Surging Canadian dollar a warning for RBA vis-a-vis tapering policy...

Kieran Davies

Coolabah Capital

The Reserve Bank of Australia (RBA) will decide in July whether to extend the 3-year bond yield target and undertake further quantitative easing (QE) when the current round is completed in September. Coolabah Capital Investments (CCI) expects another $100bn of bond purchases will be required for the RBA to achieve full employment and generate a sustained increase in inflation, although the RBA will probably opt not to extend the yield target. Canada provides an important example of the risks involved with tapering QE, with the Canadian dollar rising sharply to its highest level in years as the Bank of Canada reduced its pace of bond purchases. This serves as a warning that tapering QE too soon could drive the Australian dollar higher, undermining the RBA's efforts to meet its economic objectives.

A pivotal moment looms for financial markets with the  RBA deciding whether to taper its unconventional monetary policy in July. With the Term Funding Facility (TFF) - which offers 3-year loans to banks at an interest rate of 0.1% - closing to new applications in June, the RBA has said it will decide whether to extend its 3-year bond yield target of 0.1% and implement a third round of bond purchases at its July Board meeting.   

  • The extension of the 3-year bond yield target hinges on whether to roll the underlying Commonwealth bond from the April 2024 to the November 2024 maturity. The RBA may hesitate to roll the bond as it would indirectly signal that the cash rate would likely remain unchanged until at least the end of 2024, contrasting with its more formal guidance that the conditions required for raising rates were "unlikely until 2024 at the earliest".  
  • Extension of QE would involve announcing an additional round of government bond purchases (aka QE3) once the current $100bn round is completed in September. The RBA is open to this idea, noting,  "The Board remained willing to undertake further bond purchases if doing so would assist with progress towards the Bank's goals of full employment and inflation".     

CCI's view is that the RBA will extend QE with a third $100bn round of bond purchases, likely followed by a fourth tapered round in 2022. However, the RBA is unlikely to extend the 3-year bond yield target as it may be reluctant to signal the cash rate remains on hold until at least the end of 2024.  With inflation still very low and wage growth subdued, further QE would support the RBA in achieving its ambitious goal in reducing the unemployment rate to the low 4%s to engineer a sustained return of inflation to the 2-3% target band. 

The RBA has said the July decision would be "based on close attention to the flow of economic data and conditions in financial markets in Australia" (previously, "close attention to the flow of economic data and the outlook for inflation and employment").  Financial conditions will tighten at the margin as the closure of the TFF will place some upward pressure on fixed-rate mortgages when banks replace cheap TFF loans by issuing bank bonds.  More important, though, will be what happens to the exchange rate, where the RBA has paid close attention to Canadian experience with tapering, noting that the Bank of Canada (BoC) reduction in the pace of its bond purchases "had been anticipated and there had not been a significant market reaction to the announcement".  

In CCI's view, there has been a significant market reaction to tapering in Canada, which acts as a warning to the RBA about the risks involved in unwinding easy policy too soon. The BoC has tapered its rate of bond purchases twice in recent months, namely: 

  1. October 2020 – purchases were reduced from $C5bn to at least $C4bn per week and directed more at longer-term bonds such that the “[BoC's] Governing Council that with these combined adjustments the QE programme is providing at least as much monetary stimulus as before”; and 
  2. April 2021 – purchases were reduced from $C4bn to $C3bn per week, where “this adjustment to the amount of incremental stimulus being added each week reflects the progress made in the economic recovery”.

A large market reaction to this tapering is clear in the Canadian currency, where the nominal effective Canadian exchange rate rose by 5% from October to April and is already up 4% from the April announcement.  This significant appreciation means that the Canadian dollar is now at its highest level since early 2015. With the BoC tapering, monetary policy has not been able to counter the influence of rising commodity prices on the currency, where weekly Canadian commodity prices surged by 36% from October to April and are up 5% since the April announcement to the highest level since 2014. At the same time, tapering has reinforced market pricing of an earlier increase in the BoC's policy rate, with the Canadian-US 2-year bond differential increasing over this period to 18bp, which is the widest spread since March 2020 (the 10-year differential has also increased from -19bp in October to -9bp now).   

Based on this experience, early tapering of QE in Australia would likely lead to a significant appreciation of the Australian dollar and bolster market expectations that the RBA would start to raise rates sooner than 2024. This would make it harder for the RBA to achieve its economic objectives, such that the Canadian experience with a rising dollar provides a clear warning about the undesirable risks of tapering policy too soon.    

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Chief Macro Strategist
Coolabah Capital

Based in Sydney, Kieran Davies joined Coolabah Capital in 2020, an asset manager than runs over $7 billion in fixed-income strategies, and is responsible for macroeconomic research and investment strategy, contributing to the investment decisions...

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