The RBA weapon that will help push rates up further

While there is a lot of focus on what the Reserve Bank, the US Federal Reserve and other central banks are doing with interest rates, in the background is another process that will also tighten financial conditions and help push rates even higher.

How much it will withdraw liquidity from financial markets and how much it will add to the increase in interest rates is uncertain because, with one relatively brief exception, we’ve had very little experience of quantitative tightening and its effects.

RBA Governor Philip Lowe. Australia and other economies have had very little experience of quantitative tightening and its effectsCredit:AAP

In response to the pandemic, since mid-2020 central banks – the Fed, the European Central Bank, the Bank of Japan, the Bank of England, our Reserve Bank and others – have pumped about $US12 trillion ($17.1 trillion) into the global financial system through the unconventional monetary policies pioneered by Japan in the early 2000s and then made mainstream by the Fed and ECB in response to the global financial crisis.

That first bout of financial crisis-related “quantitative easing” – the purchases of government bonds and other fixed interest securities – expanded the Fed’s balance sheet from about $US900 billion to $US4 trillion. The second pandemic-related program that ended in March grew that balance sheet to $US8.9 trillion.

The ECB’s balance sheet swelled from about $US1.5 trillion pre-GFC to more than $US5 trillion pre-pandemic to more than $US9.5 trillion.

The RBA, late to deploy unconventional policies, spent about $280 billion buying Australian government and semi-government bonds between November 2020 and February this year, when it halted the program. It also provided $188 billion of term funding to banks and other financial institutions at minimal interest rates.

Those programs have now all peaked and the central banks are just starting to back out of them by allowing, in the Fed and RBA cases, their portfolios to gradually run down and their balance sheets to start shrinking as the securities within them mature and the proceeds aren’t reinvested.

The ECB has stopped adding to its portfolio but it appears it will use the proceeds from its maturing securities to put a ceiling on interest rates in the particularly vulnerable economies in southern Europe to defuse the threat of fragmentation of the eurozone.

In effect, the Fed and RBA and other Anglosphere central banks are withdrawing liquidity from their systems as well as hiking their interest rates. The Fed has raised its version of the RBA’s cash rate four times in five months – by a total of 2 percentage points – and the ECB its by 50 basis points.

The RBA has increased the cash rate by 125 basis points so far this year and is expected to add another 50 basis points today to lift it to a six-year high of 1.85 per cent.

Since mid-2020 central banks including Jerome Powell’s US Fed have pumped about $US12 trillion into the global financial system through the unconventional monetary policies pioneered by Japan in the early 2000s.Credit:Bloomberg

The effects of the QE programs are pretty well understood. Combined with zero or near-zero policy rates, which affect short-term interest rates, they injected massive amounts of liquidity into the central bank’s financial systems and forced rates on longer-term securities lower.

The paucity of returns from traditionally safe assets, like 10-year government bonds, in turn forced investors to accept more risk – ever-increasing risk as it transpired – to chase positive returns. That was good for shares and other risk assets like property.

It was particularly good for the riskiest of assets, like crypto assets or technology stocks with good prospects but modest, if any, earnings.

For tech companies, that’s because the discount rate used to calculate net present values for companies’ future cash flows is generally the 10-year bond rate. In the US the yield on 10-year bonds traded down to about 50 basis points in mid-2020. It’s now about 2.65 per cent, having been as high as 3.25 per cent last month.

Rising policy rates and QT could be expected to broadly reverse those effects and, to some degree, have already started to.

The start of the new rate cycle in the US has seen a savage sell off of shares and bonds (there is an inverse correlation between bond yields and bond prices) and a strengthening of the US dollar as investors flow back into the market for US Treasury securities, although cash seems to be the favoured repository in what’s been a volatile year so far.

Try to work out how much of an impact QT might have beyond the rate rises, however, is problematic because there is so little experience of QT.

Between October 2017 and September 2019 the Fed did try to unwind some of its purchases in a program that peaked with net shrinkage in its balance sheet of $US50 billion a month.

There remains a lot of uncertainty over what QT processes will do to markets and economies.Credit:AP

When the run-off of securities accelerated to that level, however, markets revolted – the sharemarket slumped and bond yield spiked and the Fed was forced to back away and halt the program.

For investors, with their safety net of the “Fed put” option back in place it was back to an environment with little need to assess or price in risk.

The Fed is now running down its balance sheet by $US47.5 billion a month. From September that rate will climb to $US95 billion a month.

In Australia the RBA is allowing its hoard of government and semi government bonds to run off as they mature. Because it bought mainly relatively short-dated bonds – other central banks were buying some bonds with 20 to 30 year maturities — the process of restoring its balance sheet to a level that it feels is more aligned to financial conditions will be quicker than the Fed’s or Bank of England’s.

Try to work out how much of an impact QT might have beyond the rate rises, however, is problematic because there is so little experience of QT.

About $2 billion of bonds mature this month and the proceeds won’t be reinvested. There’s another $2 billion in November and more than $13 billion next April, after which the maturities will average closer to $40 billion a year through to the end of the decade. The $188 billion term funding facility that provided windfall profits for the banks will end in June next year.

While there is uncertainty over how much impact QT might have on markets and economies, researchers at the Atlanta Fed have tried to relate it to the impacts of rate rises.

They estimated that a $US2.2 trillion passive roll-off of Treasury securities held by the Fed over three years is equivalent to an increase of 29 basis points in the federal funds rate in “normal” times. During “turbulent” periods it could be as much as 74 basis points.

That $US2.2 trillion figure that the Atlanta Fed cited will, if the Fed sticks to its current plan for the running off of its portfolio, be reached by the end of next year – about half the time period the Atlanta research used. That could magnify its effects on rates and volatility.

Hopefully the central banks won’t blink, as the Fed did in 2018. Since the global financial crisis monetary policies have become increasingly unconventional and their effects have deliberately distorted risk pricing and the signals risk premia send to investors and managers. They have corrupted and distorted the way markets have functioned.

QT might not be, as former Fed chair (and now US Treasury Secretary) once said, “something that will just run quietly in the background over a number of years” – it could add to the weight of increasing policy rates on economies and generate volatility and liquidity mismatches – but the era of ultra-cheap and ultra-available credit and the distortions to financial settings that QE has created needs to end.

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