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BFCSA: The coming of Aussie quantitative easing: waiting on rates

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The coming of Aussie quantitative easing

Australian Financial ReviewMay 10, 2019 10.13am

Christopher Joye

The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.


The Reserve Bank of Australia’s governor Phil Lowe passed our controversial intelligence test with flying colours by surprising many of the best forecasters in the business with his sensible decision to wait on rates.

And contrary to claims at the time, this has no ramifications for the RBA’s inflation targeting regime—whether it goes in June, July or August does not make a jot of difference to the ensuing economic outcomes.

While I personally felt Lowe would be mad to go in May, immediately prior to the meeting I was torn on what he would do in practice. Based on both the RBA’s past behaviours (where it has not hesitated to pull the trigger close to an election) and the inflation targeting “reaction function” the RBA has historically adhered to, one would have expected it to go.

What we learnt about Lowe is that he may be different to his predecessors in terms of his pragmatism, judgement and humility. This might indeed be a more sensible RBA decision-making regime to the one that blew the biggest housing bubble in history between 2012 and 2017 in blind pursuit of artificially precise inflationary outcomes.

An alternative possibility is that the RBA executive team ran with its inflation-targeting instincts and recommended a cut, but were persuaded by the board’s independent directors to minimise the tail risks of becoming one of the central narratives in the election campaign. Rightly or wrongly, this could have tarnished the RBA with a partisan brush.

My old sparring partner, Terry McCrann, certainly protested this column's cheeky description of the RBA’s board as a “rubber stamp”, which 95 per cent of the time is exactly what it is. We will have to leave it to future historians to divine what transpired last Tuesday in the debugged Level 12 boardroom at 65 Martin Place.

Impact on investments

Barring a demonstrable move lower in the jobless rate, the central case has to be that the RBA eases its cash rate over the next six months to a new record low of 1.0 per cent, which has profound consequences for portfolios.

As I’ve argued before, this is incredibly positive for housing: lenders should pass on 40 to 50 basis points worth of home loan rate reductions given the striking recent compression in bank funding costs (save for a subordinated bond issued by NAB this week that was heinously expensive for the bank and which I was happy to acquire).

Coupled with a potential 50 basis point cut in the banks’ minimum interest rate serviceability test, which APRA requires to be set at no less than 7.0 per cent, this would promptly end the housing correction.

If the Liberal Party pulls off a miracle and wins the election, house prices will move higher as investors price out the prospect of negative gearing being eliminated and capital gains tax jumping by 50 per cent. If Labor prevails, which betting markets assert is all but certain (I am not as convinced), then house prices should, at the very least, stop falling.

Do I reckon the RBA should cut? No, it should let the housing market clear and allow fiscal policy to inject any stimulus the economy needs. On this note, the chair of the National Press Club of Australia incorrectly alleged that the federal budget was still in deficit when questioning Scott Morrison during his otherwise excellent final debate with Bill Shorten, which is must-see TV. The fact is that Josh Frydenberg’s budget is now in surplus on all key measures over the 12 months to March.

The RBA remains an inflation-targeter and is understandably motivated to defend its credibility. So while the standard errors around its core inflation forecasts are huge, it thinks the current 1.4 per cent annualised rate is unacceptably short of the mid-point of its mandated 2 to 3 per cent target range.

QE in Australia

Another reason Lowe will cut if the jobless rate does not materially drop (which it could do) is that he is probably not that exercised about exhausting his policy ammunition given the possibility of initiating an Australian version of quantitative easing (QE).

Because most of our borrowers pay “variable” as opposed to “fixed” rates of interest, the cost of borrowing in Australia prices off short-term (variable) rather than long-term (fixed) interest rate benchmarks. In the US during the crisis, the Federal Reserve bought long-dated government bonds to reduce the risk-free rate that America’s 30-year fixed-rate home loans price off. Doing so in Australia would lower bank funding costs (by slashing their benchmark rates), and translate into cheaper money for fixed-rate borrowers.

But more than 80 per cent of our home loans are variable rather than fixed, and broadly price off the overnight cash rate. This means that once the cash rate gets near zero, the RBA will want to extend the idea I successfully pitched to the Rudd Government with Professor Joshua Gans in 2008, which involved the government buying $15 billion of residential mortgage-backed securities (RMBS).

The RBA already accepts AAA rated RMBS as collateral when lending to counterparties through its repurchase, or repo, arrangements, which was a change introduced during the crisis that substantially improved the liquidity of, and thus the demand for, these securities.

Taking it one step further by engaging in an outright RMBS buying program, as other central banks did during the crisis, would be particularly potent for Aussie home loan rates by reducing the cost of capital for both banks and non-banks that source money via selling RMBS bonds backed by home loans.

If the RBA wanted to concurrently ease the cost of small business borrowing, it could extend this to buying portfolios of small and medium enterprise (SME) loans alongside Scott Morrison’s new Australian Business Securitisation fund.

This was the proposal I put to the prime minister – that the government invest billions into asset-backed securities (ABS) full of SME loans to help attract global institutional capital to the sector, which would enhance the liquidity and reduce the cost of funding small businesses in Australia just as we have seen the booming RMBS market do for housing.

A 1.0 per cent RBA cash rate will translate into substantially higher demand for any relatively low risk assets paying decent spreads above it, including bank and insurer bonds, hybrids (Labor's franking policy appears dead), and ABS and RMBS.

So while we sold our RMBS holdings in February 2018, and it has been the worst-performing fixed-income asset class in 2019, I am preparing to revisit this opportunity in around one or two years.

Before doing so, I would want to see what the Federal Court has to say about ASIC’s case against Westpac on responsible lending, which should favour the latter, and observe house prices recovering.

And I will avoid like the plague any home loans written between 2016 and 2019 that have suffered from falling house prices, deteriorating collateral, higher arrears and potential breaches of responsible lending laws.

Given the choice, I will also always prefer bank-issued RMBS over non-bank bonds since the latter are not ordinarily regulated by APRA, which is the global gold standard when it comes to minimising credit risks.

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