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The RBA goes unconventional

Andrew Mayes

10 minute read

With financial markets convulsing and central banks (and governments) hastily responding with both conventional and unconventional measures, the Reserve Bank of Australia (RBA) has announced its response to COVID-19.

Summary

Having lowered the cash rate to 0.25% on 19 March 2020, the RBA announced it will also purchase government securities (across the yield curve) in an effort to target a yield on 3-year Australian Government bonds of around 0.25%. By not specifying a particular quantity of bonds it will purchase, the RBA is opting to achieve its objective through the use of yield curve control. Put simply, yield curve control is concerned with the price of bonds; quantitative easing is concerned with the quantity of bonds.
The RBA also reiterated and extended its support for interbank liquidity. Following similar actions taken by the New York Federal Reserve as well as the European Central Bank and Bank of England, the RBA has responded to the rising tension amongst interbank funding by injecting increasing amounts of cash into the banking system through its repurchase (or ‘repo’) arrangements
It has also announced the provision of at least AUD90bn in funding for banks at 0.25% (in return for eligible collateral--explored further below), with further funding available if directed toward small business customers.
One unique feature of current markets is the sell-off (or liquidation) of both bonds and equities. There appear to be two main reasons for this. Firstly, the growing risk of a health (and economic) crisis morphing into a credit crisis. Secondly, and relatedly, there appears to be a rush for cash (especially US-dollars) on expectations of liquidity shortfalls.
The impact of yield curve control by the RBA is generally greatest on the particular rate (or maturity) at which it intervenes. As such, we expect yields at the shorter-end of the Australian government yield curve remain anchored for an extended period of time. Given this, we believe the following should be considered (rationale provided further below):
- Shorter duration
- Inflation linked bonds
- Higher-rated credits
- Selective high-yield (fixed and floating)

The Reserve Bank of Australia goes unconventional (as does the rest of the world)

With financial markets convulsing and central banks hastily responding with both conventional and unconventional measures, the Reserve Bank of Australia (RBA) has announced its response to COVID-19.

Recall that the RBA has previously signalled a cash rate of 0.25% as the so-called ‘lower bound’, at which point the central bank would consider unconventional monetary policy measures such as quantitative easing (we explored this last year).

Having lowered the cash rate to 0.25% on 19 March 2020, the RBA has announced it will also purchase government securities (across the yield curve) in an effort to target a yield on 3-year Australian Government bonds of around 0.25%. Targeting the shorter-end of the yield curve makes sense within the Australian context as most borrowing is done for relatively short maturities--generally less than five years. The RBA also announced the provision of at least AUD90bn in funding for banks at 0.25% (in return for eligible collateral-- explored further below), with further funding available if directed toward small business customers.

By not specifying a particular quantity of bonds it will purchase, the RBA is opting to achieve its objective through the use of yield curve control (explained below). The RBA does not expect to increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band.

Yield curve control involves the central bank buying and selling bonds as necessary to achieve its short-term interest rate target (i.e., controlling yields at certain point(s) along the government yield curve, hence the term “yield curve control”). Yield curve control is also more closely modelled on conventional monetary policy; the central bank simply transacts in the bond market to keep yields consistent with its target, as it does for overnight rates. This is in contrast to quantitative easing, which involves the purchase of a quantity of bonds (hence the term, “quantitative”), increasing the stock of money in the economy.

In simple terms then, yield curve control is concerned with the price of bonds; quantitative easing is concerned with the quantity of bonds.

In effect, quantitative easing and yield curve control would aim to achieve the same outcome as (now exhausted) conventional monetary policy--keeping the front end of the risk-free curve low for a period of time, thus maintaining low borrowing costs. Debt serviceability is similarly preserved, assuming households remain employed--a matter for fiscal authorities to address at this juncture. Lower borrowing costs are designed to encourage economic activity by bringing demand forward--the question is whether such demand exists in this period of considerable and unprecedented uncertainty (we also explored that theme last year). For now, solvency appears the primary objective.

