Ep24: RBA ends QE and pushes back on rate hike

The RBA announced an end of QE and kept interest rates on hold as they wait to see stronger wage growth. If inflation continues to rise faster than forecast, and the RBA hikes earlier than expected, what could the knock-on effect be on markets? 

Tune in to hear Darren and Chris discuss this and more in episode 24 of The Rate Debate.

Transcript

Speaker 1: 0:01

Hello, and welcome to the first episode of the rape debate for 2022, having you year to all our listeners. I'm Darren Langer, co-head of fixed income at Yara capital. And joining me as my co-portfolio manager, Chris rans. Hello everyone. It's the first Tuesday of February. And I'm back after a few weeks away from the office and the market landscape seems to have already shifted it a lot, but as always, we're here to talk about what the RBA is thinking. Certainly, Chris, we, we saw a few changes today. Uh, the RBA kind of, uh, did what we expected and quantitative easing off the table, but a lot of, uh, a lot of the other speculation of, um, big changes, some of their forecasts also came about, but probably not to the extent the market thought, what, what we, what did you see?

Speaker 2: 0:44

I certainly thought that this was the first tightening of the cycle. So they've removed QE, you know, it might be unconventional policy, but it's still policy easing when they bring it in. So I certainly see this as the first tightening. I think the market was, was probably a little bit upset with the messaging that we've seen, because the RBAs telling us that the they're still gonna be patient because they wanna see inflation sustainably within that two to three band. So, you know, as Lowe told us in the past, it's not gonna be enough to see a, a one print in the band. We're gonna need to see it a couple of times to make sure that it sticks here.

Speaker 1: 1:14

Yeah, it was certainly quite a dovish statement, um, given that they actually tightened, uh, what we would call, uh, interest rates, uh, obviously they're of the actual rate policy rate didn't change. But as we've talked about before, you know, quantitative easing does have impacts on the overall level of rates and probably the currency as well, but, you know, they were pretty Sangu about the, the rest of the things, you know, there'd been a lot of cries out there for, for the RBA to sort of, uh, I guess, admit that they got it wrong. And, uh, um, and to some extent, yeah, the RBA has changed their forecast. They've certainly lifted their level of inflation from what it, what they had been. And, and they've certainly talking about slightly stronger growth and, and better wage and, um, employment outcomes, but, but they certainly were not, you know, talking about us style inflation and growth outcomes. Yeah.

Speaker 2: 2:03

That's probably kind of as good a point as ever to, to focus on here for the RBA and just kind of the differences in, in inflation that we're seeing at the moment. So, you know, the RBAs got core inflation at 2.6%, and that is square in the two to 3% ban that they've been targeting. When you look at the fed, or if you look at New Zealand, some of those countries have 4% core inflation and, you know, closer to 7% headline CPI. So certainly for us at the moment, we are not sitting in, in that situation. Maybe it will get there in the future, but from the RBAs perspective, they have said multiple times, as I said before, that they wanna see it sustainably there. And so the thing that I've kind of had a little bit of, I guess, struggle coming to terms with compared to the way the market is seeing it is we're starting to see people say that the RBAs losing their credibility. And you know, this is the first time they've been in that two to three band for about six years. And so it seems odd now to be questioning what they're doing when they've kind of had the policy in place to get us back there. Yeah.

Speaker 1: 2:57

I think you hit the nail on the head. You know, the RBAs credibility has been questioned quite a lot for missing the band. Um, they now have a smack bang in the middle of the band, at least as far as core inflation goes and, and suddenly they don't have enough credibility again, because they're, they're not following, um, what the market wants. I think realistically, it's a fair statement to make a, it doesn't mean that interest rates aren't gonna go up later this year or early next year, but the RBA is still saying that they really don't want to be in a situation where they tighten too soon and they kill off any chance of, um, growth in the future. And I, and I think that's why something we've been very, uh, critical of central banks globally, not just the RBA that they have tended to go far too quickly. And, and, you know, at a time when inflation it's a high by any means, um, relative to what's happening offshore. And certainly whilst you might be able to argue that the fed might need to tighten interest rates sooner than later. There's certainly not the case here.

