At their monthly monetary policy meeting on the 6th of July, the Reserve Bank of Australia (RBA) announced its first tentative step towards tapering and eventual policy normalization.  The well telegraphed decisions were broadly in-line with market expectations and balanced the stronger than expected post-pandemic recovery with the commitment to “provide the continuing monetary support that the economy needs as it transitions from the recovery phase to the expansion phase”.  These changes will have longer term implications for money market yields and cash investors – although money market rates are likely to remain low for the foreseeable future.

FIRING ON ALL CYLINDERS:

Australia has experienced a rapid economic recovery from 2020’s Covid-19 induced recession.  Supportive fiscal and monetary policies limited the negative economic impact of the pandemic and created a solid base for future growth. 

Strong commodities demand and successful Covid containment measures have supported a rapid industrial rebound - boosting exports, production and business confidence.  Meanwhile, low interest rates and a further reopening of the services sector have supported retail sales, the property market and consumer confidence.  

The labour market, a key RBA metric, “has continued to recover faster than expected” with unemployment declining rapidly from a post-pandemic high of 7.4% to 5.1% in May. Almost one million new jobs created during the last 11 months (Fig 1a) has offset the Covid-19 inspired losses.

RBA’S DOVISH TAPER:

The July monetary policy meeting statement affirmed the central bank would maintain its overnight cash rate (OCR) target at 10bps and Exchange Settlement (ES) balances rate at 0bp. More notably, they also decided to retain the April 2024 Australian Commonwealth Government Bond (ACGB) for its yield curve control (YCC) operations and end the Term Funding Facility (TFF) for banks.  Finally, while the RBA announced a third quantitative easing (QE3) program, the pace of purchases would be lower..  

This is the first significant monetary policy adjustment since the RBA introduced QE in November 2020. More importantly, it lays the foundation for the eventual normalization of monetary policy while still allowing the central bank flexibility to react to unexpected changes in circumstances – representing a pivot in focus from dates to data.

Recently, excess market liquidity has kept the actual overnight cash rates anchored at almost zero (Fig 2a), while the 3-year government bond remained below its 0.10% target, curtailing the need for additional YCC purchases.  In contrast, the central bank has fully utilized the first QE program (AUD100bn) and has only AUD49bn of the second program remaining to invest before September.  The new purchases under the third QE program will likely totaled a smaller amount of approximately AUD30bn to AUD60bn, taking total RBA holdings to almost 30% of the total outstanding government bonds and 15% of outstanding state and territory bonds.

MANAGING EXPECTATIONS:

The RBA’s latest policy actions were logical given the strength of Australia’s recovery; allowing the central bank to reduce forward guideline and provide additional policy flexibility while still ensuring adequate liquidity.  Nevertheless, with inflation below the RBA’s target range and muted wage prices (Fig 1b), the RBA Governor reaffirmed the bank’s commitment to low rates; although the final statement sentence was altered and compressed the timeframe for eventual increase in the cash rate until “not… before 2024”.

The earlier and more rapid economic recovery had increased market expectations of an accelerated hawkish pivot by the central bank.  Yet the slow domestic vaccine rollout combined with recent Covid-19 outbreaks in several major cities highlights the risks of early monetary policy tightening.  The RBA is also keen to avoid a likely spike in the AUD, if QE is reduced before other major central banks.  Following the RBA announcement, Bank Bill Swap Rates (BBSW) yields were broadly unchanged while the money market yield curve steepened slightly (Fig 3a). 

OUTLOOK AND IMPLICATIONS:

For cash investors, the RBA’s dovish taper has increased expectations that interest rates will eventually increase, broadening their investment palette.  Although money market rates are likely to remain largely unchanged for the foreseeable future, the choice to end the term funding facility should reduce the risk of cash rates slipping into negative territory, while further improvements in the labour market could trigger additional BBSW curve steepening.  In addition, the decision to curtail forward guidance has triggered a rebound in intermediate bond yields. This should allow investors to extend their investment parameters to slightly longer duration tenors and a broader range of instruments, offering an attractive yield pick-up opportunity relative to cash.