The RBA’s attempt to control yields has impacted the bond market

A decision that was made to ensure Australia stayed afloat during the pandemic is now wreaking havoc in the economy.

Throughout history, humanity’s attempts to tame things and bring them under our control has been a consistent driver of technological and social development.

From the first domestication of canines, all the way through to the harnessing of millions of tons of rocket fuel to jet us into space, we have already reached for that next horizon, even if sometimes it quite literally blew up in our faces.

But after millennia of achievements, there is still something that often finds a way to trip us up, the unpredictable realities of human nature.

This brings us to the recent failed attempts by the Reserve Bank to control something that may be untameable, Australia’s trillion dollar government bond market.

The bond market

Through the bond market, the federal government and the states and corporations borrow money from investors in order to fund projects or simply to pay their bills.

The interest rate or yield on the debt is determined by what rate the market (investors) is willing to lend at, based on the risk of the investment, the expected rate of inflation and a number of other factors.

The bonds market is what the federal government and states borrows money through.

By design, bonds are meant to be a liquid asset, as in they can be bought or sold with relative ease within a well-established and regulated market.

Due to this ease of transactions, they are traded often and the price can fluctuate significantly even over the course of a single day.

While the interest rate payable by the originator of the bond, say the federal government, remains the same across the life of the bond, the interest rate receivable by a potential bond buyer can vary based on the price when they bought it.

In the same way that the yield changes on an investment property when a new owner buys it for a higher price when the rent stays the same, so too the yield of a bond changes depending on its price when it changes hands.

The RBA tries to fix the game

At the height of the financial market upheaval in March of last year, the RBA announced that it was going to introduce yield curve control.

In plain English, the RBA committed to buying a specific government bond due to be repaid in April 2024, in order to ensure that the yield on the bond never significantly exceeded 0.25 per cent per annum.

By doing this the RBA attempted to ensure that the short term borrowing costs of the federal government and the states would be pinned to that 0.25 per cent rate for the duration of that bond, giving them substantial room to borrow money to fund the pandemic stimulus packages.

Yield curve control was introduced to help during the height of the global pandemic. Picture: Ian Currie

But government wasn’t the only beneficiary of the RBA’s attempts to fix the game.

By committing to ensuring bond market funding costs remained low, they also ensured that the banks could fund mortgages at these low rates for years to come.

In November 2020, the RBA revised down its target to just 0.1 per cent, effectively ensuring that short term borrowing costs would remain roughly at or below that level until April 2024.

But that was not to be.

Beach balls and the uncontrollable

For almost 18 months the RBA’s attempts to control borrowing costs was largely successful, amid a backdrop of broader economic uncertainty.

But as concerns continued to build over inflation, all of a sudden keeping borrowing costs in check got a lot harder and soon became completely impractical.

By attempting to suppress rising borrowing costs, the RBA was effectively holding a beach ball under the water as it tried to keep the market under control.

Despite the RBA’s previous attempts to hold on for dear life, borrowing costs out to April 2024 did what beach balls do when you hold them underwater, rocket higher.

On October 25, the RBA’s target bond sat a yield of 0.125 per cent, within reasonable striking distance of the central banks 0.1 per cent target.

Just four days later it hit a peak of 0.775 per cent, almost eight times the RBA’s target, amid rising concerns about inflation and rising global yields.

This is how Yield Curve Control ends ... it blows up in the central bankers' face (chart) and then Central bankers go to great pains to explain this was really all part of the plan.

I hope the Fed is taking notes.

*RBA SCRAPS APRIL 2024 0.1% GOVERNMENT BOND YIELD TARGET pic.twitter.com/sEdpsQZYHr

— Jim Bianco biancoresearch.eth (@biancoresearch) November 2, 2021

With that explosion in the relative cost of borrowing, the RBA’s attempts to rigidly control elements of the bond market effectively came to an end, with the RBA finally formally waving the white flag on Tuesday.

The aftermath and the consequences

While markets and economists will always sit up and take notice when the RBA releases a statement or the governor does a press conference, one would imagine that their forecasts are now being taken with more than pinch of salt, after their spectacular (by bond market standards) beach ball moment.

In the days since yields blew out, markets have calmed down. As of the close on Wednesday, money markets were pricing in three rate hikes by the end of next year, rather than the four that were expected late last week.

The RBA has now changed its tune on ruling out rate hikes before 2024, now taking a more data dependent approach rather than the blanket statements that have defined their recent rhetoric.

While the market is pricing in an aggressive rate hike cycle, it remains to be seen when rates will actually rise. Economists are widely split on the issue, with some suggesting it could occur next year, while others believe it could be toward the end of 2023 before the RBA finally pulls the trigger.

Ultimately, as this attempt to control what may be uncontrollable has shown no one knows the future, not even one of the most well-resourced organisations on the planet, especially now.

Tarric Brooker is a freelance journalist and social commentator | @AvidCommentator