Wednesday, 28 October, 2020
What to expect from RBA on Melbourne Cup day (from CCI’s Chief Macro Strategist)…
Cutting Edge Investment Research
Coolabah is pleased to publish three new research reports that you can read at your leisure. Specifically:
1. What to expect from RBA on Melbourne Cup Day, which was authored by Coolabah’s Chief Macro Strategist, Kieran Davies
2. How tight can semi-government bond spreads go post QE, which has been authored by Dr James Yang, Senior Data Scientist, Christopher Joye, CIO, and Matt Coleman, a Senior Consultant, and
3. Upside surprises unlikely: tracking state budgets and term debt issuance, which is another report authored by Coolabah’s Chief Macro Strategist, Kieran Davies
What to expect from RBA on Melbourne Cup Day…
Kieran Davies, Chief Macro Strategist, Coolabah Capital Investments
For a number of months now Coolabah Capital Investments (CCI) has forecast that the RBA would embark on another round of policy easing, which is a view that markets have gradually come to embrace. This new report summarises our current expectations regarding the precise policy mix the RBA will consider adopting in November (click to read). Our central case is that this includes:
· Cutting the cash rate/3-year bond yield target/Term Funding Facility rate from 0.25% to 0.10% (market consensus forecast: 0.1% for all rates).
· Cutting the deposit rate on exchange settlement balances from 0.10% to 0.01%, although it may opt for 0.05% given earlier concern about a zero deposit rate (market consensus forecast: 0.01%; range: 0.00-0.05%).
· Potentially adopting a 5-year bond yield target of 0.1% (market consensus forecast: no target; range: target to no target). The board has not discussed this option, but staff may be considering an additional target. A target would suggest the RBA expects a longer period of a near-zero cash rate, although the RBA would likely promote it as a tool to lower long-term bond yields.
· Introducing outright QE involving, on CCI’s estimates, approximately $140bn (range of $115-180bn) of purchases of Commonwealth and semi-government nominal bonds, initially over a year and tied to economic objectives (market consensus forecast: $100bn over 1 year; range: $75-180bn/7-18 months). This estimate is based on the required increase in the RBA’s balance sheet to achieve full employment, allowing for the increase in RBA assets due to purchases related to the existing 3-year target and a further drawdown on the Term Funding Facility. It is also similar to international experience.
CCI’s estimate of QE is at the high end of market expectations reflecting the challenge in reducing unemployment towards its full-employment level. The actual amount of purchases will depend on the how the economy evolves, but strategically the RBA may opt for a larger amount to have a greater effect on market expectations and to avoid revising the estimate in the short term (e.g., the RBNZ has revised the ceiling for its current LSAP programme up over time). These purchases might also be spread across a potential 5-year yield target and longer-term 5-year to 10-year purchases of Commonwealth government and semi-government bonds.
Please click here to download our Chief Macro Strategist’s full report on the RBA’s meeting next week.
How tight can semi-spreads go post QE?
Dr James Yang, Senior Data Scientist, Christopher Joye, Chief Investment Officer, Matthew Coleman, Senior Consultant, Coolabah Capital Investments
This brief note seeks to provide some evidence on how tight state government (semi) bond spreads in Australia could go in an environment in which the RBA is seeking to drive the jobless rate back to its full-employment (NAIRU) level. Pre-covid-19 estimates of the NAIRU published by the RBA were around 4% to 4.5% (see Ellis (2019)) while Treasury has recently parameterised the NAIRU at 4.75% to 5.0%.
Coolabah’s Chief Macro Credit Strategist, Keiran Davies, published a research report in October on the likely contours of the RBA’s next monetary policy stimulus program, which you can read here. Kieran also provides a sensitivity table that summarises the amount of QE required by the RBA in order to get the jobless rate down to different NAIRU estimates. He writes:
Given that a key input into this [QE] calculation is the NAIRU, we explored the impact of alternative scenarios on the estimate of QE. Assuming that the NAIRU is unchanged from the RBA’s pre-virus estimate of 4.5% – or, more plausibly, it may have been lower than the RBA’s figure – the RBA would have to do about twice as much QE as we have estimated and/or call on additional government support. Alternatively, if the NAIRU is closer to 5.5%, the analysis suggests that the RBA can broadly rely on existing policy settings, including a full drawdown of the Term Funding Facility, to eventually achieve full employment.
At the RBA’s pre-COVID-19 estimated range for the NAIRU, the implied QE requirement is very large at between $272bn to $404bn. Note, however, that Kieran’s forecast range is lower at $115bn to $180bn given he has adopted a higher 5% point estimate for the NAIRU.
In the analysis that follows we provides an historical comparison between spreads on bonds issued by KFW, a German state-owned development bank, and the yield on German (government) bunds. We also examine the spreads on NSW Treasury Corporation (NSWTC) bonds relative to (1) Australian Commonwealth government bond (ACGB) yields (known as the “G-spread”) and (2) the swap rate on a matched maturity basis for 5 year and 10 year maturities (called the “I-spread”).
What is evident from the data is that the ECB’s QE initiative via the public sector purchase programme (PSPP) in March 2015 initially drove the 5- and 10-year KFW-Bund spread into negative territory.
There is a significant risk that further QE from the RBA, in addition to continued demand from bank balance sheets fuelled by increases in the size of the RBA’s Term Funding Facility, the winding down of APRA’s $223bn Committed Liquidity Facility, and excess ES (cash) balances held at the RBA could accelerate the compression of the 5- to 10-year semi vs ACGB spread towards zero.
In fact, it’s possible semis could trade on negative G-spreads given I-spreads (or spreads above swap) remain at historically very attractive levels for bank balance-sheet buyers and the fact that the supply of semis is going to be relatively constrained compared to the supply of Commonwealth government bonds.
Upside surprises unlikely: tracking state budgets and term debt issuance
Kieran Davies, Chief Macro Strategist, Coolabah Capital Investments
In a major effort, Coolabah Capital has developed a simple framework for tracking potential revisions to the term debt funding task for the largest state borrowing authorities in the current financial year, driven by the likely impact of changing state economies on state budgets. Like any framework, the underlying assumptions involve important trade-offs, some of which we have attempted to gauge by constructing a range around the updated issuance estimates. Complementing the framework, we have constructed a database to track state budgets on a monthly/quarterly basis. The work has focused on New South Wales, Victoria, Queensland and Western Australia, but can be extended to the other states and territories.
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