In a speech yesterday the Deputy Governor of the Reserve Bank gave a fairly clear hint that the Board is set to cut the cash rate and other key policy rates at its October Board meeting.
The Bank is also likely to extend its objectives for bond purchases to include general support for the Australian and semi government yield curves in the five to ten year maturity range. It is likely to leave this commitment open ended at this stage.
We have discussed these issues in previous notes but did not expect the action as soon as the next Board meeting as now seems to be the case.
The theme is likely to be, as we saw in March, a Team Australia moment where the Reserve Bank is directly supporting a bold Federal Budget.
The prospect of the RBA “sitting back” to assess the Budget, which has been seen as the “norm” in previous years is not appropriate for these unique times.
We now expect the RBA to cut the overnight cash rate to 10 basis points; to adopt a 10 basis point three year bond target; and to adjust the rate on any new drawdowns of the Term Funding Facility to 10 basis points. All these rates are currently set at 25 basis points , which the Governor has generally described as the effective lower bound for the cash rate.
The Bank is also likely to reduce the rate which the Bank pays on Exchange Settlement Account balances from 10 basis points to 1 basis point.
If the banks are only earning 1 basis point on their ESA balances there will be significant incentive to purchase bonds, even if the bond is only yielding 10 basis points, or lend to the private sector.
That rate will be the key to driving the effective overnight cash rate to below 5 basis points – with a risk that it could print negative on certain days.
To supplement the reduced rates, the RBA is also expected to allocate more of its balance sheet to general purchases of AGS and semi government securities in maturities between 5 and 10 years.
These purchases will be in addition to the funds required to defend the three year bond target, and will be a clear signal to governments that the Bank is committed to play a key role in supporting their increased borrowings which it has been encouraging.
The Bank is unlikely to signal a specific volume of such purchases or any monthly “timetable”. However, the policy will indicate a broadening of the objectives of the current policy which is restricted to achieving the three year bond target and addressing disfunction in the Australian and semi government bond markets.
The government spending increases are likely to be announced by the federal and state governments in their respective budgets over the next few months.
In particular, the RBA is expected to announce all these policy changes on October 6, the day of the announcement of the Federal Budget, as a Team Australia initiative
There has already been speculation that the Board will await its forecast revisions which are available for the November meeting before committing to the policies.
Westpac is optimistic about the short term outlook but that is not what is driving this likely decision.
It is the medium term projection that the unemployment rate is still likely to be around 7% by the end of 2022 – the Deputy Governor refers to a “slow grind” – and that the shortfall in demand will be” a significant break on the recovery”.
That outlook is unlikely to change in the November forecast revisions, hence no real case can be made to “wait”.
In a note on September 11 “Next Steps for the RBA” I canvassed all these issues for an across the board reduction to 10 basis points; concluded that the moves expected above would remain “live” for all foreseeable Board meetings but assessed that there was no urgency.
The Deputy Governor’s speech and answers in the Q and A point to that assessment being an underestimate of the Bank’s assessment of that urgency.
The Speech
The take on the speech is that the RBA is concerned about the outlook for the Australian economy.
While in previous speeches from RBA officials considerable emphasis has been given to boosting the fiscal stimulus this speech focused mainly on RBA policy.
That policy discussion was in the context of a downbeat outlook for the economy’s trajectory.
He notes that the Bank’s current forecast is that the unemployment rate will still be above 7% by the end of 2022. He noted that “Prior to the pandemic, the unemployment rate was around 5 per cent. That was not low enough to generate sufficient wage growth consistent with achieving the inflation target”.
So, in the Bank’s current figuring, restoration of the full employment rate (which through wage pressures and the resulting required narrowing of the output gap is significant for achieving an inflation target) is in the far distant future.
That means that policy needs to be very stimulatory. Indeed in the Q and A he referred to the desirability of erring on the side of over supporting the economy rather than running the risk of under supporting it.
In the speech he reviewed the Bank’s current suite of stimulatory policies including “other options for monetary policy”.
Current policy has focussed on restoring stability to the Australian and semi government bond markets and targeting the three year part of the curve since “Australian financial instruments price predominantly off the shorter end of the curve”.
The Deputy Governor gives detailed attention to the topic of “Other Options for Monetary Policy”.
He considers buying bonds further out along the curve and notes that “additional purchases could occur further out the curve on a regular basis.” He points out that the benefit of bond purchases is also a portfolio effect to incentivise investors who are seeking higher yields at the longer end of the curve to diversify into higher yielding, including potentially, foreign assets (an implied benefit would be lowering the AUD).
He also supports governments acquiring more debt – “there is not a trade off between more debt and supporting the Australian economy”.
