In brief

• Constrained by a new effective lower bound, the Reserve Bank of Australia (RBA) is leveraging its balance sheet to ease monetary policy and use a new mechanism, the exchange rate, to stimulate the economy.
• There remains scope to increase the size of any bond purchase scheme to keep pace with monetary policy globally and achieve the RBA’s desired targets.
• The RBA can’t decouple monetary policy from the rest of world and success in weakening the exchange rate will be influenced by global factors as well as local ones.

The effective lower bound for the cash rate has been moved once again as the RBA reduced the official cash by 15bps to 0.10%. In line with this move, the associated rates on the three-year yield curve control (YCC) target, Term Funding Facility (TFF) and the interest applied to excess reserves were all lowered to 0.10% and the interest on excess reserves to 0.00%.

The RBA has committed to purchase AUD 100billion government and semi-government bonds over the coming six months split 80/20 between government and state and territory level bonds. The purchases will be bonds with maturities of five to ten years and be in addition to any bonds bought to defend the YCC target.

The RBA’s swivel to a more vanilla style quantitative easing (QE) program that targets the quantity of purchases rather than the price (or yield) on bonds shows its intent to utilize the balance sheet to achieve the desired outcomes of higher inflation and full employment at a point when rate cuts are less effective.

The shift to QE may seem like a late move by the RBA, but it has the benefit of judging the success of programs elsewhere and determining an appropriate level of purchase. The AUD 100billion represents 5% of GDP, a similar size adopted elsewhere. The move also reflects the difficulty in decoupling monetary policy from the global shift to even looser policy and the renewed focus on the exchange rate as the transmission mechanism to lift economic activity in Australia.

Balance sheet tools

A year on from when the RBA first discussed possible extra-ordinary policy options, it has moved through that list rather quickly. The package of policy measures to date include forward guidance, cheap loans to bank via the TFF and YCC. From the initial list, negative interest rates and direct intervention in the foreign exchange market are all that is left.

For the RBA negative rates, at this point at least, remain a step too far. Other central banks are happy to proceed in this direction, as the Bank of England and the Reserve Bank of New Zealand explore this policy tool. The difference is that both those institutions have already done large scale asset purchases, while the RBA has not. The AUD 63billion in bonds purchased since May of this year under YCC to address any perceived market dislocations doesn’t meet this definition.

EXHIBIT 1: THE RBA HAS LAGGED INTERNATIONAL PEERS WITH ITS ‘QE LITE’ APPROACH
CENTRAL BANK BALANCE SHEET % OF NOMINAL GDP

Source: Bank of England, European Central Bank, Reserve Bank of Australia, Reserve Bank of New Zealand, U.S. Federal Reserve, J.P. Morgan Asset Management. Data as at 31 October 2020.

The effectiveness of a 15ps cut to the cash rate on stimulating economic activity is debatable, but the next best option is replicating the impact of a larger rate cut through balance sheet expansion. That easing is required because sustainability above target inflation is likely to remain elusive. Moreover, the RBA has shifted from a proactive policy stance to a reactive one when it comes to tightening monetary policy. Rather than moving policy based on a forecasted level of inflation, it will now do so on the actual level of inflation. This means that inflation will have to remain in the 2-3% target band before expectation of a rate hike. The increasing focus on job creation and more than just progress to full employment in the economy reinforces the stance that the RBA wants the economy operating as close to potential as possible before lifting rates.

Quantity is king

Both outright QE and YCC add to the size of the RBA’s balance sheet but they are designed to influence the economy through different means. Lowering borrowing costs at the short end of the curve through YCC supports the availability of credit by lowering funding costs for banks and businesses and was paired with low interest loans via the TFF. As looser monetary policy is required for longer the focus shifts further along the yield curve and utilizing the exchange rate as the transmission mechanism to the economy.

As nearly every developed market has their own cash rate at effectively zero, and most major central banks are undertaking their own QE programs, bond yields have collapsed. Australian government bond yields had risen above those of other developed markets, notably the U.S. The wider the spread of Australia bonds over international ones, the more upward pressure on the Australian exchange rate.

