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.

Access Coolabah's intellectual edge

With the biggest team in investment-grade Australian fixed-income and over $7 billion in FUM, Coolabah Capital Investments publishes unique insights and research on markets and macroeconomics from around the world overlaid leveraging its 14 analysts and 5 portfolio managers. Click the ‘CONTACT’ button below to get in touch.

........
Investment Disclaimer Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments Pty Ltd (ACN 153 327 872). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting www.coolabahcapital.com. Neither Coolabah Capital Investments Pty Ltd, EQT Responsible Entity Services Ltd (ACN 101 103 011), Equity Trustees Ltd (ACN 004 031 298) nor their respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Institutional Investments Pty Ltd holds Australian Financial Services Licence No. 482238 and is an authorised representative #001277030 of EQT Responsible Entity Services Ltd that holds Australian Financial Services Licence No. 223271. Equity Trustees Ltd that holds Australian Financial Services Licence No. 240975. Forward-Looking Disclaimer This presentation contains some forward-looking information. These statements are not guarantees of future performance and undue reliance should not be placed on them. Such forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual performance and financial results in future periods to differ materially from any projections of future performance or result expressed or implied by such forward-looking statements. Although forward-looking statements contained in this presentation are based upon what Coolabah Capital Investments Pty Ltd believes are reasonable assumptions, there can be no assurance that forward-looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Coolabah Capital Investments Pty Ltd undertakes no obligation to update forward-looking statements if circumstances or management’s estimates or opinions should change except as required by applicable securities laws. The reader is cautioned not to place undue reliance on forward-looking statements.

4 topics

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...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.