–  DECEMBER 2021 INSIGHTS BY THE CURVE TEAM –

Summary

RBA Recap

  • The RBA kept their policy settings unchanged.
  • In February they will decide whether to taper or end QE.

Markets Recap

  • There were numerous investing opportunities in TDs and NCDs as ADIs sought funds ahead of Christmas.
  • The yield curve is flattening as rate hikes begin to be priced in at the shorter end and the subsequent drag on economic activity is priced in for longer tenors

Investing Considerations

  • Although ADIs remain very liquid, the past month gave a glimpse of the investing environment when there is a negative funding gap.
  • As ADI liquidity positions normalise to pre covid conditions, investors will have more bargaining power.

Australian Economy

  • The economy is poised to recover strongly in the new year as covid restrictions are eased.

RBA Recap

Policy Decision

The RBA left its policy settings unchanged in December. In February they will decide whether to continue with QE and if so what volumes to continue purchasing. They are currently purchasing $4 billion a week.

Their decision will be based on “the actions of other central banks; how the Australian bond market is functioning; and, most importantly, the actual and expected progress towards the goals of full employment and inflation”. Either a taper of purchases to around $2 billion a week or a complete end to QE is expected.

Whereas the cash rate will remain unchanged until actual inflation is sustainably in the target band, economic forecasts are still relevant in determining whether QE will continue. The Fed’s decision on accelerating their QE tapering will also be relevant to the RBA. If the Fed decide to end QE by early next year, then the RBA will have less need to continue QE.

Markets are still pricing in cash rate hikes far sooner than the RBA expects. By July next year, a cash rate of 0.25% is expected. By mid 2023 a cash rate of at least 1.25% is priced in. On the other hand, the RBA believe the cash rate will remain at 0.10% until at least the end of 2023.

Markets Recap

Term Deposit Rates Increase

Term deposit rates rose during the month. They went as high as 1% for 3 months for an unrated ADI. For BBB rated ADIs, 1% and higher is available from 6-12 months. For 5 years, rates near 2% are available. The number of ADIs open to taking funds also picked up substantially.

Black Friday spending and increasing cash positions ahead of Christmas were the main motivators. With multiple ADIs experiencing the same pressures, ADIs began lifting rates above others. As these pressures subside, rates may fall back down and ADIs may have less need for cash.

Over time though, rates should remain near current levels. Pre pandemic, margins over the cash rate of around 100 points (1 percentage point) for 3-12 month term deposits was the norm. As the TFF maturities come closer, ADIs demand for funds and rates should more closely resemble pre pandemic levels.

NCD Rates Rise

The same forces that led to TD rates rising resulted in more NCDs being issued and upward pressure on margins. Up to 10 domestic ADIs were happy to issue NCDs in the first week of December.

For the past year +10 for 3 months has been the standard rate when issuing NCDs. ADIs were as high as +20 in the first week of December. Pre pandemic, NCDs were regularly issued at +30 or higher for 3 months.

Not Transitory

The Federal Reserve changed its stance on transitory inflation. With core inflation for the year to November at 4.9%, the Fed admitted that inflation can no longer be viewed as transitory.

As a result, the Fed will likely hasten its tapering of QE, which would allow cash rate hikes by mid next year. It follows several central banks having to change their tact, including the RBA who abandoned their yield curve target in November.

Curve Shape

With cash rate hikes as soon as mid next year priced in, rates for 1-5 year tenors have been lifting. This month it started to occur in NCDs and TDs, whereas prior to this month the moves in rates were much more pronounced in fixed bonds.

For terms longer than 5 years rates have been much more stagnant. As a result, the yield curve is quite flat. This reflects the fact that higher rates will be a drag on economic activity, so over the long term will keep inflation and economic activity lower, albeit at a more sustainable rate.

QE tapering across the world could also be a spanner for bond yields. Estimates of the impact of QE on yields vary, but there is little doubt that all else being equal, QE tapering will put upward pressure on yields. In Australia, the end of the CLF will at least partially offset QE tapering as ADIs buy government bonds to adhere to regulation. Overseas though, yields may rise as QE is tapered, which will flow through to Australia’s curve.

Investment Considerations

Funding Gap

Pre covid, a negative funding gap was the norm. This is where ADIs write loans faster than they can take on deposits to match the loans. In this environment, investors had considerable bargaining power. Because multiple ADIs would need to raise funds, rates would increase as ADIs competed to bring in deposits.

Since covid, a positive funding gap has been the norm. The TFF allowed ADIs to borrow for a three-year term at 0.25% when it was first introduced which subsequently went to 0.10%. This allowed ADIs to raise funds very cheaply and without raising deposits through TDs and NCDs. Additionally, as people were unable to spend during lockdowns and the government provided very generous support payments for affected workers, savings increased considerably. This further increased ADI liquidity and lessened the need to raise funds elsewhere.

Recent weeks have provided a glimpse back to a negative funding gap environment. As the first TFF maturities arrive in 2023, funding markets should begin to resemble a pre pandemic environment. The keys to consider with a negative funding gap are:

  • Shop around for rates. If multiple ADIs are looking for funds then there are multiple options to consider. Whereas during covid there have been very few ADIs looking for funds.
  • Negotiate on rate. Because ADIs need to raise funds, they will be more willing to offer higher rates, especially if it is to compete with an alternative ADI.

However, it is worth being mindful that the transition back to a more traditional negative funding gap will be gradual. ADIs on the whole remain very liquid, so it will take time to drain the excess liquidity.

There is also a limit to an investors’ bargaining power. ADIs have multiple channels to raise funds, especially the larger ADIs. They can issue bonds, NCDs, TDs, change at call account rates and so on. So there is a limit to what ADIs will pay to get funds in.

Australian Economy

Covid continues to have an impact on the economy and the outlook. Omnicron is not expected to completely de-rail the reopening of the economy but will likely slowdown the speed in which we emerge from lockdowns and restrictions. Almost all stage border restrictions are now wound back with Western Australia announcing they will finally open up on the 5th of February to fully vaccinated interstate travellers.

Data over the past month supported the narrative that we will see a pick-up in economic activity as the economy emerges from restrictions and people resume a somewhat normal level of activity with freedom of movement. Job advertisements continue to rise as employers look to rebuild workforces. There is also a lot of churn in the labour market which is driving up the overall level of vacancies as people take advantage of opportunities in the absence of immigration and people reassess their careers following successive lockdowns. However, employment growth hit a hurdle in October as it was just gathering pace, while the jump in the participation rate showed what can be expected as things open back up.

Retail sales were surprisingly strong while trade flows were weaker and building approvals continue to fall. Most importantly though, confidence from both business and consumers remains well above pandemic levels which bodes well for investment and consumer activity if we get a clear run from any future lockdowns or restrictions on the back of the Omnicron wave.

Joshua Stewart

Associate - Money Market