–  AUGUST 2021 INSIGHTS BY THE CURVE TEAM –

Summary

RBA Recap:

  • The RBA stuck to its plan to slightly taper QE purchases by September.
  • Forecasts in the Statement on Monetary Policy for August largely showed a more optimistic outlook compared to May despite the recent lockdowns.

Markets Recap:

  • Market pricing for the RBA raising the cash rate was volatile over the month. Markets anticipated a backtrack on QE tapering due to lockdowns, only for the RBA to stick to its tapering plan.
  • Lockdowns and swathes of liquidity continued to weigh on rates, despite expectations that rates would begin to rise post TFF.

Investing Considerations:

  • The reality of lower rates for longer needs to become a central focal point of investment strategies.
  • A bar bell approach presents a risk adjusted way to increase portfolio yield.

Economic Summary:

  • Lockdowns remain the key variable for economic updates.
  • Delayed releases show the economy was still strong up until June but signs of weakness began to show when lockdowns commenced in July.

RBA Recap

Policy Decision:

The RBA surprised markets by opting to go ahead with its plan to taper QE purchases in September. At the July meeting they announced that once the current program of $5 billion a week of bond purchases expires in September, they would purchase $4 billion a week until November. With lockdowns across the country over July, markets had anticipated the RBA to back track on this plan and continue to purchase $5 billion until November. Instead, they will go ahead with the tapering as planned.

Otherwise, there were no changes from the RBA. Notably, they still believe the ‘central scenario for the economy’ is that the cash rate will remain unchanged until 2024.

Statement on Monetary Policy:

The Statement on Monetary Policy for August was released, which contained updated forecasts for the economy. Key assumptions for the forecasts include:

  • The Sydney lockdown being in place until the end of Q3
  • ‘A significant share of the population being vaccinated by the end of this year’.
  • International travel opening at least partially by mid 2022
  • Ongoing fiscal and monetary support.
  • A swift “V” shaped recovery from the recent lockdowns, similar to the growth in the first half of 2021.

The updated forecasts included:

  • Unemployment – Expected to be 5% by the end of the year, which is unchanged from May’s forecasts. If not for the lockdown this would have been even lower given current unemployment is 4.9%. Forecasts for unemployment for 2022 and 2023 have improved despite the recent lockdown, with 4% expected by December 2023. This is the rate where the RBA is confident wage driven inflation will begin.
  • Inflation – Has been upgraded for 2021, with annual inflation expected to be 2.5% by the end of the year, up from the 1.75% expected in May. It is expected to fall below the target band in 2022 before rising back to 2.25% in December 2023. These forecasts reinforce the RBA’s belief that the recent spike in annual inflation to 3.8% will prove to be transient.
  • Growth – Little changed from the May, except annual growth to December 2021 was downgraded to 4% from 4.75% due to lockdowns. This led to slight upgrades for 2022 as the RBA anticipates the economy will rebound when lockdowns are unwound.

Market Recap

Cash Rate Futures

A slightly hawkish RBA surprised markets. Prior to lockdowns ravaging the country over July, a cash rate of 0.25% had been fully priced in by October 2022. Over the month, markets began pricing in QE to remain at $5 billion a week until mid-November, which would delay tapering and therefore delay a cash rate rise. It resulted in expectations of 0.25% cash rate being delayed until 2023. Once the RBA confirmed it would go ahead with its tapering plan, markets once again priced in a cash rate of 0.25% by the end of 2022, albeit not as soon as October.

General Rates Remain Suppressed

Beyond the expiry of the Term Funding Facility (TFF) at the end of June, market rates across the curve were expected to gradually increase. Instead, rates have experienced an ongoing malaise.

Lockdowns are clearly putting downward pressure on rates, which has similarities to much of 2020. As people’s spending options are restricted, saving increases, providing elevated retail deposits for ADIs. Simultaneous to this, lending slows as incomes and the ability to physically see homes are impacted from lockdown. The extent of these effects is not yet available given the delayed releases of saving and lending data. Combine this with the $188 billion in total TFF drawdowns, which amounts to 6% of total credit and enormous balances held as excess with the RBA in ES accounts, rates across the curve have been suppressed. This is especially the case at the shorter end of the curve.

The general shape of the curve remains the same, which is very flat out to three years in line with the RBA’s yield curve target and TFF rate of 0.10%. Beyond three years, there is a sharper pickup in yields in line with expectations of ADIs raising funds to repay the TFF and multiple cash rate increases expected by that time.

Investment Considerations

The RBA and markets seem to be understating the impacts of recent lockdowns. Whereas last year the risks to the downside were overstated (using the benefit of hindsight), it seems the opposite now.