Speaker 2: 3:54

Yeah. There's, there's also a few other things that kind of jumped out to me in the inflation figures that I think the I B a C certainly picked up today. The first of those is, if you look at the breakdown of inflation goods, prices are running at, you know, essentially 30 year highs, whereas services are about where you would expect to see them. And so that's really reflecting the supply chain problems that we've seen. That's forcing up goods prices. If you look through the breakdown of domestic versus international inflation, what you'll see is that inter national inflation is higher in Australia than, than the local sources. And certainly from the RBAs perspective, I think that this should raise two questions. The first of that is after 30 years of stable, good prices, do we think we're entering a regime now where they're gonna go up continually? Or is this just a, a spike because of the COVID supply chain issues? And then the second one certainly jumps to mind is if we reduce demand, does that even fix the supply chain issues that we're caught that we're seeing? Or is it just gonna cause some other problem? So I think that's why they're being a little bit defensive here and saying, look, we're still being patient because we just haven't seen this before. And we don't know, maybe it'll keep going, but we certainly don't know. And we don't wanna kill it early if, if

Speaker 1: 4:59

It's not. Yeah. And I guess that, that's also one of the things we need to look at is, you know, inflation running at 4% per anum has to keep going at 4% per anum. I, if it's gonna stay there, if we just hit 4% and then suddenly see inflation tail back to one or 2%, you know, we just to be back in the same boat that we've been the other few times over the last 10 years where we have seen a couple of big inflation prints, generally off the back of higher energy prices in oil being the main culprit, a and then we've seen it come back off again. So I, I think that will be in the back of the RBAs mind at the moment saying, well, we've seen this happen before everyone sort of told us we should be tightening last couple of times we thought about it and got pretty close this to we're just gonna wait and see. There's

Speaker 2: 5:43

Kind of one last thing that sits in my head and this probably doesn't really kind of relate too much to what the RBAs probably thinking at the moment. But certainly it's something that I come back to is before the kind of COVID supply chain issues. They had been overestimating their inflation forecast for essentially 10 years. And so certainly it seems maybe that in the back of their minds, they're thinking, well, when we go back to that environment, maybe we're still gonna be over forecasting. That doesn't mean that for the next kind of 12 months, there isn't the chance that it's gonna pick up. But I think from their perspective, they're saying we really wanna see it before we go. Yeah,

Speaker 1: 6:16

I almost, to me, there's one thing that makes me a little uncomfortable about being on the same side as the RVA in terms of our views is that they haven't been right very often.<laugh>, um, it, it's not a, not always a good feeling, but, but I think, you know, we we've got enough evidence, um, you know, in our own work that we can sort of see where the inflation's coming from and to have it sustainable, as you say, we've gotta see either a really big pickup in services inflation higher than what it has been or goods inflation continue to keep going. And we're, we're increasing good prices at rates, you know, never seen before. And we're in the middle of, you know, our pandemic, you know, it's hard to say that if the pandemic goes away, good price info will continue at the same pace. So that I guess is, you know, for us, we wanna see some evidence of post pandemic numbers rather than worrying about what's happening in the pandemic itself. So Chris, the RBA has, uh, decided to end QE. What that means is after the 10th of February this month, they won't be buying any more bonds. They still haven't actually told us though whether they will continue to reinvest maturities and things like that, or whether they will actually start the process of quantitative tightening. How, how do you think, um, it's likely to play out over the next couple of months and what do you think that ending of QE actually does to the overall level of, I guess, could it in the system and the ultimate level of interest rates, this is

Speaker 2: 7:42

Actually kind of the play that I was hoping to see from them. So when you look at what you, what you're seeing from the federal reserve at the moment, what they're saying is that they could remove QE and then tighten rates basically at the same time, I'm generally a little bit cautious when they start talking like that at because the quantitative easing that they've done was easing. I know it's unconventional. I know you can't see the effect on the cash rate, but a lot of the estimates that I've seen in the research tells us that it does take the kind of effective cash rate lower. So to put that into perspective, we talked about this kind of in mid 2020, when we were kind of hoping that the RBA would start the program, that to 10% of GDP purchases is equivalent of about a 1% rate cut the RBA through its bond. Buying purchases has bought about 300 billion. So that's about 15% of GDP. And that would mean that the, the rate effect is in the range of kind of one and a half to 2%. So the reason that I kind of say, I would like to see them, you know, stop this program and, and pause is we need to see what effect that's gonna have on the economy. You can kind of already start to see bits and pieces of that turning up. You know, we've got higher swap rates, that's flowing into higher fixed rate mortgages. You're starting to see, you know, bank spreads. You're starting to see semi-government spreads start to push out a little bit, that pushes up the cost of funding. And so the ultra low rates kind of come outta the economy. When you look across kind of different countries, you know, when the fed ended QE in 2014, it took them about two years before they could move rates. And when the ECB tried to end their QE program in 2018, they basically had to stop straight away. So it's been very hard to quantify what the effect is going to be. But I think when you're looking at it prudently, you know, that the best approach is probably in the program. And then let's reassess in three to six months time if we've caused any problems, because we know rates are probably gonna back up a little bit, especially in spreads and that's gonna cause high borrowing costs.

