The global Covid-19 pandemic pushed Australia’s GDP to a record low in 2020. Fortunately, the successful containment of the virus combined with proactive fiscal and monetary policies helped limit the economic impact. However, cash investing remains extremely challenging with institutional investors trapped between an extremely dovish Reserve Bank of Australia (RBA) and markets pricing in inflation and steepening yield curves.
AN IDEAL RECOVERY
The Reserve Bank of Australia (RBA) Governor, Philip Lowe, acknowledged in a recent speech that the “economic downturn was not as deep as was initially feared and the bounce-back has been earlier and stronger than we were expecting”.
As recently as the August 2020 Statement on Monetary Policy (SOMA), the RBA forecast unemployment to peak at 10% and not return to 6.6% until mid-2022. In reality, unemployment peaked at 7.5% and reached 6.6% (Exhibit 1a) by December 2020, a full 19 months ahead of schedule. While the economy lost a record 877.6k jobs between March and May 2020, the subsequent recovery meant net job losses in 2020 were only -63.9k .1
The strength of this rebound is also visible in other economic data. Robust exports, stronger business confidence, an improving housing market data and a sharp recovery in consumer consumption all highlight the strength of the recovery. This has allowed the central bank to upgrade its 2020 GDP estimate from -4% in August to -2.5% in the latest SOMA, while upgrading its 2021 GDP forecast from 2% to 4%.
With the household savings ratio (Exhibit 1b) remaining close to record highs and the positive wealth effect of higher house prices enabling and encouraging consumer spending, economists have concluded that growth and interest rate hikes could be faster than expected. Anticipating that vaccines and easing of social distancing rules could trigger a further, strong rebound in the labor intensive and inflation sensitive service sector, the market is currently pricing in multiple rate hikes starting in 2023.
THE IMPORTANCE OF BEING DOVISH
Despite these robust economic signals, the RBA remained extremely dovish at its first monetary policy meeting of 2021. The central bank left the cash rate unchanged at a record low of 0.10% (Exhibit 2a) and its yield curve control target unchanged at 0.10%. They also confirmed the availability of an additional AUD99bn via the Term Funding Facility and announced a further AUD100bn (Exhibit 2b) of quantitative easing (QE).
The RBA justified its monetary policy stance by highlighting the “very substantial spare capacity in the Australian economy” and an opaque economic outlook. Unemployment remains significantly above pre-pandemic levels, the wage price index hit a new record low of 1.4% (Exhibit 3a) and core inflation continues to hover below the central bank’s target level (Exhibit 3b). Meanwhile, the uncertain impact of fiscal policy tapering and the weakness of private investment due to the uncertainty and lack of demand remain significant concerns for the central bank. The RBA concluded that rate hikes were unlikely until 2024 at the earliest.
A DIVERGENCE OF NO IMPORTANCE
While the gap between the RBA and market’s interest rate forecasts has created an interesting dichotomy for longer duration investors, it is less important for cash investors. Instead, the rapid growth of exchange settlement (ES) balances, expansion of QE and decline in corporate bond issuance are more relevant.
ES balances represent excess commercial bank cash on deposit at the RBA. Despite the central bank cutting the ES interest rate to 0.00% in November 2020, ES balances have grown significantly from a pre-pandemic average of AUD26bn to AUD165bn at present and are likely to increase to AUD300bn by the end of 2021. This surplus liquidity has triggered a widening gap between the RBA’s target and actual overnight cash rate (Exhibit 2a), pushing the latter towards zero.
Secondly, QE has already swollen the RBA’s balance sheet from a pre-pandemic level of AUD180bn to AUD330bn at present. These purchases have helped offset the rapid increase in government bond issuance and pegged short term bond yields at record lows.
Finally, weaker private sector borrowing demand has curtailed primary bond and money market instrument issuance. Year-to-date primary, non-government issuance has declined 50%2 versus pre-pandemic levels – prompting a tightening of credit spreads and sharp decline in secondary market inventories.
Combined, these factors have created the most challenging environment ever for AUD cash investors trying to address demands for higher yields while ensuring adequate liquidity and avoiding losses.
THE SOLUTION FRAMEWORK
For cash investors, holding all short term liquidity in time deposits is no longer a viable strategy. Fortunately, opportunities still exist for investors who have well defined investment objectives and pursue a disciplined approach to cash segmentation.
Operating cash, for an organization’s day-to-day needs, is volatile and requires high levels of liquidity and security. Therefore, overnight deposits, overnight repo and triple-A money market funds are still necessary for this segment of cash.
However, extending the investment parameters for non-operating cash balances into slightly longer tenors and lower rated investment grade securities greatly increases the range of instruments and issuers available while also potentially offering an attractive yield pickup relative to cash. Laddering maturities minimizes the risk of curve steepening, while ensuring adequate diversification is critical to minimize the security and issuer risk.
Regardless of the outcome of the debate between a dovish RBA and a more hawkish market, cash yields are likely to remain low for the foreseeable future. A well-written, up-to-date investment policy that enables cash segmentation should allow an organization to take advantage of potential yield enhancing opportunities while successfully balancing the needs for liquidity and security.
1 Source: Bloomberg, as at 31st January 2021
2 Source: Bloomberg data as at 31st January 2021. January 2021 bond issuance totaled AUD3.1bn versus AUD7.6bn in 2020, AUD5.6bn in 2019 and AUD5.6bn in 2018.