As vaccination rates rise around the globe and countries continue to make strides toward a return to more normal economic and social conditions, the emergency policy settings put in place to help ward off a more painful economic slowdown are starting to roll off.
In Europe, the European Central Bank (ECB) has announced a reduction in bond purchases associated with its temporary Pandemic Emergency Purchase Program (PEPP). Meanwhile in the US, the Federal Reserve recently provided greater clarity on the timeline for tapering its bond purchasing program, which is widely expected to start later this year. Central banks such as those of Norway, New Zealand and South Korea have actually started to move their policy rates above emergency settings, and the Bank of England has indicated inflation expectations may persist longer than previously expected, which has brought forward rate hike expectations.
In Australia, the Reserve Bank of Australia (RBA) remains intent on keeping rates low until its inflation, employment and wage growth targets are sustained at target levels. RBA Governor Philip Lowe remains resolute that interest rates are not likely to move higher until 2024, yet market participants have questioned the necessity and likelihood of the RBA’s emergency policy settings remaining in place. This helped move expectations of rate hikes forward and therefore pushed yield curves higher.
Taming runaway house price growth in Australia is becoming of increasing importance for the RBA, as it is for many other developed economies. Tightening lending regulations, as per the recent announcement by the Australian Prudential Regulation Authority (APRA) that it will increase lending serviceability standards rather than increase policy rates, is evidently the preferred method of dealing with this for now. These changes are likely to have limited effectiveness as they only impact a portion of the homebuyer market.
Policies to Support the Australian Economy
Minimising the economic fallout from the lockdowns has been front and centre for the RBA, the Australian government, banks and regulators over the past 18 months or so, with many and varied policy decisions being made to facilitate the flow of capital during the disruptions. These efforts have been supported by extraordinary fiscal policy. Likewise, low interest rates have been supported by continued quantitative easing (QE), yield-curve control (YCC) measures and a loosening of regulatory requirements on the banking system that have allowed banks to remain well funded and “open for business.”
The RBA’s dovish interest-rate forecasts suggest monetary policy settings will remain ultra-accommodative for some time yet. Looking beyond the official cash rate, however, a number of the recent regulatory changes are now being unwound. This represents a structured removal of the emergency settings put in place by the RBA and APRA, and the conclusion of the major banks’ access to the Term Funding Facility (TFF) in June is one of these changes. Through the TFF, the banks have been able to access extremely cheap funding, at 0.25% initially and then at 0.10% for three-year terms. Drawdowns from this facility were permitted until June 2021. As debt is due to be repaid between now and mid-2024, banks will begin to turn to the primary market to refinance the $188 billion in funding, which will be at spreads above the cash rate that reflect credit risk—that is, at a higher cost of funding.
Following the announced shutdown of the Committed Liquidity Facility (CLF) in September 2021, the use of Alternative Liquid Assets (ALAs) such as higher-yielding bank loans (internal loans including home loans)—senior unsecured bonds and residential mortgage backed securities (RMBS) paper as substitutes for High Quality Liquid Assets (HQLAs) to satisfy their liquidity coverage ratios (LCRs)—are no longer permitted. Instead, these banks must purchase sufficient HQLAs in the form of government and semi-government securities to satisfy LCRs in full.
Intra-bank holdings of the aforementioned ALAs have been high. As a result of this regulatory change, demand for these assets from the banks will fall, which may increase spreads slightly. While our expectations are that any impact in spreads will be marginal, as noted in our recent blog post, we are mindful of the consequences related to the regulatory changes for Australian banks.
The RBA’s reduction of QE through the tapering of its own government bond buying program is another point of consideration. In July, the RBA noted it would continue to purchase $4 billion of government bonds per week, down from a prior target of $5 billion per week.
Through its YCC program, the RBA has continued to target the April 2024 bond, and short-term rates remain pinned at artificially low levels; although some normalisation is occurring as we move closer toward that date. The RBA’s next review of this program was previously slated for November but was subsequently pushed out to February 2022. As the Australian economy continues on its path to recovery, we can expect the RBA to reduce the scope of this program further.
Monetary policy shifts will of course remain well considered, measured and gradual. Winding back from unconventional policies is not expected to destabilise what is likely to be a moderate yet sustainable recovery. Ultimately, these initial steps to normalisation change the shape of the yield curve, to one based more on fundamental drivers. As an active manager, employing a long-term fundamental value investing philosophy, this provides us with greater opportunities to add value.
Australia Core Portfolio Positioning
An underweight to duration within Australian portfolios persists, albeit narrowed recently as yields have risen. We continue to favour spread sectors; while cognisant of the impact, we don’t expect to see dramatic swings in bank and semi-government spreads as a result of APRA’s announcements to phase out the CLF. The TFF is more likely to influence major domestic bank paper spreads over time as bank reissuance gets underway.
We continue to seek and find value in other areas of the corporate and asset-backed sectors and maintain an active approach to take advantage of steeper credit curves. All portfolios draw upon a diversified range of return sources and we are always mindful of seeking to generate attractive risk-adjusted returns for our clients.