Portfolio Manager Dan Siluk explains that, despite economic conditions appearing to stabilise throughout much of Australia, the Reserve Bank of Australia felt compelled to recommence bond purchases to establish its credibility with respect to its yield curve control programme.
- With yields on the 3-year government note having crept above its targeted rate of 0.25% as mandated by the yield curve control programme, the RBA has re-entered markets to push yields down and let investors know that 0.25% means 0.25%.
- Although economic conditions in much of the country have stabilised, the RBA believes that highly accommodative policy is still necessary given the continued risk presented by the uncontrolled COVID-19 pandemic and the combination of high domestic unemployment and low inflation.
- With ‘lower for longer’ still governing bond yields, we can understand why some investors may be enticed to hold longer-duration assets, but we believe the incremental risk is not worth the slightly higher yields.
This week, the Reserve Bank of Australia (RBA), as expected, kept its cash target rate at 0.25%. But the announcement was not completely devoid of surprises. We took special note that the RBA again resumed asset purchases on Wednesday 5 August (after a 3-month gap), in keeping with its commitment to maintain the yield on 3-year government notes at a level of 0.25%. In taking this step, we believe the RBA is sending a ‘gentle’ reminder to the market that it means business with respect to keeping monetary policy highly accommodative.
A matter of credibility
When the RBA announced its yield curve control program at the outset of the COVID-19 pandemic, its goal was to convince markets that it would do whatever is necessary to maintain a targeted rate – in this case, the yield on the 3-year note – at a chosen level. Over the past month, it appears the market has been testing the RBA’s resolve. Throughout July the yield on the 3-year note has crept up ever so slightly, reaching above 0.27% mid-month. While we believe that the RBA allows a certain degree of latitude in yields, the steadiness of the upward trend since early May likely caught their attention, forcing them to remove any doubt that 0.25% means 0.25%.
Why act now?
The comments accompanying the RBA’s decision, in our view, were telling as to why the central bank has chosen to re-enter the markets at this time. After all, its outlook for the economy has not grown more negative, and that alone can seem like a small victory. In fact, for much of Australia – excluding recently locked-down Victoria – economic conditions appear to be improving. Rather, the RBA cited continued global economic uncertainty as a risk that merits continued monitoring. And we can see why the RBA wants to tread cautiously, given the still tenuous position of the country’s economy. It now expects GDP to have contracted 6% over the course of 2020 and for the unemployment rate to reach around 10% by the end of the year. We concur that with such fragility domestically, it is far better to err on the side of accommodation given the risk of yet another exogenous shock in these uncertain times. On that note, we welcome the continuation of income support, which we believe will help dampen the hit to household consumption.
Not mentioned were the double-digit gains the Australian dollar has registered against the currencies of many developed market peers since the crisis’s nadir. While we can understand the RBA’s silence on the trajectory of the dollar, we cannot help but believe that its meteoric appreciation is an unwelcome development for the country, and thus factored into its decision to dial up accommodation.
The RBA further indicated its commitment to this dovish stance by reiterating that it will maintain this policy posture as it seeks to achieve its goals of price stability and full employment. Given the dour jobless data and the central bank’s expectation of inflation to stay within the 1.0% to 1.5% range over the next two years, we see little impetus for the RBA to shift course.
Granted, it may seem like we are splitting hairs when we speak of yields on the 3-year note being pushed down a couple of basis points, but the RBA’s renewed purchases reinforce the notion that low yields are likely here to stay. With the RBA keeping its thumb on the bond yield scale, we believe that investors could be enticed into adding duration to their bond portfolios. While we understand the rationale, with a still-uncontrolled pandemic wreaking havoc on the global economy, we believe the marginal relative bump in yields an investor would receive in holding longer-dated bonds may simply not be worth the incremental risk. Consequently, we continue to view the front end of the yield curve as the most attractive destination for investors as they can still earn carry not much lower than that of longer-dated tenors while also potentially benefiting from rolldown as the securities approach maturity.