RBA: The Dynamics of QE and Yield Curve Control

The Reserve Bank Board meets next week on April 6.

We expect that the Board will decide to maintain its current policy settings.

These settings are the targets of 10 basis points for the cash rate and the yield on the 3 year Australian Government bond as well as the parameters of the Term Funding Facility and the government bond purchase program, QE.

On November 3 the Governor announced the initial bond purchase program of $100bn that will take place over a period of approximately six months, with weekly purchases of around $5bn.

On February 2 the Governor announced an extension of the original program of a further $100bn “at the current rate of $5 billion a week.”

The parameters of the extended program were not spelt out at the time of the statement but subsequent communications have confirmed an extension of the parameters of the first program:

• 80% bonds issued by the Australian Government and 20% bonds issued by the states and territories.
• Maturities of around 5 to 10 years. (But may also include bonds outside this range).

Last week Westpac revised its forecasts for future bond purchase programs.

We raised our forecast for the bond purchase program which we expect will follow the second tranche that was announced on February 2 from $50bn to $100bn. We confirmed that the fourth and final tranche would be $50bn.

We also pointed out that it was possible that the Bank could opt for an open ended policy at the conclusion of the next $100bn program.

In line with the current parameters that might be a commitment to buy $5bn per week on an ongoing basis.

This style of policy is used by the Federal Reserve ($120bn per month, including $80bn in US Treasuries) and the Bank of Canada ($4bn per week). On the other hand the ECB has a specific purchase target of euro 1,850bn by March 2022 which complements an open ended euro 20bn per month program.

Readers might notice that based on the first announcement on November 3 there was an inconsistency between a $5bn weekly purchase target for a total of $100bn “over a period of approximately six months.” The weekly target is consistent with a 20 week program compared to 26 weeks in a six month period.

At the time of the first announcement, it was reasonable to assume that there would not be a rigid fixing of the $5bn weekly volume, allowing the program to run for longer than 20 weeks to be more in line with the “approximately six months” guideline.

In fact, if we closely scrutinise the current program, we note that $2bn were bought in the week ending November 6; $3bn in the week ending December 25; zero in the weeks ending January 1 and January 8; $7bn in the week ending March 5.

In all the other weeks since the announcement on November 3 the Bank has purchased $5bn in the agreed 80%/20% break down.

By the end of this week, April 2, the Bank will have purchased $97bn under the program and will have completed the first $100bn tranche by April 9.

At this current $5bn pace, which was confirmed on February 2, the second $100bn tranche will be completed in the week ending August 27. If the RBA was to maintain this $5bn pace over our forecast new $100bn third tranche, this would be completed in the week ending January 28 (assuming a two week break in early January).

In last week’s note we favoured the six month approach, timing the QE extension later in the year for “mid October”.

But with the RBA likely to stick rigidly to the $5bn weekly program “mid October” should now read “first week in September”.

The earlier beginning of the third tranche only strengthens the case against tapering that program but slightly weakens our argument that the Board would wait until the August Board meeting to announce the extension.

The timing of the recent extension decision (February Board meeting for an early April extension) suggests the announcement could come earlier than the August meeting, perhaps July, although the advantages of August are that a new set of forecasts is delivered (August SOMP).

We saw for the February announcement (February SOMP) that the Board chose to make the announcement two meetings earlier than necessary in order to give the market ample notice and use the SOMP and its forecasts to support the decision.

We currently favour the tapering to $50bn in the 2022 extension (fourth tranche) although the timing of the extension (February rather than April) will make that tapering decision more difficult than if there was another two months to assess the state of the economy and the actions of other central banks.

With the $100bn third tranche potentially completed by the week ending January 28 (if the RBA held the purchase pace at $5bn per week) the announcement of the extension decision would need to be made at the December Board meeting given there is no meeting in January.

It seems unlikely that such an important decision to taper purchases would be announced in December.

To address timing difficulties the Bank could “stretch out” the third tranche, which we expect to start in early September, to fall more into line with the original “approximately six month” guidance.

Lowering the weekly purchase pace from $5 billion to $4 billion (to align with a six month term) but maintaining the $100 billion target would not be seen as a specific tapering by markets.

