Prospects for the unwinding of QE in the US and Australia in 2022 are finally lifting bond rates. The FOMC looks likely to have unwound its current QE program by mid 2022 along with the RBA. These forces along with prospects of rising overnight rates will see even higher bond rates.
The Reserve Bank Board meets later today at 2:30 pm.
The Board is certain not to announce any policy change.
It has committed to reviewing its quantitative easing program at the February 1 Board meeting in 2022.
Until then it will maintain its policy of weekly purchases of $4 billion of AGS ($3.2 billion) and state and local bonds ($0.8 billion).
Last month we thought that the Board would respond to the likelihood that the Australian economy was going to contract quite sharply in the September quarter and lift its purchases of bonds to $6 billion – certainly, at the very least, defer the taper of the weekly purchases from $5 billion to $4 billion which had been announced in July and confirmed in August. We expected that there would be a review of the program in November with a significant likely reduction once the reopening of the NSW and Victoria was underway.
The decision to maintain the taper was confirmed in September but there was a compromise. There was a deferral of any review until February.
We expect that the economy will expand by 5% in the first half of 2022 allowing the Bank to further scale back its weekly purchases to $2–3 billion.
If the decision is based on progress towards the Bank’s goals it is reasonable that a scaling back from $4 billion to $2 billion would be appropriate. But the lead from other central banks, particularly the Bank of Canada, which has steadily reduced its purchases by a standard $1 billion per month would point to a more cautious taper to $3 billion.
With little “history” around the RBA’s preferred approach to QE being available we cannot be sure whether the QE decisions will be based around an assessment of that progress or the more measured gradual approach that we have seen overseas.
On balance the “progress approach” seems more likely.
If that is the case another review in May would see the program phased out by August or, even, possibly immediately.
On the other hand sticking with the “gradual approach” of tapering by $1 billion per quarter would see the program extending to November.
Alternatively the RBA could choose a middle ground by staying with the “gradual approach” but shorten the periods between reviews.
If the pace of tapering is determined by progress in achieving the Bank’s objectives, then a May/ August cessation seems reasonable, with August seeming most likely.
The August timing coupled with a scaling back to $2 billion in purchases from February to be followed by $1 billion from May would see total purchases over the September( 2021)/ August( 2022) period of $123 billion.
That would leave a gap of around six months between the end of the QE program and the first rate hike.
Westpac’s inflation and unemployment forecasts are consistent with the Bank achieving its full employment (4% unemployment rate) and inflation forecast (2.5% underlying) by the end of 2022, setting the scene for the first rate hike of 15 basis points in the March quarter 2023.
We actually forecast an unemployment rate of 3.8% by end 2022.
We expect the FOMC to begin its hiking cycle at the December meeting next year, providing the RBA with a helpful lead while Bank of Canada and Bank of England are expecting to begin raising the policy rate sometime in the second half of 2022.
Bond rates have also finally started to rise. The US 10 year yield has lifted from around 1.30% shortly before the recent FOMC meeting to 1.46% today and while break even inflation rates have increased in Europe because of the surge in energy prices the increase in nominal yields in the US has been due to a rise in real yields.
US break even yields have held around 2.35% while the nominal yield has lifted by nearly 20 basis points. Even so, real yields remain at extreme negative levels of around minus 90 basis points.
That lift in real yields is due to some firming in the outlook for FOMC interest rate policy but more so in response to the encouragement FOMC spokesmen including Chair Powell have given to the prospects for the beginning of the taper of the FOMC’s $120 billion per month current bond purchase program.
Markets were also unsure as to the length of time the FOMC was likely to take to fully scale back purchases. The most likely estimated timing was that it would take around 6 months. Clear guidance from the Chairman and others is that a reasonable target to complete the tapering program was to the middle of 2022.
Real yields have been responsive to Quantitative Easing in the past- most notably during the “Taper Tantrum “(May/June 2013) when, expecting a wind back in QE, markets pushed real yields up by a stunning 100 bp’s over the course of a few months; or in 2018 when the FOMC began to a scale back its balance sheet and real yields lifted by around 70 basis points; finally we can point to the sharp increase in the balance sheet, including the current QE program, through 2020 where real yields tumbled over the year from 0.2% to -1.0%
So the global process of the normalisation of bond yields which usually precedes the beginning of a tightening cycle has begun.
Throughout 2021 we have held our call for US and AUD bond yields to reach at least 2% by end 2022( and 1.55%–1.60% by end 2021) despite real yields collapsing to an extraordinary minus 1.2% earlier in the year.
This bond cycle is posing some real headwinds for the RBA’s guidance that the overnight cash rate will not move until 2024.
In fact, that guidance looks more consistent with an even later timing – namely, the second half of 2024. Current RBA forecasts have the underlying inflation rate hitting 2.25% by end 2023 and moving in 0.25% increments every 6 months, implying that the “lift off” inflation rate will not be apparent until late July with a possible risk that a second print might be required pointing to the first rate hike in November 2024 – about the time we expect the FOMC and the RBA will have reached their peaks.
Finally, we know that the RBA respects the policy approach of the Bank of Canada.
The BOC has indicated that it will soon enter the reinvestment phase of QE. Even though it will not be adding to the size of its balance sheet it will purchase sufficient bonds to offset maturities in bonds it is already holding. That would see the size of the BOC balance sheet stabilise.
The BOC is noncommittal at this stage whether the reinvestment stage would continue through the rate hike period. Shrinking the balance sheet and raising rates are both forms of policy tightening.
The FOMC’s experience was that the impact of rate hikes was well understood whereas shrinking the balance sheet was unknown territory.
If we are right, the first rate hike in Australia will come just before the need for reinvestment given that the first stage of the RBA’s QE was to purchase 3 year bonds in the early stages of the Yield Curve Control policy in 2020.
However, if RBA’s forecasts are correct and the first hike is not till as late as November 2024, we will see a reinvestment phase in the current QE process in 2023 and 2024.
Under such a scenario, we would expect the RBA to fully invest maturing bonds – thereby keeping the size of the balance sheet stable.
Conclusion
The September FOMC meeting seems to have been quite a game changer; along with the lift in headline inflation the prospect of an imminent beginning to the taper has lifted bond rates to more realistic levels (with a lot more to come) and highlighted that central bank rate hikes are not as far away as earlier expected – Australia included.
Australia’s Quantitative Easing program seems likely to be phased out in 2022. If the RBA adopts a proactive approach to the program, it is likely to be phased out by May/August. If, as was demonstrated at the September Board meeting, it adopts a gradual approach to the taper the program could extend until November.
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