA risks real reputational damage, but nonetheless pretends nothing has changed. It assumes Delta is exactly the same as the original COVID-19. It assumes the fiscal and monetary policy stimulus is the same as last year. And it assumes the bounce-back from the lockdowns is the same. 

All these assumptions are demonstrably erroneous: Delta is clearly a new regime change, and we are going to be slow to recover from this shock precisely because Delta is here to stay --- it cannot be eradicated --- with big ramifications for how the economy rebounds (it will be much more sluggish and cautious than last year). 

But as some journalists have suggested, what the RBA can do is taper from $5bn/week to $4bn/week, and with the quarterly review program tied to the Statement on Monetary Policy forecasts, extend the $4bn/week buying through to at least the February 2022 meeting. 

This would be the smallest possible concession to the recession currently ripping through Australia while sticking to the taper mantra.

2. Zero flexibility taper deferral, $5bn/week

In this scenario, the RBA could more reasonably defer the taper to $4bn/week to the November or February quarterly reviews. So it would stay at $5bn/week. There would be no change in the current mix of bond buying: the RBA would stick with the 80/20 split between govvies/semis. 

The problem with this solution is that it runs into capacity constraints relatively quickly. The RBA potentially ends-up owning too much of the individual 5-10yr govvie lines early next year. This plan does not flex to the fact that government debt issuance has pivoted strongly away from the Feds to the States. It is basically the November 2020 QE plan, which is now stale and very much out-of-date. 

As noted above, the key issue is the capacity constraints that accrue in the govvies market. And as others have outlined, the RBA has a rich range of options to solve this problem, and crucially make its QE program a much more durable device.

3. Creative $5bn/week taper deferral with twists

This is an idea an investment-bank has canvassed, which is pretty smart. The RBA stays at $5bn/week but twists the program to help mitigate capacity constraints and redirect stimulus to reducing the public sector cost of capital that is rising sharply on a relative basis. Specifically, the RBA cuts (increases) the govvies (semis) buying by $500m/week, doing a direct switch between the two sectors. 

We know that the fiscal pulse has shifted from about a 75/25 split in late 2020 to more like a 55/45 split. Whereas the States are doing as much issuance as they did in FY21, the Feds have cut their issuance by about 45%. The current QE program ignores this fact. 

It is also well documented that since the surprise NSW funding shock in June, semi spreads have increased about 20bps-25bps from 15bps over 10 year Commonwealth govt bonds to about 40bps, wiping out the benefits of QE, and putting the cost of capital in spread terms at a higher level than the 2014 to 2018 period (and back in the 2019 range). 

Now as I explained on Friday, it does appear that NSW is going to drop the proposals that led to the June funding shock. And while total debt issuance might decline, the market is still assuming that the reduced issuance from scrapping the previous plans will be at least offset by the increased fiscal support for COVID-19 (even though the cost of this support is running at less than half NSW's provisions).

4. Team Australia QE increase

The most aggressive, and perhaps least likely, proposal would be Bill Evans' suggestion to go hard by lifting QE3 to $6bn/week ($5.5bn is another clear option). At surface level, this seems entirely reasonable, although it quickly runs into capacity constraints, as Ricardian Ambivalence has shown. But as RA also notes, these constraints are simply artefacts of the RBA's design and can be easily relaxed by buying a broader envelope of bonds (eg, 5yr to 15yrs) and by increasing the semis purchases, where there is loads of latent capacity. 

5. Creative $4.5bn/week taper with some twists

If the RBA wants to preserve the fig-leaf of a taper, and look like it is doing what some other central banks might do later this year (ie, taper), it could employ a little more creativity. It could taper to $4.5bn/week, but twist the buying program to semis where there is excess QE capacity. So this would involve buying $3.2bn of govvies per week along the lines of the original taper, but increasing semis purchases to $1.3bn/week. 

Final thoughts

The RBA's decision to lift its economic forecasts in August from those previously released in May despite the striking deterioration in the outlook surprised pretty much everybody. As I noted earlier, this presupposed that the stimulus was the same as last year, that Delta is the same as the first iteration of the virus, that the lockdowns work and eradicate the virus (or that vaccines are a perfect panacea and do more-or-less the same), and that we bounce-back as firmly as we did in 2020.  

We now know that all these assumptions are inappropriate. We also know that the vaccines have substantially reduced efficacy against Delta, dropping to around 42% in the case of Pfizer after four months, making recovery from the pandemic all the more problematic. As Israel is now showing, we are going to have to wait to jab the entire population with more refined and Delta-focussed booster shots to beat this new variant back, which will not be possible until mid 2022.

The most important point is that the RBA has given itself loads of room to move by baking flexibility into its program from the outset, and by stressing that it will adjust the program if the health situation adversely impacts its outlook. Whether it really intended to act on these words is an open question.

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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 40 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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