The Bank of Japan (BOJ) is the only major central bank to adopt yield curve control in recent times (the US Fed used yield curve control in the 1940’s to keep rates low as the government borrowed heavily to fund the war). In September 2016, the BOJ announced that it would purchase government bonds necessary to keep the yield on 10-year Japanese Government Bonds (JGBs) at 0%. Yields on 10-year JGBs, the point on Japan’s yield curve targeted by the BOJ, have mostly held near its objective (see Figure 1). Empirically, albeit with limited sample, the BOJ has purchased fewer bonds under yield curve control than it had using quantitative easing, which began in 2013 (see Figure 2)

Figure 1: Japan 10-Year Government Bond Yields (%)

Source: Federal Reserve Bank of St Louis

Figure 2: Monthly Purchase of JGB’s (Trillion Yen)

Source: Japan Macro Advisors

RBA also seeks to keep liquidity flowing and credit spreads in check

The RBA also reiterated and extended its support for interbank liquidity.

The bank bill swap rate (BBSW) is the rate banks pay to borrow short-term funds and often trades at a premium (the credit premium) above benchmark interest rates (such as the Overnight Indexed Swap [OIS] rate, which is closely tied to the overnight cash rate). A widening in the BBSW/OIS spread is generally an indicator of increasing stress within the banking sector (see Figure 3). This increase in friction amongst banks can be also seen through an increase in the level of surplus exchange settlement funds held by commercial banks with the central bank, which are used by account holders (banks) to meet their payment obligations with each other and with the RBA. ‘Surplus’ exchange settlement funds are generally paid interest at a rate that is 25 basis points below the cash rate target ; given funds held with the central bank under this arrangement are risk-free, there is an incentive for banks to lend those funds to other banks that need them. However, during periods of increased friction amongst banks, those with surplus funds may not wish to increase its credit exposure to a bank that need the funds, increasing surplus funds held with the central bank (see Figure 4). Interbank liquidity deteriorates as a result.

Figure 3: BBSW/OIS Spread (bps)

Source: Company data, FIIG estimates *Includes certificates of deposit ^of which ~80% of long-term wholesale relates to securitisation funding

Figure 4: FY20 Major Bank Funding Task (AUDbn)

Source: Bloomberg. Includes long and short-term wholesale debt FY20 for CBA: 30 June 2020. FY20 for ANZ, NAB and WBC = 30 Sept 2020 Percentage of FY20 refinancing completed in parentheses

Another factor working in favour of local banks is an anaemic level of credit growth currently (around 2.5%, compared with more than 15% in the years leading into the global financial crisis), which effectively reduces the funding task to refinancing maturing liabilities (see Figure 4). The four major banks have made good progress against their FY20 funding task and the remaining refinance task has been made somewhat easier following central bank intervention.

Capitalisation has similarly strengthened during this period (see Figure 5). For major banks locally, common equity headroom above the Capital Conversation Buffer (CCB) is equivalent to around two-times normalised earnings (see Figure 5). Typically, if the Common Equity Tier 1 Capital (CET1) Ratio falls below the CCB, earnings available to distribute to shareholders is reduced for the bank in question. Although we believe it’s unlikely local banks will breach their CCB in the near term--see below for our rationale--we believe local banks, both major and regional, will reduce distributions to shareholders in the near term to reinforce capital levels, given the high degree of uncertainty about the depth, breadth and length of the current downturn (see immediately below for further rationale). This includes ANZ and CBA who nevertheless may be better-placed given greater headroom above regulatory minimums following divestment of non-core assets. Dividend payout ratios declined to around 50% on average across the four major banks during the GFC.

We note the European Central Bank, Bank of England, and more recently, the Reserve Bank of New Zealand, have either recommended or indeed ordered banks under their jurisdiction to freeze dividend payments and share buybacks (recall that Eurozone banks, including those in the UK, required considerable government support, and as such, are still somewhat sensitive to repatriation of capital to shareholders). In New Zealand, repatriation of capital to Australia is similarly a sensitive theme.

While we do not foresee local regulators taking a similar approach, we believe capital preservation will be a priority for our domestic banks. Given the local major banks rely on dividends from their New Zealand subsidiaries to pay their own distributions to shareholders, we believe a reduction in their respective payout ratios is a high probability. Ultimately, any attempt to preserve capital will be supportive for bank funding higher up the capital structure, including Tier 2 debt.

