The RBA Checks into Hotel California – Thoughts on The RBA’s QE Program and Bond Investing

Andrew Canobi examines what the RBA’s recent quantitative easing policy may mean for Australian fixed income markets.

    Andrew Canobi, CFA

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    Quantitative easing is here. If the experience of global central banks going to down this path is anything to go by, then the lyrics of the Eagles classic, Hotel California will resonate:

    “You can check out anytime you like but you can never leave”

    So down the QE rabbit hole we go.  The RBA this week fulfilled the promises it had strongly hinted at to release even further monetary firepower.  The official cash rate was cut by 0.15% to 0.1%, the target yield for 0-3 year government bonds was adjusted to this new cash rate target, the interest rate on exchange settlement balances held at the RBA was cut to 0%, and quantity based quantitative easing was announced in the 5-10 year part of the government bond curve.  To achieve the latter point, the RBA has committed to purchase $100bn of bonds over a 6 month period, equating to around $5bn a week (80% Commonwealth and 20% State Government).  This is in addition to the purchases the RBA will undertake to keep the 0-3-year government bond curve at 0.1%.  This is profound new territory for the local central bank.  

    The RBA’s balance sheet at the end of October was approximately $295bn.  Drawings under the Term Funding Facility (TFF) stand at around $100bn.  If we add a further $100bn under the new 5-10yr QE program and assume some further use of the TFF by commercial banks to access this funding, then the balance is likely to move toward ~$550bn over the next 6 months or ~27% of GDP.   For comparison, the US Federal Reserve’s balance sheet is ~33% of GDP, and the RBA is clearly happy to move with the G-7 pack.  

    A Brief History of QE Infinity

    It’s timely to look at the history of QE in the US and recognize that what was launched as a temporary program in 2008 is now well and truly part of the furniture in the Eccles building.   The chart below is a simple timeline of the Fed’s balance sheet, which is now north of US$7tr. We have added the timeline of the various iterations of QE which have led to the current position.  

    For a historical perspective, in a speech in 2009 then Fed Chairman Ben Bernanke stressed the temporary status of the Fed’s balance sheet expansion having just embarked on QE1:

    “..the size of the Fed’s balance sheet will decline, implying a reduction in excess reserves and the monetary base…As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy – namely by setting a target for the federal funds rate”.

    - Chairman Ben Bernanke January 13 2009

    Aside from some occasional and largely modest shrinkage, the direction of the US Fed’s balance sheet has been one way.  Will the RBA be the same?

    We don’t have time or space to detail the programs of the ECB, Bank of England or Bank of Japan to name a few but the actions of the US Fed are significant as a flag bearer for developed market central bank orthodoxy.  So it shouldn’t come as a great surprise that the RBA is following a well-established playbook.

    The principal takeaway from the last 12 years is that, with the best intentions, QE is not a temporary tool but a semi-permanent feature that once deployed, might be paused, doesn’t seem easily reversed.  

    The Price of Deleveraging

    With debt levels at record highs, the fact remains that suppressing the price of money is a critical precondition for economies having a shot at deleveraging.  That deleveraging will take many years.  In such a deleveraging, the supply of money dramatically outweighs demand as the easiest of credit conditions do little to stimulate demand for new borrowing.  Equally, the oversupply of money which suppresses interest rates creates a potential savings glut – the lower the return on savings the more that needs to be saved etc.

    The central conclusion from the RBA’s actions is that nominal interest rates from the very short end out as far as ten years are going to be constrained.  Meanwhile, realized inflation will remain comfortably above the rate curve, thereby ensuring an orderly transfer of wealth from savers to borrowers over coming years.  The best way to steal money from people is slowly and without them knowing.  Avoiding nominal losses in bonds through a sharp rise in interest rates can abet this process, as the invisible thief of inflation does the work for you.

    Time will tell if our prognosis is correct, but we could well look back and regard November 2020 as QE 1 for Australia and only the beginning.

    What to Do Now?

    The question most often posed to us of late is, with yields so low how can you make money in bonds?  Our answer is always the same.  We have never been bound by yield or the absolute level of interest rates to drive return.  We are much more focused on price versus value across our investment universe and actively seeking divergences between the two to exploit.  In that regard, nothing has changed as a result of the current environment, and in fact, the future looks bright.

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