The rapid and coordinated fiscal and monetary policy responses by the Australian Government and the Reserve Bank of Australia (RBA) over the past six months have helped mitigate the most severe economic downturn the country has witnessed since the 1930’s. However, the recent Melbourne lockdown and uneven global recovery have increased market speculation that the RBA will intervene further to support the recovery – with significant implications for the AUD and short-term interest rates.
Swift then steady:
In early March the RBA was the first central bank to cut its base rate, “to support the economy as it responds to the global coronavirus outbreak”[1]. By mid-March, as Covid-19 cases spiked, the government instigated a nationwide lockdown and closed international borders. The RBA cut the overnight cash rate (OCR) again to a new record low of 0.25%, introduced a yield curve control (YCC) program and a term funding facility (TFF) to help “lower funding costs, stabilize financial conditions and support the economy”[2].
Subsequently, fiscal policy took centre-stage, with the federal and state governments announcing several stimulus packages including loan guarantees, job support schemes and one off payments to offset the loss of income due to the lockdowns.
The strict lockdown helped limit the initial spread of Covid-19, enabling the government to ease restrictions earlier than expected. Meanwhile, widespread adoption of the TFF and RBA bond purchases improved market liquidity, pushed the actual overnight rate below the target rate and propelled market driven interest rates to record lows (Fig 1).
Fig 1: Prompt RBA action helped ensure lower funding costs and adequate liquidity conditions.
Source: Bloomberg and JPMorgan Asset Management. As at 14th Sept 2020
The success of these policies help limited the economic fallout and allowed the RBA to revise its base GDP estimate upwards to -7% and its peak unemployment estimates downwards to 10%. Consequently, the central bank was able to leave monetary policy unchanged, while focusing on forward guidance to maintain yields close to record lows (Fig 2).
Uneven and bumpy:
Recently published second quarter GDP confirmed the first Australian recession in over 29-years with growth declining by a massive 7%q/q. This is likely to represent the nadir, with the latest economic data showing strong improvements.
However, at its September’s monetary policy meeting, the RBA acknowledged that the outbreak in Victoria and slower global economic growth implied Australia’s recovery would be “uneven and bumpy”[3]. The central bank extended its TFF program to keep funding costs low and rekindled speculation of further monetary policy easing by confirming that they “continue to consider how further monetary measures could support the recovery” [4].
Fig 2: The RBA has used yield curve control and forward guidance to flatten the short end of the Australian government yield curve.
Source: Bloomberg and JPMorgan Asset Management. As at 14th Sept 2020
Potential action and implications:
In numerous speeches and articles, the RBA Governor has reaffirmed the central bank’s three red-lines: No negative interest rates, no monetary financing and no active foreign exchange intervention to weaken the currency. Nevertheless, the RBA still has several policy options available to support the economic recovery; including reducing the OCR target rate, lengthening the tenor of its YCC program and instigating outright quantitative easing.
Although a lower target OCR rate would mainly be symbolic given the actual cash rate is currently trading around 0.10%, lengthening the tenor of its YCC program to five-years would trigger additional central bank bond buying. This in turn would inject extra liquidity and flattening the yield curve further. Introducing outright quantitative easing - which commits the RBA to purchasing a certain amount of bonds rather than targeting a specific yield would also inject a significant amount of liquidity, while potentially flattening the entire yield curve.
Conclusion:
Since March, short term interest rates have stabilized on the premise that monetary policy would remain unchanged for the foreseeable future. The surprise news that the RBA was considering additional monetary policy measures raised concerns that interest rates could fall even further – creating additional challenges managing cash investments.
Fortunately, the subsequent meeting minutes did not elaborate on these potential actions, suggesting that while the RBA is able to do more, it is not yet willing to alter its policy. Nevertheless, investors should get prepared for an extended period of lower returns. Therefore, segmenting cash balances to allow for investment in longer duration securities as well as diversifying across instruments and issuers remains important to achieve a risk adjusted returns.
[1] Statement by Philip Lowe, Governor: Monetary Policy Decision. 3rd March 2020.
[2] Minutes of the monetary Policy Meeting of the Reserve Bank Board. 4th August 2020
[3] Statement by Philip Lowe, Governor: Monetary Policy Decision. 1st Sep 2020
[4] Statement by Philip Lowe, Governor: Monetary Policy Decision. 1st Sep 2020