The extent and implications of the dramatic economic halt brought about by Covid-19 are still to play out and it is too early to believe that economies will return to pre-disruption levels anytime soon. Yet equity markets are trying to recover in the belief that seemingly unlimited, unconventional monetary policy (UMP) and fiscal policy will be enough. A key tenant of the recovery in equity markets is that interest rates will remain low due to RBA buying. So, what is the RBA doing?
How things have changed since the GFC
Historically with higher rates, central banks could influence borrowing rates where they matter the most (i.e. in ‘the street’ for both corporate and consumer/ residential borrowers) by just adjusting the overnight cash rate. This worked well up to the Global Financial Crisis (GFC) when the transmission mechanism (the banking sector) between central banks and the street failed.
The financial crisis disrupted the ability of banks and other financial participants to borrow and on lend funds. Massive, targeted support to the global banking system stabilised the system and equity markets began a decade long rally, based largely on the premise that central banks and governments would do any, and everything to avoid another recession. Indeed, the last decade has seen prompt action from both parties at any sign of a downturn, potentially using ammunition (such as being able to lower rates from higher levels) that would be of more value now.
The challenges of Covid-19
Covid-19’s disruption is not a financial crisis; it is a health and economic crisis that risks infecting the financial system. Governments globally are addressing the health and economic crisis by supporting affected people through massive relief packages, funded through equally massive borrowing programmes. We expect government borrowing in Australia is set to rise by about 275bn by the end of 2021. Over the longer-term, we believe that the increased supply of debt is not likely to materially push rates higher. However, in the shorter term this wave of debt issuance cannot be absorbed by savers and investors.
RBA steps into the bond market
The RBA’s participation directly into the bond market will assist markets to remain orderly, effectively stepping in to act as a buffer to these intermittent supply and demand imbalances. Some question the RBA’s ability to manage a large bond portfolio and that its involvement will distort the operation of the bond market. We do not believe this is the case. Central banks have experience in managing large bond portfolios as they historically manage the country’s foreign reserves, which have included foreign government bonds. Further, the RBA is a new type of investor into the domestic bond market and unlikely to compete with existing participants. Having a diversified range of participant types allows for a more efficient market (when markets become dominated by common investor types, distortions occur similar to the large-scale liability hedging that occurred in the UK bond market back in the late 1990s).
RBA helps keep rates low
The other action the RBA is undertaking is making sure that it still has influence over retail and corporate rates. It is doing this by keeping government bond rates out to 3-years at, or around 0.25%. It is within this 3-year term that the bulk of Australian borrowing is done.
If we look to offshore markets as to what other steps the RBA could take in support of the Australian economy, we can see some potentially far-reaching actions. The US Fed is a prime example, effectively throwing the ‘kitchen-sink’ into its support of companies. The most dramatic example of this is buying ‘fallen angels’, those once investment grade companies that have now dropped into sub-investment grade. In the US, businesses borrow a far greater amount directly from the market (investors) by issuing a far greater amount of corporate bonds, relying less on borrowing from the banking sector as we see in Australia. We don’t’ expect to see the RBA extending its buying program to include corporate bonds. Rather, its actions will be ensuring ongoing stability in the banking sector which we believe is in good shape.
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