When he came to discuss other options he noted, “A third option is to lower the current structure of rates in the economy a little more without going into negative territory. The remuneration on ES balances is currently 10 basis points. The three year yield target is at 25 basis points and the borrowing rate of the TFF is also 25 basis points. It is possible to further reduce these interest rates”.
In a speech on July 21 Governor Lowe noted, “For example ,the various interest rates currently at 25 basis points could have been set lower at, say, 10 basis points. It would have been possible to introduce a program of government bond purchases beyond that required to achieve the three year yield target. Different parameters could have been chosen for the Term Funding Facility…. The Board has not ruled out future changes … if developments in Australia warrant doing so”.
The open ended assessment from the Deputy Governor contrasts with the “past tense” approach from the Governor. But note that the Governor qualifies his “past tense” with “the Board has not ruled out future changes”.
It is reasonable to link these two commentaries together to conclude that the Board is now ready to take the next step as described by the Governor on July 21.
And note that since the Governor’s speech the minutes to the September Board meeting have included a “new” concept “ The Board agreed to maintain highly accommodative settings as long as required and to consider how further monetary measures could support the recovery”
Issues for the Market
The RBA will have a challenge to defend a 10 basis point three year bond rate.
However, by lowering the ESA rate to 1 basis point the excessive liquidity in the system will force the effective overnight rate down to 3 – 5 basis points. Note that in the current market the overnight rate has been around 13 basis points to reflect a 3 basis point margin over the ESA rate.
That will offer a comfortable funding margin to support the 10 basis point bond target.
Interestingly, it will provide the RBA and the banks with the potential for, on a particular day, a negative overnight rate. Banks, which lend at a margin above the overnight rate will still not be exposed to negative lending rates but this process may provide the RBA with a test of its comfort with negative rates.
We have written extensively on this issue but recognise the Deputy Governor’s current discomfort, which was confirmed in the speech, with negative rates.
Compared to the current margin of 12 basis points over the effective cash rate the attraction of 3 year bonds offering a funding margin of around 7 basis points will be reduced but will still be sufficient margin to support the market and allow the Bank to achieve its target.
The US Treasuries three year bond rate is around 16 basis points – below the current Australian rate of 25 basis points making the Australian bond rate relatively attractive to international investors. At the new rate of 10 basis points the margin would diminish the attractiveness although the funding margin will still support some investor interest, particularly Australian financial institutions.
The new target bond will be an April 2024 – around 3.5 years further stretching the attractiveness of the 10 basis points of the three year rate.
However, because the target will relate to a specific bond the prospect of the market swamping the RBA is limited due to the restricted supply.
If the RBA decides to maintain an “elevated” ESA rate it could encounter significant difficulty in defending its target.
Non captive investors facing a slim funding margin may need to be convinced that the cash rate can go negative before the three year bond is seen as an attractive investment.
Excluding the Bank of Japan the RBA is the only central bank that has a yield targeting policy.
If an ESA rate of 5 – 10 basis points is set then I, personally, would adjust the suite of rates to 15 rather than 10 basis points to ensure a successful targeting process.
Consequently I expect that very low ESA rate of 1 basis point to be set.
Impact on Other Markets
The Deputy Governor referred to the three year part of the curve as the key for private sector borrowing costs. There has certainly been a significant impact on three year fixed rate borrowing costs from the Bank’s policies policy to set the three year bond rate and the three year TFF facility at 0.25%.
The three year fixed mortgage rate has fallen from 3.6% to 2.35% over the last year. We have been forecasting that the 25 basis point yield target and the TFF were likely to push these rates even lower.
In a recent paper we highlighted the fall in the fixed mortgage rates as key reasons behind our expectation that house prices were likely to stabilise over the course of the next year or so prior to a 15% lift over 2022 and 2023.
With prospects for fixed rates even more encouraging this confidence in the housing market is further confirmed.
Even with a 25 basis point three year bond and TFF target the three year fixed rate was likely to fall further. Under this adjustment we look for a further 15 basis point adjustment to the fixed rtaesto work through the system.
There is also likely to be some short term residual impact on AUD but we do not believe this will entail a sustained drag on AUD. Note that we are only estimating a fall in the effective overnight cash rate of around 9 basis points and our commodity price index has lifted by 37% since April.
We still believe that the key “fundamentals” of commodity prices and global risk appetite will be the drivers of the AUD in its move to USD 0.75 by year’s end.
The Yield Curve
Without doubt the yield curve will steepen but the overall level of rates can also be expected to fall. We recently lowered our forecast for the 10 year bond rate by end 2021 to 1.2%.
With the RBA assuming a more pro active role in the bond market in the 5 to 10 year part of the curve and the three year ate being targeted at 10 basis points rates yields can be expected to fall across the whole curve.
However we still expect that 5 to 10 year part of the curve will remain above US levels with the forecast ten year margin contracting from 40 to 30 basis points by end 2021.