That would allow the program to extend into early March 2022 providing the bank with more time to assess the situation and prepare the market for the tapering to the $50 billion program which we expect to follow.

Alternatively, the bank could move to the FED/BOC/ECB approach of an open ended policy for the extension we expect for early September. However, our central forecast is for an extension of the closed ended model.

As we saw this year the February Board meeting is a traditional time for the Governor to look ahead and lay the groundwork for some policy initiatives.

It would be the ideal time to announce the tapering of QE and the scaling back of yield curve control with the purchases of the target bond not being extended beyond the November 2024 bond.

Our expectation is that from the August meeting the Board will announce that it is directing its purchase program to the November 2024 bond from the April 2024 bond.

Since the bond market sell off and the stream of better than expected data reports the market and most commentators have expected that the Bank would not switch its buying to the November bond – essentially restricting the three year YCC policy to the April 2024 bond and therefore implying that the Bank expected to have achieved its objectives by the first half of 2024.

Figure 1 tracks recent movements in the yield on the November 2024 bonds; this yield has fluctuated between 0.2% and 0.44% since bond rates started lifting in early February- currently around 0.33%.

The margin over the 0.1% (we expect the RBA would buy those bonds at 0.1% after August) and the current market pricing reflects the steepness in the curve but most importantly market scepticism that the RBA will extend YCC to buying the November bond.

Indeed, if there were no market caution, with funding costs near zero, the bonds should be trading close to the 10 basis points.

Buying a 3.5 year bond at 0.4%; holding it at a funding cost of near zero, and selling to RBA at 0.1% from August is a trade that appears not to have captured the interest of the market.

We have consistently argued that now will be too early for the Bank to scale back its YCC policy.

For us, the key will be the August Board meeting and the Statement on Monetary Policy on August 6 where the Bank will reveal its forecasts up to the end of 2023 (extended from mid- 2023 for the May SOMP forecasts).

Those forecasts will be very close to the date (first half of 2024) when the Bank would expect to achieve the conditions to justify a rate hike.

Bear in mind that the conditions for raising the cash rate will be: full employment; inflation sustainably between 2 and 3%; and wages growth running at 3% plus.

Current forecasts from the Bank’s February Statement on Monetary Policy go out as far as June 2023.

By then (Feb SOMP) the unemployment rate is forecast to be 5.25%; wages growth 2%; and inflation 1.75%.

The issue is what forecasts for the end of 2023 would be consistent with the Bank achieving its objectives by the first half of 2024.

The sharp fall in the unemployment rate in the February Employment Report from 6.4% to 5.8% has been a constructive start along that road to full employment.

But the winding back of JobKeeper will impact the unemployment rate. Westpac estimates a loss of 100,000 jobs on the basis that there are around 1 million recipients of JobKeeper. Our estimates are based on a subjective assessment of the expected proportional loss in various industries (we constructed a series for numbers on JobKeeper in each industry).

Another approach where the focus is on the wedge between hours worked and employment in each industry derives larger expected losses.

Our cautious approach forecasts that the unemployment rate, after absorbing the 100,000 job losses in the June quarter, will lift to 6% by mid year falling back to 5.7% by end year.

RBA’s end 2021 forecast is likely to be comparable (revised from 6.0% currently) pushing down their mid 2023 forecast to 5% (from 5.25%).

While an unemployment rate at 5.0% by mid-2023 would represent an improvement on current levels, that is still too high.

The Governor has indicated that full employment is in the 4-4.5% range while the Deputy Governor mused about “high 3′- low 4’s” at a recent Senate hearing.

To lift inflation into the sustainable 2-3% range and boost wages growth to “3% plus” the unemployment rate will need to hold at full employment or lower for a sustained period.

Just “touching” the upper range of full employment (assuming a reduction in the end 2023 unemployment forecast to 4.5% – a large 0.5% drop in 6 months, particularly when the supply of labour will be boosted by a return to normal immigration levels; the housing market will be slowing; and post election fiscal policy is likely to be tightening) does not seem to be sufficient to lift wages growth to above 3% and inflation to 2.5%.

With the Bank’s credibility paramount given previous failures to reach forecast targets it seems appropriate that the best approach will be to stick with YCC for the remainder of 2021 and extend the current bond purchasing program by a further $100bn, albeit at a slightly slower pace.