Figure 6: Non-Financial Corporate Gearing (Debt/Equity)

Source: Bloomberg. Source: Australian Bureau of Statistics (ABS)

Figure 7: Global Household Debt

Source: Bank of International Settlements

In recent years, Australian households have largely responded to falling interest rates by prioritising (p-)repayment of debt (see Figure 9), although low savings rates amongst households suggest these buffers are likely to shrink rather rapidly.

Figure 8: Australian Household Indebtedness

Source: Reserve Bank of Australia, Bank of International Settlements

Figure 9: Mortgage Prepayments (No. of Months)

Source: Reserve Bank of Australia

Around 90% of businesses recently surveyed by the ABS expected to be adversely impacted as a result of the virus. Accommodation and food services, and retail and wholesale trade, as well as recreation and entertainment services, have been particularly impacted, although we expect further adverse impacts to be felt more broadly, including commercial property, construction and manufacturing. Invariably, arrears and credit losses will rise, including impacted individuals with mortgages (see Figure 10 for bank exposure currently and during the GFC, including performance).

Close to a decade of benign operating conditions--including accommodative interest rates, stable employment and reasonably strong economic growth--has provided a backdrop for low arrears and credit losses across Australia’s banking sector (see Figure 11). At the height of the GFC, credit losses rose to around 80 bps across Australia’s banking sector (see Figure 11). Comparisons with the GFC are not straightforward--larger banks have dramatically shifted the composition of their balance sheets since then, while unemployment (and particularly underemployment) is likely to be much higher this time around. There are other factors, including the forementioned lower levels of corporate leverage presently. Nevertheless, if we assume (but not predict) a similar increase this time around, credit losses would amount to an average of ~AUD5.3bn per major bank--a substantial loss, but one that would be absorbed (see Figure 5). For the smaller regionals, closer to AUD430m--equivalent to a year worth of earnings, but again, one that can be absorbed.

Figure 6: US 10-Year Treasury Rate (bps)

Source: Boomberg

Figure 7: Australia 10-Year/3-Year Government Spread (bps)

Source: Bloomberg

Returning our focus back to Australia, and with specific reference to the RBA’s implementation of yield curve control, its impact is generally greatest on the particular rate (or maturity) at which it intervenes. Recall the general purpose of easing monetary conditions is to raise expectations for long-term economic growth and inflation, which is reflected in longer-term interest rates (i.e., an upwardsloping yield curve). However, the longer-end of the yield curve is driven by a number of factors--economic growth expectations, inflation expectations, and supply and demand of longer-maturity government bonds, among others. The recent steepening in the yield curve is likely to reflect the longer-end selling off (see the rationale above re: liquidation and increase in supply) and an anchoring in the short-end in anticipation of the RBA committing to keep short-term rates at around 0.25%, in our view (see Figure 7).

One potential complication (albeit, very much in its embryotic stage at this point) is the risk that imported inflation increases due to an increase in the cost of goods imported--a function of Australia’s falling currency (although the deflationary impact of falling global oil prices might offset this). Although we expect the RBA would ‘look through’ the impact this has on inflation (in terms of any formal response) it could nevertheless have an impact on fixed income. Given this, we believe the following should be considered:

Shorter duration. Maturities of around five-seven years and less given RBA preference to keep rates low for an extended period of time. The longer-end of the yield curve remains exposed to a number of moving (and potentially contradicting) variables (for example, a deteriorating growth outlook should lead to a flattening in the yield curve, but an increase in supply of longer-dated government bonds will lead to a steeping in the yield curve).
Inflation-linked bonds. Protect against inflation if surprise on the upside (re: quantity of money and impact of falling currency on tradable inflation)
Higher-rated credits. Well-placed to navigate the near-term uncertainty. The sell-off will present value in some sectors (for example, the current environment for financial institutions is less than ideal, but the sell-off in major bank bonds seems overdone in our view--particularly Tier 2’s ).
High-yield (fixed and floating). Focus on companies with clear visibility over near-term refinance requirements (if relevant) (i.e., well-funded) and cashflows.

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