By Sophia Rodrigues*
The Reserve Bank of Australia’s bond-buying plan under Quantitative Easing is likely to include bonds in the 5-10 year range but its expectation is that it would also drive down bond yields beyond that term.
Essentially it means the RBA would be eyeing a flatter yield curve not just up to 10 years but also well beyond that.
If the RBA is successful in achieving a significantly flatter yield curve, it is likely that the Australian government bond yield curve would trade below the US yield curve. And this would be welcomed by the RBA because of the impact it would have on the exchange rate.
The Australian government yield curve is currently trading slightly below the US up to 5 years, marginally higher at the 10-year and increasing positive spread beyond that.
The last time the Australian curve traded below the US was in 2018-19, when the 10-year spread reached the widest around -85bps in July 2019. The driver of the negative spread was the difference in monetary policy stance between the two countries with the Federal Reserve on tightening path and the RBA still accommodative at the lowest rate on record back then.
If the Australian yield curve indeed trades below the US on a sustainable basis, it would be the first time this would happen (in over 30 years) when both monetary policies are at the same juncture, that is both at their effective lower bound.
LAUNCH QE FOR FIRST TIME
At the November 3 board meeting, the RBA is expected to lower the cash rate target to 10bps along with a cut in the interest rate on Term Funding Facility and three-year government bond target.
In addition, the RBA is expected to launch QE for the first time with focus on quantities, rather than the yield. The RBA currently targets three-year bond yield at 0.25% and has bought bonds to achieve that target and to correct dislocations in the market.
And even though there has been quantitative aspect because of the quantities of bonds purchased, the RBA has always seen it differently to QE done by many other central banks.
This will change on November 3, when the RBA, like many other central banks, will launch a QE programme.
It is unclear what the QE programme would include but among the options being considered are introduction to a five-year target as part of yield curve control and a QE size.
EYEING INTEREST RATE DIFFERENTIALS
There are several reasons why central banks engage in QE but for the RBA some of those reasons are not applicable, at least currently. Financial markets are functioning smoothly in Australia and the government’s borrowing program doesn’t require the RBA support.
But other channels of QE like portfolio re-balancing, signalling, bank lending, liquidity would still serve the RBA well.
The most important of them all would be downward pressure on yields that would create interest rate differentials with other countries, especially the US. This would be expected to put downward pressure on the exchange or in the least, keep the exchange rate lower than it would otherwise be.
This is exactly what Governor Philip Lowe alluded to at the Q&A session following his speech on October 20. He said the RBA would be looking for the impact of QE on Australian jobs.
A key channel that this would work is through the exchange rate.
“The fact that we’ve got higher 10-year bond yields than the rest of the world, is that related to the fact that we’re not buying bonds at that maturity and if that’s the reason, is there benefit in having those interest rates come down as we try and support jobs. That’s the issue we’re grappling with,” Lowe said.
*All views, opinions and insights are those of Sophia Rodrigues, an RBA watcher and reporter and guest contributor to InTouch Capital Markets