Whatever the RBA decides, volatility is here to stay

Charlie Jamieson

Jamieson Coote Bonds

We had cautioned that 2022 could be a difficult year, driven by the triple threat removal of policy support enjoyed since the initial outbreak of the COVID-19 pandemic (quantitative easing removed, interest rate hikes and less fiscal spending). 

Over the course of January and into February, Central Bankers increased their hawkish commentary, emboldening markets to quickly price further rate hikes into expectations, causing volatility across most risk markets. Central Bankers seem globally intent on exiting emergency policy accommodation to head off material inflation prints caused by the reopening of economies, supply constraints, generous fiscal transfers and super cheap money (and excess liquidity).

Many of the moves that dragged Australian bonds to higher yields were related to offshore factors, as the RBA continued to hold a more dovish line. We expected the RBA would be a laggard in the normalisation process, and that should lead to geographical divergence amongst bond markets, but moves year to date have been convergent driven by US Federal Reserve expectations. This leaves the Australian bond market with around six interest rate hikes priced in (expected) by the end of 2022. 

We believe that the RBA cannot hike interest rates before its June meeting, as quarterly data in both CPI inflation and wages will not be delivered until after the May meeting dates. Our expectation would be for a small hike from 10 basis points to 25 basis points as an initial move, (a move of 15 basis points only which is rare), followed by two additional 25 basis points hikes to finish the year with a cash rate of 0.75% (likely hiking in August and November after CPI data releases in July and October).

Market pricing remains for a faster hiking cycle, however, we believe this is reflective of the poor handling by the RBA around Yield Curve Control policy removal in October 2021, which has led to additional yield premium being required from global investors to hold Australian bonds. Should the RBA manage to achieve the current bond market pricing, the cash rate could be back at 1.50% by year-end. 

Since the last time the RBA cash rate was at 1.50%, residential home values have risen more than 30%, generating confidence and excess consumption throughout the pandemic effected economy. Bonds are now pricing the full reversal of those generous interest rate and liquidity conditions, and an expectation that mortgage rates and credit availability will become considerably more restrictive in a very short time frame.

For now, markets seem very certain that inflation is here to stay and a massive policy withdrawal is necessary across quantitative easing programs, the material lifting of interest rates and curtailing emergency fiscal government spending. We have no doubt this can slow down inflation, but it might also stop the economic recovery as well. 

One thing remains certain - volatility is here to stay for a while yet. Watch the video below to learn more. 

Edited transcript

Hi, I'm Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, and this is a review of markets in January 2022. 

We cautioned investors at the end of last year about some of the challenges approaching markets in 2022 given that we have three major policy changes occurring, likely occurring across the year. And they are the removal of quantitative easing, and going to a term called quantitative tightening, where we're taking away a lot of that support via bond buying programmes and liquidity provision from central banks. Also, the raising of interest rates away from those emergency levels that were required to stimulate economies throughout the pandemic. And lastly, a huge fiscal contraction, so governments no longer stepping in, transferring huge amounts of money into the economy. They will be pulling back and clearly the private sector will need to stand forward to fill that void.

Independently, each one of those is a reasonable market story, but collectively, it becomes a really powerful market story. And we saw some of that occur over the first part of January and the latter part of January, particularly with quite a hawkish or non-supportive US Federal Reserve, acknowledging that they have quite a material inflation problem at the moment and they are going to need to do something about it. And this is a change from the Federal Reserve to really take that step forward and acknowledge that they've got a lot of work to do to push down this inflation pulse. 

Now, we know the inflation has come predominantly from supply side factors, but there's been $23 trillion spent over the course of the pandemic from governments. And clearly there's an awful lot of money sloshing around in the system for now. And it's caused a lot of inflationary impulse.

We have expected over the course of time that we would get material central bank divergence because everybody would come out of the pandemic at a different rate. We know that New Zealand had already come out. The Bank of England had already come out. The Federal Reserve are yet to hike, but the market's absolutely expecting that, Bank of Canada. We thought the ECB would be a laggard. We thought the RBA would be a laggard. And we still hold those thoughts. And the timings look correct on those things. But fascinatingly markets in the fixed income land have moved almost lockstep in a kind of convergence mode and all markets have been impacted. And this has caused a lot of volatility throughout asset complexes. We've seen it in crypto markets. We've seen it in risk and equity markets. And of course we've continued to see it in fixed income markets.

Some of these pricings that we've now built in, in expectation of future moves look very difficult to achieve without causing material pain and change in the economy as you know it. As we sit here today, the RBA, the expectation of the bond market for the RBA is for six interest rate hikes by the end of 2022. Now that is incredibly difficult to achieve because if, and I'll put a big asterisk on the if, we are to believe the RBA, they will wait for the inflation report and the wages reports, which will not be delivered until after the May meeting, which means the first time they could adjust interest rates on their own methodology as they've explained it would be June of 2022. And getting six interest rate hikes in to the end of the year would be to go at every meeting or to go in big steps.

The problem with that, of course, is that if they are to do that, then they can turn a lot of things that have enjoyed at a lot of good outcomes, I guess, housing markets being the major one that's driven confidence and driven that wealth creation effect. They can turn them quickly in the opposite direction. 

When we last had one and a half percent RBA cash rate, house prices were more than 30% lower than they are today. And they're very closely interlinked. The cost of money and that credit availability channel is just so crucial. And we know how important housing is for the Aussie economy. 

