“It’s not the years in your life that count. It’s the life in your years” – Abraham Lincoln
At this month’s meeting the RBA Board confirmed that the April 2024 bond would remain the target for Yield Curve Control instead of extending it to the November 2024 bond. The Board also met expectations for QE, announcing that a weekly purchase target will replace the 5-month $100bn program which is set to end in September. What surprised however was that the RBA decided to taper purchases as the change in program takes effect, with purchases to occur at a $4bn per week pace instead of $5bn, the effective weekly pace of the current program. The scale of purchases will be next assessed in November 2021. We believe that purchases will continue beyond this date to mid-2022, albeit with repeated reductions in scale. Markets have now discounted a possible increase in rates during Q1 2023. The data supporting this thesis was the May employment report which saw the unemployment rate fall from 5.5% to 5.1%. That said any change in monetary policy will hinge on inflation and wages growth reaching the RBA’s targets.
Looking to the US, minutes from the FOMC’s most recent meeting state that there is clear evidence the US labour market in performing better than expected. That perceived strength has also clearly fostered a belief that underlying inflation will strengthen sustainably to target, justifying an increase in rates, albeit not until 2023. Westpac expects FOMC rate hikes to come earlier, beginning in December 2022. However, unlike prior cycles, we believe this cycle will end with the fed funds rate more-or-less at its neutral level, which we hold to be 1.625%. That said, Westpac believe both the US and Australian 10-year yields should peak around 2.3% approx. halfway through the FOMC/RBA tightening cycles.
It seems China, however, is marching to the beat of a different drum. Just when other Central Banks around the world are staring down the barrel of possibly higher rates, China’s central bank has significantly reduced the capital ratio requirements for its national banks essentially releasing approx. 1 trillion yuan (US$ 155 billion) into the Chinese economy. This flies in the face of increasingly higher commodity prices and raises concerns of possible inflationary pressures. This is all with the hope that China’s post-COVID recovery is as strong and as even as possible.
It’s also interesting to address what’s happening across the ditch in New Zealand. There has been a clear shift in the conversation around what’s going on in the New Zealand economy. Cost pressures and supply constraints have been apparent for some time, but there’s now growing evidence that this is running up against better-than-expected demand which in turn raises concern over creeping inflation rates. We now think that this combination will prompt the RBNZ into action before the end of the year. Westpac’s NZ team have revised expectations for the RBNZ to include rate hikes from November this 2021. The cost and labour pressures faced by NZ because of global supply disruptions and closed borders are well known; but there is now growing evidence of strong demand coming through, increasing the risk of more enduring price pressures.
It has been a key theme across financial markets for a long time so we thought it may be worth revisiting what Quantitative Easing (QE) entails. Quantitative Easing is where a nation’s Central Bank purchases financial instruments from the private sector. These are predominantly government bonds and mortgage-backed securities, although some Central Banks also include stocks as part of their purchases. With that said, most Quantitative Easing programs focus on purchasing long-term government debt. Central Banks will look to create money electronically and then use this money to purchase government debt from private institutions. This debt is then stored with the central banks who can then sell it back to the market later.
Reduced interest rates occur as a result. This is because central banks purchase government debt which increases its price and reduces the yield. For instance, the government may borrow $1 million at 5 percent interest, earning $50,000 in interest per year. Business and people borrow more as interest rates fall. This is because the central bank depresses the interest rate of government bonds, which has a knock-on effect to other forms of debt.
In turn, mortgages are cheaper, loans are cheaper, and businesses that are doing well can access cheaper credit to expand their operations. Therefore, they are actively incentivised to borrow and move purchasing decisions forward. Businesses and consumers spend more, thereby creating jobs. As interest rates fall and borrowing is incentivised, consumers and businesses start spending and investing more. For instance, businesses may hire additional workers to increase production, whilst consumers may start buying more products.
The chart below gives a good summary and overview of how the strategy [QE] works.