EXHIBIT 2: COMPETITIVE QE HAS FORCED BOND YIELDS LOWER
AUSTRALIA AND U.S. 10-YEAR GOVERNMENT BOND YIELDS

Source: FactSet, Tullet Prebon, J.P. Morgan Asset Management. Data as at 31 October 2020.

The QE program will flatten the Australian yield curve by bringing down longer dated bond yields when short dated yields are already anchored. This would lower the exchange rate by narrowing the spread of Australian bonds relative to the rest of the world. The weaker currency helps the economy by (i) increasing substitution of higher priced foreign goods and services to relatively lower priced domestic ones, and (ii) increasing the attractiveness of Australian exports that are more attractively priced internationally. The combined effect increases net exports and stimulates demand in the economy. A recent RBA publication illustrated that it’s the exchange rate that has the greatest impact on the outlook for unemployment and inflation¹. The lower the RBA can push bond yields the more pronounced impact on the exchange rate.

EXHIBIT 3: RISING INFLATION EXPECTATIONS TO BE TESTED WITHOUT FISCAL STIMULUS
CONSUMER SURVEY OF INFLATION OVER ONE AND THREE YEARS, AND 5Y5Y CPI INFLATION SWAP

Source: Bloomberg, FactSet, Federal Reserve of New York, J.P. Morgan Asset Management. Data as at 31 October 2020.

The challenge the RBA faces is that it has no control over other central bank policies, only tries to keep pace with them. What happens in the coming year in terms of viral spread and size of any U.S. fiscal stimulus package will have a large impact on investor sentiment, bond yields, currencies and the prospects for further extended QE programs by other central banks.

Inflation expectations in the U.S. had been rising on the anticipation of a large fiscal stimulus package in 2021, with those hopes fading, U.S. government bond yields are again falling and expectations for more QE from the U.S. Federal Reserve rising. Should this occur the RBA would have to act to relative to the movement in foreign bond yields to influence the currency. The flexibility the RBA has given itself is in the openness of the QE program, where they can do more if needed, and the pace at which they purchase bonds. AUD 100billion over six months equates to approximately AUD 5billion per week, but purchases may not be that consistent.

So why now?

QE may appear to becoming too late to stimulate the economy especially as Australia has successfully suppressed a second wave of the COVID-19 virus and has passed the worst of the economic downturn. The RBA has upgraded its view on the economy with growth expected to be 6% year-over-year (y/y) by the middle of 2021 and 4% y/y in 2022, but the unemployment rate will be persistently high with low wage growth and muted inflation. The RBA expects inflation to remain below the lower end of the 2-3% target band until 2022.

However, the limitations of monetary policy are well known and the RBA’s view is that policy easing at a time of extreme weakness in demand (thanks to social distancing restrictions) would be even less effective. Ensuring that borrowing costs are low when demand is rising is more likely to facilitate the expansion and job creation that the RBA is looking for.

Investment implications

Our current view is that this is still the early stages of the economic recovery and bodes well for riskier assets such as equities and credit over government bonds. Australian equities have lagged international peers, the ASX 200 is still 9.1% down year-to-date compared to the 2.8% return on the U.S. S&P 500 and the -1.7% return on global developed markets. The announcement of fiscal stimulus, further easing from the RBA and economic reopening of the local economy could mean a period of catchup for Australian equities, especially as COVID clouds darken the near-term economic outlook in Europe and the U.S.

The ‘QE lite’ approach of the RBA earlier in the year, relatively softer recession and better handling of COVID-19, along with sustained demand for bulk commodities and the unwinding of U.S. dollar strength helped drive the Aussie of its March lows. The currency has already weakened on the expected easing and while upside may be limited from here, the expected decline in the U.S. dollar over the medium term should prevent the Aussie from falling too far. However, global forces will have a large say in whether the RBA achieves outright deflation or a currency that appear weak relative to cyclical forces such as global growth or commodity prices.

Government bonds, whether locally or in Australia, are expensive at such low yields and real yields are either negative or flat. While the risks to the outlook suggest that bonds will have some role in diversifying portfolios, the cushion is thin and we still favour high yield bonds and selected emerging market debt when looking for yield and an expansion into private markets and real assets for portfolio diversification. 

¹The Economic Effects of Low Interest Rates and Unconventional Monetary Policy, 17 September 2020, www.rba.gov.au. 

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