We don't think that the RBA nor the politicians of the day really have the will or the want to deliver that. It would obviously cause a tremendous amount of economic pain. But we do have a much lower inflation pulse here, but it's something that we do need to deal with. I don't think that emergency settings are no longer required when the vast majority of the health crisis is now behind us. So we do expect that the RBA will get going this year, albeit in a much slower fashion than some other central banks that will clearly move a lot faster. 

So why does the market have so much priced for the RBA when it almost seems very difficult to deliver that much pricing? Well, it's really got to do with the credibility of the RBA. And last year, which we talked about when they dropped their yield curve control policy, an RBA board wide accepted policy, which was dropped at the discretion of the singular governor, which I think is just a massive process issue in and of itself, which will no doubt be debated in their own internal review that is occurring from the government. The markets have taken them on and they have defeated them.

Think George Soros on the Bank of England in the '90s. The RBA have no credibility with their forward guidance and as such Australian bonds, we still expect we'll trade cheap to global bonds. When we talk to a lot of global investors, they've lost a lot of confidence and rightly so when the central bank sets out a policy and a framework, which they're going to work through and then changes that policy without acknowledging it, without holding an emergency meeting, it's a disgrace. And it's something that you'd see in emerging markets. And for it to be occurring here is extraordinary. But that's why Australian bonds are going to move lockstep with some other global markets and we expect that to continue.

The rate of change in some of these things that we are monitoring is something that we really do need to bear in mind because a lot of folks now believe that inflation is here to stay for time immemorial. We absolutely do not believe that. There's no question that it has moved a lot higher than a lot of folks have forecast, ourselves included. 

But the rate of change on the way into that is really important. The sustainability of that rate of change and then the decline is also really important. So if we think about it in these terms, we know oil has come from zero all the way up. It's trading at $90 right now. But let's just assume it was at $45 in the last period and it moved to $90. Well, the rate of change is 100%. If it then goes on to go to $135, another $45 increase, the rate of change is only 50%. And that means inflation starts to lose its velocity as a rate of change. When you're looking at one period versus the previous period, it's slowing down.

Now that doesn't help you when you fill up your car on a Saturday morning. It's still going to cost a lot more and I think we all feel that squeeze out there on the main streets these days. There's no question that prices have gone up and there's been some price gouging as things have reopened. We know that we haven't had international labour with the borders being closed. All of these types of things is making for these relatively extraordinary outcomes. But it is that longer run trend, which we're really interested in. And certainly there will be a moderation to that inflation data just on the base effect alone. It works exactly the same way for the things like growth. You've got to keep that velocity at extremely high levels in order to keep printing these same kind of numbers.

So the major question that markets are searching around for is where will that longer run trend be? Has the pandemic unleashed things that have big secular changes in the economy that will generate more inflation going forward or are we going to settle back towards trend once the whole episode has come and gone? And that's a fascinating thing to debate and something that's very difficult to land on. If you ask 10 people, you've got 10 different opinions, no doubt. We still believe that there is a lot of secular disinflationary force in a globalised world. We have not broken apart from that globalisation. Once the borders open, and these supply lines, which is so important, start to heal, we are seeing a big improvement in those supply lines. If you look at things like Baltic Dry and the like, they have come down materially, so cost of shipping and getting people into work and actually producing things clearly as we move through the pandemic.

And we know that Omicron thankfully has been far more mild and hasn't required the lockdowns that we've seen previously. We will get to that other side and we will get the answers soon enough. But for now, central bankers are very intent globally on making sure that they pull back on these super accommodated policies of Quantitative Easing of zero interest rates essentially around the world. And the fiscal obviously is coming from the political side. It's not justified. We know that Biden is really struggling with his Build Back Better and the like. There's just not going to be that impetus coming into '22 and as we approach into '23. So lots of change coming up and we need to think through what that means.

The one thing that I can guarantee you is that it will remain volatile. We saw intense volatility in January across asset classes. I absolutely believe that we will see more of that with a shrinking pool of liquidity and the tightening of financial conditions. A lot of things that have been soothed into a comfortable place, we know that they can have a violent outcome at the end and entropy if you will, and that volatility can return. So that's the one thing that we feel incredibly confident about. We don't believe the RBA can complete on what the markets are pricing. But at the moment, momentum is still very poor in some of these instruments and that is going to take other things with them. So it does bode watching very carefully. 

We look forward to having these macro conversations with you across the year. We'll try and explain these twists and turns as best we can. But I think that the one thing that we've got to remember is that interest rates are the locomotive on the front of a huge train of assets. Where they go ultimately really matters. They are our funding rates. They are our discount rates and they provide that liquidity through the system. 

There have been episodes in the last few months where that train right at the front has derailed. It's gone around to such a steep corner. It's had some chaotic outcomes. And yet a lot of the train has still been broadly travelling straight ahead. But in January, they're starting to realise that there are some twists and turns coming up. So think about that. Clearly, if central bankers continue to deliver aggressive withdrawal of accommodation, we have to expect that volatility is going to be very pronounced. 

Thank you very much.

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Charlie Jamieson
Chief Investment Officer
Jamieson Coote Bonds

Charles is a co-founder of Jamieson Coote Bonds (JCB) and oversees portfolio management of the Australian and Global High Grade Bond and Dynamic Alpha investment strategies. Prior to JCB, Charles forged a career as a seasoned bond investor from...

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