The RBA expects the current Sydney lockdown to be over by Q4, which seems optimistic given the growing case numbers despite strict lockdown measures. There has been little mention on new variants beyond delta proving difficult to contain. A sharp “V” shaped recovery, ongoing fiscal support and high levels of vaccinations are all assumed by the RBA and seemingly markets. Should any of these assumptions prove incorrect, then the economy would be far weaker than what is expected.

Investors should consider the prospect of:

  • Market rates (not the cash rate) remaining at the current very low levels until the end of the year. Only lockdowns ending by the end of September, in line with the latest RBA predictions, would see rates elevate materially prior to 2022.
  • Enormous amounts of system liquidity to keep downward pressure on rates, as the RBA has outlined it will, until the ADIs raise capital to finance repaying the TFF. April 2023 will mark the beginning of repaying the TFF, with the few months preceding September 2023 and June 2024 when the largest amounts are to be repaid.
  • The RBA struggling to increase the cash rate to levels the market expects. Markets are notorious for being poor predictors the longer the forecast period is. The current optimism has translated to a buoyant outlook for the cash rate and interest rates beyond three years. Increasing levels of debt due to current record low interest rates and the huge TFF refinancing task are just two factors that could restrict the RBA from raising the cash rate too high. Although the short-term outlook for the economy is very positive once lockdowns end, there are a range of factors beyond this that could derail a continuous increase in the cash rate.

Barbell Investing:

This outlook lends itself to a barbell investment strategy. Typically, this involves having a large portion (90% for example) of investments in very low risk assets, and a small portion (say 10%) in high-risk assets. This way, the overall risk remains low, but the higher risk assets can increase the potential return.

More relevant to the current outlook is its application to the tenor of investments, i.e. holding a large portion as liquid/short term and a smaller component long term. Because yields are so suppressed for terms less than three years, the pick-up in yield by investing for 12 months instead of 6 months, or three years instead of 1 year is very low. Once the term is beyond three years, yields pick up more sharply, as cash rate rises and TFF refinancing is priced in.

With no exposure to longer terms, portfolio yields would be very low given the current market rates. A barbell strategy would be a proponent of investing a small portion of the portfolio for long tenors, for example 5 years, which would increase yield without reducing the liquidity of the portfolio given the bulk of funds could be held short term. This would lock in the current higher rates at these longer tenors, which would also prove advantageous should interest rates not rise as fast as is expected.

The opportunity cost of keeping the majority of the portfolio at shorter tenors, say one year and less, rather than investing for two-three years would be low given the yield curve is so flat out to three years. This is particularly relevant for clients with access to a high at call rate. Having liquid funds will also enable you to invest in any opportunities that become available as interest rates rise, especially come 2023 when ADIs are set to raise a lot of funds to repay the TFF.

An example of applying the barbell strategy as opposed to a more traditional staggered maturity approach is below. The barbell approach has 80% of investments with a term of 12 months and under whereas the traditional example has 65%. So both are well placed in terms of liquidity, but using more of the portfolio for the longer tenor of 5 years proves advantageous in terms of the yield pickup.

The current market also lends itself to applying the barbell strategy to credit ratings. There is only a slight uptick investing in a BBB ADI as opposed to an AA rated ADI because rates in general are so suppressed. Putting most investments in AA rated or higher and a small portion in higher risk assets could potentially increase the yield of the portfolio without increasing overall risk. An added benefit of this is as interest differentials between credit ratings normalise, you will likely have more space in the policy to take advantage of A and BBB rated opportunities as they become available.

Australian Economy

  • Economic updates over the last month are largely outdated given lockdowns. Most data has been for the June period, which at most captures the end of June period where multiple states began lockdowns. It does not factor in the extended Sydney lockdown and the snap lockdowns of other states over July.

    The June data verifies the strength of the economy prior to lockdowns. Unemployment reached 4.9%, a remarkable recovery since the highs of covid. Inflation reached an annual rate of 3.8%, which was slightly higher than the RBA had anticipated. However, the trimmed mean remains at 1.6% annually, and the RBA believe the spike in the headline figure will be transient, with or without lockdowns.

    Of the indicators that captured the July lockdown period, the business survey showed the most drastic impact. Confidence fell 18.5% to be negative at -7.9. Conditions fell 13.5% but remain at 11.4 overall. Job ads declined but remain very elevated. The high levels are considered indicative of ongoing labour supply issues, rather than demand driven. Surprisingly, consumer confidence ticked up 1.6% as end of June and early July lockdowns were unwound for many states during the July survey period. As long as the Sydney lockdown remains in place and lockdowns in general remain a threat the economy will be limited.

Joshua Stewart

Associate - Money Market