Speaker 1: 9:32

The other thing too, is that we're probably gonna see a few other central banks doing the same thing. We've had a lot of liquidity sloshing around in the system. It's created artificial problems in the bond market in particular, but, but you know, it flows through into other markets. So when we suddenly see, it's not just what, what the RVA does, but what the fed does and what the ECB does all at the same time, international markets suddenly you're gonna have, who's the main buyer of bonds in particular disappear, whether that helps liquidity in the, in the long run, whether it frees markets up to do what they should do it, it's hard to know because we've, we've really, haven't had many years in the last 10 or 15 where we haven't had some sort of quantitative easing somewhere in the world. So it'll be a, an interesting experiment from that point of view. But, uh, and I say interesting from a, I'm not sure what's gonna happen kind of view, but I don't think we really know the effects we, we did see in the us when they tried to remove quantitative easing once before it started to create other issues for, um, the fed in particular around liquidity and Revo markets and things like that. So there's a lot of moving parts to this, that people don't really understand. And we think, you know, it's not something you want to take off and then suddenly gem interest rates higher at the same time, because it could actually, um, exacerbate other problems that they haven't really even tried to think about yet. Yeah.

Speaker 2: 10:56

And I, I, this probably as well comes back to, I guess, the opportunity cost of, of what they're doing, you know, the, the fed the RBA, sorry today said that they're expecting core inflation to rise to a bit over 3% and then kind of drop down again in 2023, if that's your forecast and you've had core inflation running under the band for the, you know, the past six years, then being a little bit to, to hike the rate after you end QEs, I don't think gonna be a huge problem, but if you remove the accommodation too quickly and you cause problems, then you know, you might see that inflation figure drop down far faster. And so I kind of come back to the idea of, I don't know what it's going to do. It's very hard to quantify the effect, but the pastors told us, you need to be a little bit careful. This they're only forecasting inflation, just kind of above the band. So I, I don't think it's too much for them to kind of sweat over it at the moment.

Speaker 1: 11:45

So that brings us, I guess, to the, the thing many people wanna know about is how is it gonna affect the housing market or will it affect the housing market? You know, we've already seen rates, at least fixed rates starting to rise, um, in some cases as much as, you know, 150 basis points, um, that's even without the cash rate moving, you know, prices are still rising in, in December at least, you know, what, what do you think will be the outcome for housing over the next six to 12 months?

Speaker 2: 12:12

Yeah, I think when you look at the lead indicators, it's clearly going to be a, a tougher market for prices to rise this year than it has kind of for the past 18 months. Uh, we're already starting to see a bit of softening in the, the clearance rates for the auctions building approvals have started to drop off. And certainly the mortgage finance figures look like they're probably peak at the moment. So typically those things would, would point to probably close to the top, um, maybe kind of six months away. But when you put on top of that, the fact that 50% of the mortgage market was going through fixed rates and they've backed up 1%. It probably means we're a little bit closer than we expect. If the RBA is as patient as they claim they're going to be, then I probably wouldn't see too many problems for the housing market are slowing, but potentially sideways. If they kind of start hiking rates aggressively in the second half of this year, that's probably when I'd become more concerned.

Speaker 1: 13:05

So, Chris, it seems a bit ludicrous, I guess, to me to think that quantitative easing coming off, you know, we we've said that it was quite a, a large percentage of GDP. A lot of that has flowed into housing, not just from the level of interest rates, but just the availability of cash that people have. You know, are we being a little bit, um, I guess cute in saying that house prices will stay flat to unchanged unless we get a rate hike or do we really think they should be coming off a little more, even with that a rate hike,

Speaker 2: 13:36

When I kind of calculate the cost of finance on a house with interest rates where they are, I still think housing is relatively affordable. So if rates stay down here and the fixed rates are able to stabilize, maybe the Sydney and mark Sydney and Melbourne property markets that have had kind of the most, most profit in the them come under a bit of pressure, but places like Brisbane, Adelaide, Hobart, whether it's not quite as expensive, probably hanging there quite well. Once you start pushing rates up above kind of 1%, that's when the metrics that I use kind of start to come under pressure. And, you know, house prices have risen 30% from a, a one and a half percent fall in the cash rate. So I think it does stand to reason once we start moving them higher, we start to see that pain, but certainly with where interest rates are at the moment, it still seems affordable in terms of debt to income ratios and those types of things. Yeah,

Speaker 1: 14:27

I guess the, the other thing to take into account is that if we do start to see some pickup in wages, you know, people's capacity to borrow, probably isn't gonna change to automatically, unless rates do go up. So it's something to keep an eye on. Obviously, you know, rates affect the ability to, to pay interest, but they also affect the, the amount banks will lend to people. The level of housing prices are a function of available finance. So it's probably unlikely as you say, QE will have a huge impact on, on that ability to borrow and, and ultimately house prices. But certainly you wouldn't expect to see prices, you know, rapidly rising from here, which again, may take some of the froth out of the investor market as well. So, so I guess if we put down our Chris still ball and we look a little bit further out, some of the reasons that we think the RBA might wanna be a little bit cautious, um, and it's been interesting, um, sitting out for a couple of weeks and, and only seeing what's going on in the main sort of press, we've seen a, a few things where people are talking about the possibility of recession in the us, right at the time when they're actually talking about tightening interest rates, you know, we're in a situation past history, PBE, isn't that helpful for, um, how we come out of this particular, um, cycle, you know, we're in a situation that we talk about a lot where we have demographics changing very quickly. Automation are also a big part of what's going on out there. A and we've got reasonably high levels of debt across all economies yet we're still talking about, oh yeah, this is what happened in the 1990s and 1970s. A and you know, this is where we're gonna go to. Is it more complicated than that? Do you think it's a

Speaker 2: 16:08

Relatively tough kind of question to answer? And I think at the moment, certainly anyone who's probably listened to the rate debate over the past kind of two years will know that we're, we're kind of very bullish on rates being low for a very long time. The thing that kind of has got me to that view over the past five years is a combination of a few things. I think wages are going to struggle to rise in an aging of economy is, is probably one of the biggest kind of things that we see a lot of what the RBA is hoping for. A lot of what the fed and, you know, the ECB and the BOJ have been hoping for over the past kind of 10 to 15 years, is that wages pick up and with that people spending. But what kind of doesn't seem to be too well known is that as an economy, ages, wages, growth naturally slows because older people don't get the same wage gains that young people do, and we know the economy's aging. And so to expect that we're gonna see wages growth similar to the 1990s, take us into this, you know, beautiful pickup in, in growth to me, kind of just goes against what we've seen over the past last 10 years. That's kind of what builds into why I'm probably more bullish than others on rates staying low, because I think it's gonna be harder to pick them up. And as you said, all we've seen over the past 10 years is just a constant increase in debt. So every time they go to move rates, the person who's borrowed too much money seems to come out and say, you know, please stop doing that. But as you kind of point out before, or that's kind of jarring with some of the views of the market at the moment, because clearly the market thinks inflation is here to stay. And, you know, I kind of feel like a bit of a stick in the mud saying, well, hang on a minute, you know, it's just goods. It's, it's not services, there's all these things going on. What I would really need to see to be wrong is wages picking up into that four, you know, four and a half percent ban to really think that we're going into a new regime. There

Speaker 1: 17:56

Is a, a, a capacity in particularly market commentary to oversimplify problems. We think, again, you know, rates can go higher. We we've never, ever suggested they can't, but the magnitude of the rate hikes is limited by those factors. And unless something dramatically changes to affect that, you know, it's a trend that is been happening now. We've seen probably since the early, uh, 2010s and, you know, there's no sign of it changing, you know, even, even economies that are rapidly growing, China are aging and all those things are likely to have an impact on, on, on what happens with rate markets over the next, you know, two to, to 10 years. So, yeah, it'll be an interesting, uh, outcome to see if we're right. It's obviously said a lot of crystal ball gazing and we're certainly, uh, not in the camp that, uh, a lot of people agree with or even want to agree with. But, um, you know, these are the sorts of things that sort of sit in the back of our mind a and sort of, um, keep us awake at night, I guess.<laugh>. Yeah. And,

Speaker 2: 18:57

And I think to, to kind of pick up on that, the, the reason why I kind of I've been harping on about goods prices so much at the moment is that if you look at the raw index of good prices for inflation, they went nowhere from about 1999 through to 2020. And so you had this 20 year period where good prices went sideways. You know, people said it was demographics, it was automation. It was China joining the world trade organization, it's globalization. And then when COVID hit, suddenly goods prices have risen 15% in 12 months. It's a little bit complicated for me to say, well, this inflation going to be here forever. When the thing that is driving, it was something that was in a very kind of sticky trend, not going anywhere for reasons that we kind of understood. So again, that's probably not quite a sexy to say inflation's here to stay, but I, I think that's the big thing that the RBA needs to grapple with here. How real do you think this is? If it's a new regime, then rates gonna go much higher. And if we back off to where we were before, then we, we could be stuck at zero for, for longer than the market expects. Yeah.

Speaker 1: 19:58

It would be very easy to be flipping and just say the, the cure to all economic yields is the pandemic. Cause that, that ultimately seems to me what's happened. But yeah, I, I, I tend to agree. It's um, we gotta wait to the end of the pandemic to see you where things end up settling, I guess. So that's it for the month. I think if you ever want to suggest topics or discuss further anything with Chris and myself, we can be contacted@theratedebateatyaracm.com tune in next month, when we deliver our latest thoughts on the RBAs March rate decision and provide an update on what's been inhabiting in markets until then stay safe.

Speaker 3: 20:36

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